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Bankruptcy is the financial and legal result of failure to pay off outstanding debts by a person or an organization. It has become very common all over the world because of rapid economic growth and the problems caused by this. In recent years, huge corporate bankruptcies have been witnessed, such as the Lehman Brothers bankruptcy filing on September 15, 2008, with $639 billion in assets and $619 billion in debt. Policy makers have tried to find the best way to overcome the serious economic problems caused by the increasing number of bankruptcies. While the United States has adopted reforms designed to limit access to bankruptcy procedures, the United Kingdom and Japan have implemented reforms to encourage more filings.
The terms bankruptcy and insolvency are often confused, but there is a subtle difference between them. While insolvency is a financial state of being unable to repay debts, bankruptcy results from a legal adjudication that stems from this failure.
Contrary to the common view, bankruptcy does not mean disappearance of the bankrupt company. It is a legal mechanism that allows creditors to take over the assets of the debtor. The main aim of modern bankruptcy procedures is to allow the debtor to have a new and fresh start and the creditor to be repaid.
In case of insolvency, the creditors may file a bankruptcy petition. However, bankruptcy is often initiated by the debtor. Bankrupt debtors generally have some assets to pay off some of their debts. But these assets are not enough to pay off all the debts. Bankruptcy court adjudicates bankruptcy by appointing a trustee, who closes the company and auctions off the assets. Then, the appointed trustee creates a list according to which the creditors collect their money under the control of the bankruptcy estate.
The word bankruptcy is derived from the Italian banco rotto (“broken bench”). This term is formed from the Ancient Latin bancus (for “bench” or “table”) and ruptus (“broken”). In the early 1800s, people used to come together in marketplaces. Merchants would set up their businesses on either tables or benches in these common areas. Even bankers had a bench and operated their transactions on it. When merchants or bankers could no longer afford to stay in business, they broke their bench to declare to the public that their activities were ended. Therefore, the meaning of this word comes from the habit of breaking the bench by bankrupts.
Some choose instead to derive the word from French banque (“table”) and route (“trace”) by referring to the sign of a table left on the ground. Those who advocate this idea take the origins of bankrupts to the Ancient Roman mensarii or argentarii, who had their tabernae or mansae in certain public places. When they made off with the money that had been entrusted to them, they left the sign of their former station behind them.
Bankruptcy used to be considered a shameful last resort. However, later, its important role in solving serious financial problems was accepted. The rise of debt in recent decades has led to the creation of bankruptcy systems in the jurisdictions of many countries. Even countries that have had bankruptcy systems for many years, such as the United Kingdom and the United States, needed major reforms in their jurisdictions because of the increasing levels of bankruptcy in recent years.
In Ancient Greece, if a man could not repay his debt, his wife, children, and servants were forced into debt slavery till the creditor recovered the losses through their physical labor. Debt slavery was limited to a period of 5 years, and debt slaves had protection for life. But servants of the debtor could be retained beyond 5 years and even forced into lifelong service. Unlike other types of slaves, the masters of debt slaves could not kill them or remove any of their limbs.
The roots of U.S. bankruptcy laws come from English laws dating from the 16th century. England first introduced a law (Act of Henry VIII) related to the issue of bankruptcy in 1542. A criminal statute was directed against men who made very prodigal expenditures and then failed to repay. Until the 18th century, debtors were punished by imprisonment in England. In the 18th century, the development of debt discharge became the main point of interest. Thus, bankruptcy law, which was designed to punish the debtor, evolved into a law that protected the debtor while encouraging resolution of the outstanding debt. Modern laws focus less on punishment of the debtor and more on rehabilitation of the person or company. So debtors will be able to manage their financial balances, and the economy will be protected from the adverse effects of bankruptcies.
The Bankruptcy Act of 1800 in the United States emphasized creditor relief and did not allow debtors to file for relief voluntarily. Because of public disapproval, this act was repealed after 3 years. The first modern Bankruptcy Act in the United States came into effect in 1898 and became the basis for current bankruptcy laws. In 1934, the U.S. Supreme Court ruled that bankruptcy laws were designed to give debtors a fresh start by removing previous financial burdens. The goal was to provide a new opportunity, which was no longer related to former mistakes. The Chandler Act of 1938 gave unique authority to the Securities and Exchange Commission for the administration of bankruptcy processes. The Bankruptcy Act of 1941 offered debtors more protections and allowed them to file for bankruptcy relief voluntarily. The Bankruptcy Reform Act of 1978, which entered into force in 1979, replaced the old bankruptcy laws and is still in effect today. This law made it too simple for consumers and companies to file for bankruptcy and recover their debts. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made several significant changes to the U.S. Bankruptcy Code. The U.S. government designed the act to limit consumers’ access to and increase the cost of liquidation-type bankruptcy procedures. Chapter 7 of the U.S. Bankruptcy Act allows debtors to get rid of most of their debts, which usually leads to liquidation. Chapter 11 helps a business stay alive by encouraging negotiation. Chapters 12 and 13 are reorganization programs designed for individuals. Chapter 12 is designed for owners of family farms, while Chapter 13 is for everybody else. As of March 2015, bankruptcy filings totaled 911,086 in the United States; of these, Chapter 7 filings totaled 596,867, while Chapter 13 filings totaled 306,729.
Personal bankruptcy is a legal procedure for people who are unable to pay off their debts. Modern legal systems allow an individual to declare bankruptcy and include debt relief. Debt is the result of spending more than one’s income in a certain period. If anybody continues to spend more than his or her affordable limit, bankruptcy will be inevitable. Some groups of society are more prone to debt problems than others. For example, young people have been pointed at as the most vulnerable group. There is no doubt that excessive amounts of consumer credit have played a significant role in bankruptcies. The increasing debt problems of households have led governments all over the world to create efficient personal bankruptcy procedures. Personal bankruptcy procedures, which lead to partial or total relief of outstanding debt, have been the solution to depressing debt problems in Anglo-Saxon jurisdictions. This solution process has also been increasingly common in European countries as well as in the industrialized Asian countries.
