Corporate Bankruptcy Needs A Fresh Market Review

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THE RECENT SPATE OF bankrupt cies involving large corporations has triggered a new public alarm.


Indeed it is disturbing to see the number of companies that faced with impending insolvency choose this op tion In a recent Fortune article Anna Cifelli noted that corporate bank ruptcies almost doubled between 1981 and 1982 atone Cries for reform of the bankruptcy statutes are now being heard , all in the name of protecting society from any deleterious effects of massive bankruptcies Unfortunately as is so often the case proposed political corrections may only worsen the problem

It is important to distinguish bankruptcy the situation encountered when an individual or a firm finds itself unable to meet all just claims against it, and bankruptcy laws which provide a public agency with the power to dictate a specific “solution” in that event In a world of uncertainty and risk bank ruptcy is an unfortunate but always possible contingency The current cor porate bankruptcy laws however pro vide for a number of questionable remedies including Chapter 11 re organization or complete liquidation The former remedy reorganization is a type of pre insolvency bankruptcy that can be invoked when a firm anticipates economic disaster This remedy specifies a detailed procedure whereby a public agency typically a court is authorized to suspend all outstanding obligations against the firm to develop and implement a plan to set tle these claims and then to discharge all further claims against the firm.

In reorganization proceedings courtst have gone far beyond the point of merely defining the law They are activists. They interpret statutory provisions to decide who are the more worthy lenders and if it s in the public inerest to keep a company going regardless of why it became insolvent in the first place

The first key to understanding cur rent bankruptcy laws is defining the role of the court There is the persistent idea that the courts are neutral third 

parties who will altruistically act on behalf of justice to decide what should be done in the case of a Chapter 11 declaration. But as economist Gordon Tuliock points out, the courts are often as much a part of the government pro-

cess as the rest of bureaucracy. The proper role of the courts in a free economy is a complex subject, but as the laws provide greater and greater discretionary authority to the judges, it is clear that the court becomes another mechanism for government to modify individual rights in the public interest. Judges, after all, are political officials, and their decisions tend to reflect the prevailing opinions about what is best for society. We should not be surprised to find that most bankruptcy decisions accept a strong, albeit benevolent role for government to adjudicate business insolvency.

The essence of current bankruptcy laws did not arise from common law, which, while establishing precedents for resolving complex debt situations, made no allowances to discharge—or forgive—the debt save those allowed by 

the creditor. The conflict between contract law and the Iaw of bankruptcy was long recognized and limited the growth of the bankruptcy concept. Discharge features began to be enacted in this country first at the state level. Horwitz notes the tendency of the legal system in the early 19th century to adopt an “economic growth” emphasis. The idea was that the courts should facilitate economic development; nothing should impede that progress,

BANKRUPTCY RULINGS seemed to favor entrepreneurial activity—it put companies back on their feet

and in the market again quickly.

Creditor rights were important, but perhaps less so than encouraging the more activist debtors, thus the case for allowing debts to be revised under court direction was strengthened. Creditors, especially those preferring swift and certain partial repayment to uncertain total repayment, favored granting government the power to force reluctant creditors into an agreement.

Bernard Siegen in his Economic Liberties and the Constitution notes Chief Justice Marshall’s minority dissent on the legality of an early New York bankruptcy law (Ogden v. Saunders). “Essentially Marshall argued that the contracts clause (of the Constitution) secured freedom of contract from molestation by the states. Under this view, the states would have very limited power to regulate commerce.” Siegan quotes Marshall: “The Constitution protects all contracts, past or future, from state enactments limiting the commitments sought by the parties.”

Marshall’s view of the sanctity of contracts did not prevail; nonetheles, it lays out the issue well. Bankruptcy law contravenes the rights of individuals to enter into voluntary agreements. No third party—not even the courts—can “forgive” debts without abrogating the rights of the lender. Yet the bankruptcy courts can and frequently do rewrite debts and other forms of contractual arrangements. The bankruptcy laws limit the ability of all reorganizations are successful; most end in liquidation. Private-sector options might well better this record.

The bankruptcy laws arc typical of modern political paternalism. When the consequences of corporate or individual decisions are painful, someone—the courts, Congress, a bureaucracy—is supposed to intervene and see that things are put right. The fact that the marketplace is characterized by risk, by profit and loss, is immaterial—it’s up to government to correct the unfairness of economic change. The fact that property rights and contract rights are violated is also irrelevant—it’s the group interest that nips’ be protected.

THE LEAST THAT could be done to correct these flaws is to introduce changes that would permit

corporations and lending institutions to specify legally enforceable arrangements that would prevail in the event of bankruptcy. This minimum freedom is essential to provide the experiential basis necessary for a more vigorous private-sector alternative to emerge.

In brief, the bankruptcy laws are non-market procedures for resolving economic problems_ They are justified, as are most such interventions, as more efficient, less prone to destructive results, and more likely to yield an equitable solution than the market. Like other government interventions, the structure of regulations and laws that has emerged reflects the interests of major creditors and debtors rather than that of the individual. Too often such interference becomes nothing more than a subsidy or protection for the unlucky or imprudent businessman.

Insolvency is a difficult issue, but one far too important to be viewed as “outside the market.” Scholars and policy analysts should take the current opportunity to explore the topic creatively so that in this next round of reform efforts the free market option is at least considered.