What is Bankruptcy?

Many of us have experienced difficult times in our lives. Due to recent economic events, many people are experiencing tough economic times. For some of the younger people in the population, this is the toughest time they can remember. For those of us who have been around for a while we can remember tougher times. However, when we find ourselves in the middle of economic tough times, we often do not know where to turn. Many of us will turn to our faith at these times and others will seek help from friends, family, or even the government.

Companies also experience hard times not knowing where to turn either. The recent bailout mania in Washington has demonstrated that many of these companies are turning to the government to bail them out. In last weeks posting “Bailout Mania” we determined that simply bailing out failing organizations is not a good idea. This week I want to take a few minutes to explain why bankruptcy is a viable option for organizations finding themselves in difficult times but there is much confusion as to what bankruptcy is. So, let us begin by explaining what bankruptcy is.

The Bankruptcy Act was passed by congress to provide an organized procedure for, under the supervision of a federal court, dealing with insolvent debtors. It provides two methods for dealing with insolvency, chapter 7 and chapter 11. Under bankruptcy protection a means for the creditor to receive some measure of payment of the debt while giving the creditor an opportunity for a fresh start is developed.

Under chapter 7 bankruptcy, also known as liquidation or straight bankruptcy, the debtor individual or organization is required to disclose all assets they own. The individual or organization then is required to surrender these assets to the bankruptcy trustee who sells or liquidates the assets and distributes the proceeds to creditors in accordance with the relative rights of the creditors under the law. When an organization files chapter 7 bankruptcy, the company goes out of business leaving the employees unemployed and customers having to go elsewhere to purchase the products or services they previously received from the now liquidated company.

Under chapter 11 bankruptcy, also known as reorganization bankruptcy, the debtor seeks a business plan where they, under the supervision of a federal court, can solve their financial problems. The organization continues to do business but its operations may be curtailed if so ordered by the court. Under this form of bankruptcy, only those employees affected by any court ordered curtailment of operations loose their jobs. In addition, customers are still serviced by the organization but possibly at a lower level to court ordered business curtailments.

Chapter 7 bankruptcy is generally is not a viable business strategy for turnaround since the company goes away. However, chapter 11 does provide a viable option for companies in financial difficulty and many companies in business today have used this option to turnaround their operations. One example of this is Delta Airlines whose jets are still flying in our skies today.

This week we witnessed the CEO’s of the big 3 automakers flying to Washington in their private jets seeking a bailout from Uncle Sam for their financial difficulties. This prompted the members of congress, who were initially positive to the idea of bailing out the automakers, to take a second look and put any potential bailout on hold until the automakers could return with a plan for turning around their ailing companies. This also prompted President Elect Obama to issue a statement about the possibility of a bankruptcy package to rescue ailing automakers. It is unclear what the specifics of such a bankruptcy package would be, but if it involves a chapter 11 bankruptcy where the automakers, under the supervision of the court, will develop a plan to turnaround their ailing companies. The option should be seriously considered.

If nothing is done, these companies will eventually run out of cash causing them to begin defaulting on their obligations. This could force the companies into a chapter 7 liquidation situation. This would mean that thousands of people working for these companies, and employees of creditors who will be hurt financially, to go on unemployment overnight. This will not only be devastating to the finances of the laid off people but will place a strain on already strained federal and state budgets affecting all taxpayers. Before it is too late, a chapter 11 form of bankruptcy reorganization for automakers needs to be considered so that many jobs are saved. Please feel free to comment on what you think.