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.

Mike Tyson

The former world heavyweight  once had an estimated worth of $300 million. But with an incredibly lavish lifestyle — including pet tigers, a custom-built Bentley, and a removable glass roof on his mansion — his wealth quickly vanished. He filed for bankruptcy in 2003.

Rapper M.C. Hammer

Rapper M.C. Hammer reportedly spent more than $33 million in two years. When he filed for bankruptcy in 1996, he claimed to be about $14 million in debt.

Dorothy Hamill

The 1976 world figure-skating champion who bought the Ice Capades faced tough competition from Disney’s World on Ice. Hamill’s marriage collapsed, and she was forced to sell the Ice Capades at a loss and declare bankruptcy in 1996.

Francis Ford Coppola

Although the acclaimed movie director won five Academy Awards in the 1970s, he was less fortunate in the 1980s. Three big box-office flops — Rumblefish, The Outsiders and One from the Heart — forced him to seek protection from creditors under Chapter 11.  He filed for bankruptcy in 1990 while shooting The Godfather III.

Kim Basinger

In the early 1990s, the Oscar-winning actress was ordered to pay Main Line Pictures about $8 million for backing out of the movie Boxing Helena. The ruling forced her to sell Braselton, Georgia — a town she bought as an investment — at a loss of about $19 million. She filed bankruptcy in 1993.

Anna Nicole Smith

In 1996 the Playboy Playmate  was ordered to pay $830,000 to a former employee who accused her of sexual harassment. Although Smith was battling for a cut of the billion-dollar estate of her deceased husband, oil tycoon J. Howard Marshall, she filed for bankruptcy.

Burt Reynolds

After his highly publicized divorce from Loni Anderson in 1993, the actor sank deeply into debt, owing an estimated $10 million. He declared bankruptcy in 1996.

Don Johnson

The Miami Vice star  filed for bankruptcy in 1994 to protect his $20 million Colorado ranch from creditors. Johnson managed to get his finances in order, pay off his debts, and emerge from Chapter 11 still owning his ranch.

Gary Coleman

Citing years of financial mismanagement, the former child star filed bankruptcy in 1999. At the time he said, “This is the last step in 10 years of steps to mitigate and eliminate the dead weight of the past.”

The last resort

You can’t make your mortgage payment. Or you’ve lost your job and are faced with a mountain of credit card debt. Either way, you’re a casualty in the nation’s economic avalanche and you find yourself contemplating the last resort — bankruptcy. Bankruptcy is a choice more and more Americans are willing to make these days. Bankruptcy filings peaked in 2005, when more than 2 million American individuals and businesses rushed to file before a more creditor-oriented law went into effect, according to AACER, a bankruptcy data firm. Filings fell considerably in 2006 and 2007, but in 2008 climbed back up to 1.1 million.

The larger economic picture

The vast majority of filings are personal bankruptcies. The swelling tide of foreclosures is taking its toll. People are struggling in today’s economy, and it’s showing up in the bankruptcy courts. According to AACER, in February of this year, bankruptcies took their biggest year-over-year jump – 37 percent – since the bankruptcy law changed in 2005.

Coming soon to a debtor near you

Bankruptcy can offer a fresh financial start, although it will remain on your credit record for up to ten years, which may make it impossible to obtain competitive interest rates on loans. Many people, however, already have poor credit records when they file and have nowhere to go but up. So, how do you know when it’s time to file? There are no hard and fast formulas, but here are some common indicators:

• You are dipping into your retirement savings regularly.

• Your wages are being garnished by creditors.

• You have large credit card debts and are able to make only the minimum payments.

• Your house is in foreclosure proceedings.

A little something for everyone

Home ownership status and income level are some of the factors in determining whether you file a Chapter 7 bankruptcy or a Chapter 13. Under Chapter 7, many if not all of your debts can be canceled, with exceptions including unpaid child support, student loans, and some kinds of taxes. If you have regular income in excess of a certain amount, you may have to file under Chapter 13, which involves paying back some or all of your debts over a three- to five-year period.

Chapter 13 can be the preferred route if you want avoid a foreclosure, and if you have significant equity in your home or car. In a Chapter 7 case, you remain at risk of foreclosure if you can’t bring your past-due mortgage payments current. In Chapter 13, you can pay your mortgage arrearages over three to five years.

Also, Chapter 13 allows you to keep some kinds of non-exempt property that you would have to give up under Chapter 7, including equity in your home and car. But many people who file under Chapter 13 fail to complete their debt repayment plans and end up converting to Chapter 7, sometimes losing the houses and cars they were trying to keep.