Business bankruptcy occurs when a commercial organization does not have sufficient readily available funds (capital) to pay its current debts. Further, the business is either unable or unwilling to sell its assets, or to use debt (by borrowing capital) or equity (by selling ownership shares), to pay such obligations. As a result, the owner(s) declare(s) the business to be bankrupt. This declaration in most developed countries invokes laws and procedures designed to protect the interests of both the owner(s) and the creditor(s) in an orderly fashion. In the United States, the declaration and resolution of a business bankruptcy is most often governed by the provisions of Chapter 11 of Title 11 of the U.S. Commercial Code. Hence, although a business may also file under the provisions of Chapter 7 or Chapter 13, reference is usually made to a business being “in Chapter 11.”
Business bankruptcies are a fact of the life cycle of some businesses and of the economic cycle in general. During the decade from 1995 through 2004, despite such high-profile filings as WorldCom (US$104 billion) and Enron (US$63 billion), the relative rate of business bankruptcies in industrialized countries worldwide decreased by almost 10 percent. The typical rate of business bankruptcy filings worldwide is less than 1 percent of all organized businesses, although it is often difficult to discover data separately reporting business and personal bankruptcy filings. In the United States, bankruptcy filings of all types—both business and personal—from 2000 through 2005 ranged between 1.3 million and 1.7 million each year.
Direct and Indirect Effects
U.S. bankruptcy filings directly affect tens of millions of new persons annually and many more tens of millions of persons indirectly. Those directly affected are generally the laborers, managers, long-term lenders of secured capital, and owners, including shareholders. These individuals and organizations, as direct participants in the business, have a vested interest in the vitality of the business. Thus a business failure usually impacts them more immediately and more severely. However, a business bankruptcy may also harshly affect indirect participants in the business, such as suppliers of raw materials, customers down the supply chain, and especially the residents of the cities, regions, and national economies of the bankrupt business.
The direct effects of bankruptcies are usually reported first, as they are the easiest to measure. Among these are the impacts on the financial investment in and the human capital of the business. The effects on the financial investment tend to be the loss of capital invested, including reductions in revenues and profits and, if it is a publicly traded company, the drop in share pricing. The effects on the human capital are, bluntly, the job losses associated with the bankruptcy and subsequent restructuring or sale of the business.
As an example of indirect effects, an automotive industry analysis stated in June 2006 that 24 percent of parts suppliers to the world’s automobile companies themselves faced fiscal danger as a result of the near bankruptcy of their clients, in addition to the US$60 billion in parts supplier company bankruptcies since 2001 in North America alone.
As a specific example of some of the human fallout of a business bankruptcy, consider that all 21,000 Enron employees were eventually fired—5,000 of them the day after the bankruptcy filing. All had their company-paid health insurance coverage terminated upon dismissal, and none of those under the age of 50 was able to sell any of the Enron stock held in his or her pension plan until that stock had lost over 98 percent of its value. While this is dire in itself, the larger picture includes all those persons and their families who had invested their savings directly in shares of Enron or in pension and similar funds that invested heavily in the company. It also includes all those creditors and their employees and their families who had extended credit to Enron. Two years after the bankruptcy filing, the company still owed more than US$31 billion and ultimately never paid most of that debt.
Related Social Problems
While it seems clear that the most obvious effects of a bankruptcy are economic, it also seems reasonable to project that many social ills—physical and mental abuse, development of chemical dependencies, heightened racial or ethnic tensions, criminal activity, and self-destructive behavior—may find key sources in the direct and consequential effects of business bankruptcies. However, little research is readily available that investigates the “social cost” of bankruptcies. Despite the many studies conducted on social issues arising from unemployment and depression, few, if any, link these issues directly to bankruptcy. It is tempting to extend these results to stress, long-term depression, and other ailments that may arise from unemployment, financial uncertainty, or social unease experienced by a person affected by a business bankruptcy.
A recent Harvard University study concluded that illness and medical bills caused half of the nearly 1.5 million personal bankruptcies in the United States in 2001 and affected a total of nearly 2 million people. However, this is the inverse of a research finding that reveals clearly identified cause-and-effect data showing that business bankruptcies create social problems.
A paper published by the European Bank for Reconstruction and Development puts forth the concept that bankruptcy is one of the clearest indicators that an economy is open and market oriented. The rationale is that bankruptcy is the result of the community limiting credit to ventures that do not succeed in producing marketable goods at a sustainable return on investment. It is worthy of note that this rationale is somewhat circular, in that the bankruptcy of a going business concern has multiple and usually profound effects on both the economy in which the business is organized and the lives of those involved in its activity. Further, focused study might help estimate the total cost of a business bankruptcy—not just the financial loss—that the entire community endures.
- Averch, Craig H. 2000. “Bankruptcy Laws: What Is Fair?” Law in Transition 26(Spring):26-33.
- “Medical Bills Leading Cause of Bankruptcy, Harvard Study Finds.” 2005. Consumer Affairs Online, February 3. Retrieved March 29, 2017 (https://www.consumeraffairs.com/news04/2005/bankruptcy_study.html).
- Payne, Dinah and Michael Hogg. 1994. “Three Perspectives of Chapter 11 Bankruptcy: Legal, Managerial, and Moral.” Journal of Business Ethics 13(January):21-30.
- “Q&A: The Enron Case.” 2006. BBC News Online, May 7. Retrieved March 29, 2017 (http://news.bbc.co.uk/2/hi/business/3398913.stm).
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