In all modern legal systems, a key question is why debtors file bankruptcy. Unemployment, family breakdown, and loss of financial overview are the main reasons for personal bankruptcy. As national income and consumer spending rise, the personal debt level increases. When personal debt becomes common, household financial distress rises. This situation is the chief antecedent of high bankruptcy rates.
In countries with bankruptcy systems that offer less generous relief, fewer debtors file for bankruptcy. When the legal system offers more generous relief, more debtors file for bankruptcy. Ronald Mann, who has conducted an extensive study of variation in the levels of consumer credit in several countries, compares the filing rates in several jurisdictions with a view to explaining what factors influence the different bankruptcy per capita rates. As of 2004, there were 930 filings per million residents in the United Kingdom, 1,300 filings per million residents in Australia, 3,100 filings per million residents in Canada, and 5,500 filings per million residents in the United States. Personal debtors in the United States file for consumer bankruptcy more often than those in other countries. This difference is not because they have a lax attitude to repayment of debts but because they have more debt. However, legal and cultural factors have influenced filing behavior. For example, when Canadians are overindebted, they seem to have a lower threshold of filing for bankruptcy than debtors in comparable situations in other countries. The easy access to bankruptcy in Canada, with low up-front payments and fewer requirements for a judicial determination, may be the reason for this.
In the United States, people can use two different ways to file for personal bankruptcy. It is possible to meet all or part of the debt with the direct liquidation procedure under Chapter 7. This way is suitable for people who have large amounts of debt and insufficient income. The second way is suitable for people who have enough income to repay their debt in a reasonable amount of time. In this situation, debtors repay all or part of their debt according to a payment plan under Chapter 13. In spite of the advantages of personal bankruptcy, it has negative consequences as it remains on one’s personal credit report for 7 to 10 years. People with low credit scores usually face problems in obtaining loans, or higher interest rates are applied to them due to their financial risk.
Bankruptcy laws allow personal debtors to keep certain assets, such as common household goods. Thus, a basic standard of living is provided while repaying the creditors. For this reason, if a debtor has no wages and no property, it is called judgment proof, meaning a judgment would have no impact on his or her financial situation.
Corporate bankruptcies occur when shareholders exercise their right to default. Because of the limited liability of shareholders, they can avoid meeting all their debt obligations. A limited liability structure allows the assets of a company to be considered separate from its owner. Thus, the personal assets of the owner are protected from the bankruptcy process, which has some direct and indirect costs for companies. Direct bankruptcy costs are fees paid to lawyers, accountants, consultants, and other professionals involved in the process. Other expenses that are directly related to the bankruptcy process and administration of this process are accepted as direct costs of bankruptcy. Lawrence Weiss found that the average cost of bankruptcy is about 3 percent of the total book assets and 20 percent of the market value of equity in the year prior to bankruptcy. Bankruptcy is more costly for small firms and firms that have more growth opportunities.
Indirect bankruptcy costs are economic losses incurred during the bankruptcy process. These losses may be caused by inefficient decision making in a company due to the required approval of the bankruptcy court in business decisions. Additionally, focusing on the bankruptcy process instead of the main activities of the company by managers gives rise to inefficiency. Indirect bankruptcy costs also include loss of consumers, loss of important suppliers, loss of key employees, and missed investment opportunities. It is almost impossible to measure the indirect costs of bankruptcy.
The threat of bankruptcy may minimize or discourage debt financing. Bankruptcy is more likely to occur for leveraged firms that are unable to make more interest and principal payments. Therefore, cost of bankruptcy is an important factor of capital structure. More debt creates a larger tax shield but leads to higher bankruptcy costs. According to the trade-off theory of capital structure, optimal capital structure will be determined by the balance between benefit of tax shield and cost of bankruptcy. Tangibility is an important factor to determine how serious the bankruptcy is. A company with more tangible assets is exposed to less bankruptcy costs than a company with more intangible assets. It is easy to convert tangible assets to cash, but such a conversion is difficult for intangible assets. According to Merton Miller, the supposed trade-off between tax shields and bankruptcy costs looks like the recipe for the fabled horse and rabbit stew. In other words, bankruptcy costs are unimportant compared with tax shields. But some other scholars reject this idea and emphasize the importance of bankruptcy costs.
The bankruptcy process in the United States may be initiated by the creditors, but in the case of public corporations, it is usually the firm that decides to file. Two procedures that are commonly used are Chapters 7 and 11 of the Bankruptcy Act. The purpose of Chapter 7 is to oversee the firm’s death, while Chapter 11 seeks to nurse the firm back to health. Chapter 7 is used for small firms, and it means the end of the road. Chapter 7 process is often initiated not by the firm but by its creditors. Large companies that cannot meet their debt obligations try to rehabilitate their businesses with the procedures described in Chapter 11.
- Brealey, Richard , Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance, 10th ed. Singapore: McGraw-Hill Irwin, 2011.
- Mann, Ronald “Making Sense of Nation-Level Bankruptcy Filing Rates.” In Consumer Credit, Debt and Bankruptcy: Comparative and International Perspectives, J. Niemi, I. Ramsay, and W. C. Whitford, eds. Oxford: Hart Publishing, 2009.
- Miller, Merton H. “Debt and Taxes.” The Journal of Finance, v.32/2 (1977).
- Weiss, Lawrence A. “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims.” Journal of Financial Economics, v.27/2 (1990).