Bankruptcy is going to visit many firms over the coming months, but it does not have to be a mystical, fear-inspiring word. The grim reaper will not come to visit you at night and Rumpelstiltskin will not be coming to take your firstborn if your business goes bankrupt. The full term is bankruptcy protection. It prevents debtors from being pursued after they have gone through the process. So, say the firm you work for (or an important firm in your community) has filed for bankruptcy (protection). What happens next?
Contrary to popular belief, a bankrupt firm does not get swallowed by the ground and turn into nothing. Almost every business has valuable assets; the existence of high levels of debt does not change the value of the assets in the business. Even service businesses have valuable assets such as intellectual property and processes for utilizing human capital. When a firm enters bankruptcy, the pile of paperwork that a corporation really is becomes worthless (it’s more complicated than that, but this is sufficient explanation for our purposes). However, the things that were used by the business to make money are unchanged. Those assets will be sold off to pay back creditors or, in some cases, a new structure is created utilizing the same assets. Regardless, they are repurposed for a (hopefully) more productive new life. There’s a good chance most employees will keep their jobs with the primary difference being that their labor is put to more productive uses than servicing a massive pile of debt. In the event employees do lose their jobs, it is also important that our safety net is strong enough to catch them, but that’s a separate conversation.
Who, then, loses in a bankruptcy? Equity holders, certainly. Most of the time they lose their entire investment. Creditors would also take a hit, but depending on the seniority (priority for receiving payment) of the debt, they could recover most of their investment. This is all natural; equity holders take the biggest risk, but they also have the best upside. It also enforces responsible business practices. Businesses that take on high levels of debt are generally approached with more caution by investors and this is how the market encourages responsibility.
All of this can cause pain. Well-run businesses can be victims of circumstance and the collapse of a poorly run firm can still negatively impact a community. In a perfect world, government steps in and gives people a helping hand while assets get restructured in a business cycle downturn. We do not, unfortunately, live in a perfect world. Rather than helping people and letting poorly run companies die, we prop up the companies and assume they will take care of the people. Firms may be treated differently based on political connections, too, and advantage goes to older, well-established firms in the bailout lottery. There is nothing insidious going on with that. The squeaky wheel gets the oil, after all. It’s not capitalism, though, and what happens afterwards is continued high pay for poorly performing executives (for more on executive pay, check out my post on CEO pay here), and layoffs still come for lower-level employees as cost-cutting becomes the name of the game. So, who is really getting the biggest benefit here? You’ve probably guessed it: shareholders! That includes people with 401(k) retirement accounts and pension funds, but the people with the largest proportion of their money in stocks are those with lots of it. Wealthy people are getting the advantage in this game.
That’s not to say there is no place for intervention. During brief periods of extreme distress, some reassurance is important to keep things like payroll functioning (corporations often rely on short-term debt markets to bridge their needs for cash even if they have healthy books). Still, it’s also important that we do not overuse this tool, because it exacerbates inequality and puts younger firms at a disadvantage. The pace of innovation slows and we all suffer. The danger is turning our market economy into a quasi-command economy.