Bailing Out on Bankruptcy 

Bailout vs bankruptcy

Recent government bailouts of private businesses have generated debate about whether the time-honored institution of bankruptcy is the appropriate mechanism for dealing with big business insolvency. Naysayers of the TARP bailouts contend that rescued businesses are candidates for bankruptcy and that bolstering them with public funds not only fails to address underlying problems but erodes the purpose and uniform application of federal bankruptcy law.

Whose losses are these?

One of the basic tenets of a free market is that a corporation’s shareholders and lower priority debt holders enjoy the profits when a business is up and bear the losses when it is down. This notion is consistent with both liquidations and reorganizations in bankruptcy, but it is at direct odds with bailouts funded by taxpayers. The bottom-line effect of the bailouts is to substitute reductions in the disposable income of taxpayers for reductions in the disposable income of shareholders and non-insured debt holders of distressed businesses.

Toss those, keep these.  Who decides?

Should deciding which private companies deserve to be bailed out and which do not be the job of the government? Is bankruptcy (or its banking counterpart, FDIC receivership) really a viable option for some businesses but not others? To be sure, WaMu, Wachovia, and IndyMac have cycled their way through the FDIC, and Lehman is wending its way through bankruptcy. But the roster of companies rescued from the bankruptcy ringer by TARP payments (http://www.opensecrets.org/news/2009/02/tarp-recipients-paid-out-114-m.html) is much more impressive: Citigroup, AIG, JP Morgan Chase, Wells Fargo, GM, Goldman Sachs, Morgan Stanley, American Express, Chrysler, and on and on.

Looking back on bankruptcy

The bailout trend is new and disturbing, but just how “time-honored” is the practice of corporate restructuring in bankruptcy? Bankruptcy law, or some variation thereof, has existed since the days of the Roman Empire. Our modern bankruptcy law has its origins in British bankruptcy statutes dating back to the sixteenth century, but bankruptcy in the form of corporate reorganization is a relatively new phenomenon.

Once a prison, now a sanctuary

Bankruptcy today is generally a voluntary proceeding initiated by the debtor, although it can also be an involuntary proceeding brought by creditors. Early bankruptcies were always involuntary and often resulted in the imprisonment of the delinquent debtor. Today, bankruptcy today can mean the liquidation of a business and the closing of its doors, or the sophisticated restructuring of debt and the continuation of business. Early bankruptcy always involved the liquidation of a debtor. Early bankruptcy was more an “inglorious end” than the “fresh start” we associate with bankruptcy today.

Individual United States colonies adopted various versions of British bankruptcy law. Although imprisonment often remained an option, along the way some debtor-friendly modifications such as property exemptions were added. Section 8, Article I of the Constitution authorized Congress to establish uniform laws on the subject of bankruptcy, but uniformity was slow in coming.

It was not until the enactment of the Bankruptcy Act of 1898 that modern bankruptcy law began to evolve in earnest. Slowly the law began to focus on the rehabilitation of over-extended debtors and the creation of equitable compromises for different classes of creditors. The Chandler Act of 1938 created specific bankruptcy proceedings to allow public and privately-held companies to reorganize instead of liquidating their assets. With that, bankruptcy was on its way to becoming a survival tool instead of a death sentence.

Businesses opt for user-friendly update

The Bankruptcy Reform Act of 1978 made it significantly easier for businesses and consumers to reorganize rather than simply liquidate debts. As modern bankruptcy practice began to take shape in the 1980s, corporate reorganizations moved out of the shadows and into the light. Before that time, major corporations generally did not opt for bankruptcy.

As recently as the 1970s, major corporate bankruptcy was still an oddity. The only two well-known corporate bankruptcies in the 1970s were Penn Central Transportation Corporation in 1970, and W.T. Grant Company in 1975. But beginning with the 1978 Act, bankruptcy became a legitimate option for sophisticated corporations in need of financial overhauls.

Giving legislative history its due

Somewhere in the last 30 years, corporate bankruptcy became a household phrase and a socially acceptable choice for insolvent businesses. Thirty years does not a “time-honored” institution make. But the prioritization of debts in a bankruptcy reorganization has a long and convoluted legal history that should not be ignored.

Objections concerning political impropriety and socialism aside, it may be that government bailouts are efficient and even judicious in a time of economic crisis. But at a minimum, when the injection of equity capital comes from the public sector, the bankruptcy blueprint for prioritization of claims should be observed. To some degree, the offensiveness of taxpayer subsidies would be ameliorated if shareholders and lower priority debt holders were pushed out of the game until the corporation’s assets are sufficient to cover its other liabilities.