Bankruptcy: From a Legal Standpoint

Bankruptcy is often defined as a financial phenomenon. It is defined as a state in which a company does not have enough assets to pay off its liabilities. However, even though the definition of bankruptcy is financial, the process by which bankruptcy is declared is actually legal. The process does not begin unless a creditor files a plea for liquidation of the assets of the incumbent firm in a court of law.

It is, therefore, important to know that courts play a very important role in the bankruptcy process. Hence, no study of bankruptcy is actually complete until the point of view of the court of law is not understood and taken into account.

This article explains some of the principles based on which bankruptcy laws across the world have been designed.

Bankruptcy is a Purely Business Phenomenon

It is important to realize that bankruptcy is not a purely legal matter. It is not like a case of fraud or murder where one party may be clearly guilty, and the other may be aggrieved. The court’s job is not to intervene and find the morally right thing to do. Instead, the job of the court is to enforce contracts that were signed before the company went into bankruptcy.

Bankruptcy Courts Have to Balance Conflicting Needs

It is important for the courts to realize that different stakeholders in a bankruptcy court may have different needs. For instance, shareholders of a company may want the company to continue, whereas the creditors may want to liquidate the firm. There is no clear aggrieved party. Instead, parties may have very different and conflicting needs. Balancing these needs based on interpretation of the corporate law is the job of the bankruptcy court. Sometimes, bankruptcy cases become complex. This happens when different stakeholders file cases against one another, claiming that the actions of different parties have accentuated their loss.

The Court’s Job Is to Maximize Value

Many investors feel like it is the job of bankruptcy courts to keep the business up and running. However, this is not the case! Bankruptcy courts are not rehabilitation centers. Ideally, they should have no interest in whether the business will continue to survive or not. The job of the court is to ensure that the value of the firm is maximized. This means that all the stakeholders of the firm viz. customers, vendors, employees, etc. must be given a chance to maximize value. If shutting down a firm immediately maximizes value, then the courts must be ready to do so.

However, in reality, firms only go into bankruptcy when their liabilities go higher as compared to their assets by a huge amount. In such cases, the only way that creditors can hope to get paid is if the business continues for some time and earns enough to pay back the debts. This is the reason why courts prefer to keep the business running. However, it must be understood that courts do this only because this is the best option and maximizes cash flow for everybody. Courts do not place any emphasis on the humanitarian task of ensuring that the business remains a going concern.

The Courts Job is to Discharge Debts

The job of the bankruptcy court is to take control of the assets of the firm and discharge debts according to the priority which has been decided in the contracts. It is not the job of the courts to decide who gets priority. For instance, there have been cases where the promoters of the firm, who have been responsible for the downfall of the firm, have got paid. This is because they were holding bonds in the firm. Therefore, given the fact that the corporation and promoters are separate legal entities, the promoters got paid since their debt had a higher priority as compared to the debt of others.

In many cases, burn victims, and asbestos poisoning victims have been denied compensation, whereas commercial banks have been allowed to retain their dues. From a humanitarian point of view, this might seem like a disaster. However, the job of the courts is only to discharge the debts. The priority of these debts is decided by the law of the land and the contracts which precede bankruptcy proceedings.

Absolute Priority

In most countries, the order in which debt will be discharged has been fixed. The order is as follows. At first, payments due to government agencies, as well as taxes, have to be paid. Then, secured debts, which has the first priority, has to be repaid. In the next stage, unsecured debt has to be paid. Trade creditors and lawsuits have to be paid next.

If all debts are paid, and money is still left over, then the money is apportioned between shareholders. Here too, preference shareholders are given priority in the discharge of debt. If, at any stage, the leftover money is not enough to pay off the entire tranche, then all the people at the same level are paid on a pro-rata basis.

The bottom line is that the court is not concerned with humanitarian causes. Instead, it needs to follow directive principles and help maximize the value of the firm while upholding the contracts which were signed prior to bankruptcy proceedings.

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