Explaining the purpose of bankruptcy

May 08, 2020

354 years ago a young Isaac Newton retreated to the family farm during the Great Plague of London. In the serenity of the moment, he, oh, invented the underpinnings of Calculus. I think I'm productive getting through the fifth episode of The Last Dance during quarantine and he comes up with fluxions.

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"Capitalism without bankruptcy," former astronaut Frank Borman once said, "is like Christianity without hell." Bankruptcy has a bad reputation, but it serves a critical function in a capitalist system. It's often misunderstood.

A firm in bankruptcy often continues to operate. Generally the shareholders of a firm lose their asset and the debt holders receives the asset in exchange for debt concessions. It's a rearrangement of the equity and debt on the balance sheet, but the employees do not necessarily lose their jobs. Presumably the new shareholders will hire a new management team, saddled with less debt, to rejuvenate the business with new ideas.

The process is overseen by a court. There are many variations, and given the difficulties surrounding a distressed firm, groups other than shareholders often end up "taking a haircut." It's not a happy time.

The core idea, if not always implemented fairly or timely, is that the shareholders who stood to recognize the largest gains in the success of the firm also take the largest losses. But the firm itself continues to operate.

What happens if a business goes into Chapter 7 bankruptcy, whereby it liquidates its assets and ceases operations? This is worse, as people do lose their livelihood. But in an organized economy and market, the assets are sold, often at low prices, to other entrepreneurs who can reassemble them into a stronger, more efficient, or more relevant whole. So there is some benefit, albeit smaller.

You are going to hear the term bankruptcy a lot in the next year, often as a pejorative. It's important to understand that is not always the case. Often it signals a revival.

Dan Cunningham

1. Isaac Newton's epitaph in Westminster Abbey reads "Hic depositum est, quod mortale fuit Isaaci Newtoni" which translates to "Here lies that which was mortal of Isaac Newton."

2. Frank Borman was also the CEO of Eastern Airlines as it slid into bankruptcy, which gave him more relevant experience on the topic than the Apollo missions.