Home » Education » Impact of Bankruptcy on Companies

Impact of Bankruptcy on Companies

by Daniyal
63 views

Table of Contents

  • Introduction
  • Bankruptcy
  • Benefits And Consequences Of Bankruptcy
  • Psychology Of Businesses Filing For Bankruptcy
  • Consequences And Drawbacks Of Bankruptcy
  • Types Of Bankruptcy
  • Causes Of Bankruptcy
  • History Of Bankrupt Businesses
  • Avoidance Of Bankruptcy
  • References

Introduction

Businesses working in a global business world are primarily motivated by the need to make a profit or, at the very least, raise adequate income to cover their expenses. Many firms will take out loans from governments, finance agencies, or other buyers to help them operate their activities more efficiently, and eventually use the funds to invest in future ventures to help support their existing operations. Businesses, on the other hand, might face difficulties or are unable to cover their expenses. When a company runs out of cash and is unable to pay its expenses, it can be deemed bankrupt or seek bankruptcy on its own (White, 2011).

This is a critical moment for a company, and it is a state of emergency for its debtors, who will be unable to regain the majority of their debts. Such circumstances harm a company’s image, its ability to obtain future financing, and its ability to compete. However, both young companies, as well as many older businesses, are seeing a growing number of bankruptcies (White, 2011).

Impact of Bankruptcy on Companies

Overspending, excessive interest rates on debt, business losses, mismanagement, and unexpected economic events are just some of the factors that can lead to a company going bankrupt. As a result, when debtors offer loans to companies, they normally check to see if the company is heavily leveraged and has a lot of profit opportunities before approving the loan (White, 2011).

As a result, before a company can go through proper liquidation, many legal disputes must be resolved. The correct legal concept of bankruptcy, as well as the legal ramifications that companies must deal with prior to and after the bankruptcy stage, would be thoroughly explored. Within the article, the psychology of bankruptcy management would be illustrated, as well as the past of corporate bankruptcy and the circumstances that have arisen. The article would move on to address the triggers of bankruptcy, how they impact companies, and how they can be stopped. The report will conclude with an examination of the economic outlook of companies facing certain challenges, as well as recommendations on how to improve the situation. (2002) (Vinten).

Bankruptcy

The legal and appropriate definition of bankruptcy in the case of businesses or corporations is when a business is unable to repay its outstanding debts and thus files a petition in order to reduce the amount owed or remunerate its creditors by paying off a portion of their debts and putting their business into a state of liquidation (Vinten, 2002).

The common proceedings for filing bankruptcy usually begin with the filing of a petition by the debtor in which the business shows its financial position and proves that it does not have enough cash nor sources of finance to repay its creditors. In this situation, the businesses assets are usually evaluated to determine their saleable value and then their assets are liquefied in order to be sold or auctioned. The money obtained from this sell-off is then given to the creditors in return for the debt that the debtor owes them as a full settlement of the debt. The amount paid to the creditor may be less than what the creditor has paid to the business initially. However, the creditor will have to settle for a portion of the debt owed to them in the situation of bankruptcy as the business has officially shown that they do not have the ability to pay back the debt in full (Vinten, 2002).

However, some creditors may have very strong legal contracts with the business making their debts the most important and thus the business filing for bankruptcy must pay off their debts in full before they pay off other smaller debts. Debts may be prioritized according to the level of legal obligation that the business has incurred with the creditors. Some important debts may include debts incurred through banks, financing institutions, and priority investors. Thus, those debts must be paid off first before investors and other informal debts are paid off. Some creditors may not even receive anything for the debts that the business has incurred through them if the business does not have enough assets to facilitate the paying off these debts (White, 2011).

Once this liquidation process has been done and the business’s assets have been sold off, some or all of the creditors have received a portion or all of their outstanding debts, the business filing for bankruptcy is fully relieved of their legal obligation towards these debts. This usually gives the business a chance to start freshly and can be relief from a large burden if proceedings go successfully (White, 2011).

In this manner, the business and the creditors may both benefit as the business is relieved of their debt while the creditor may still receive a portion of their outstanding debt. This situation can sometimes be highly beneficial for an economy when many businesses are highly leveraged with debt and are unable to operate properly, bankruptcy may be the most viable option (White, 2011).

However, it must be noted that various countries have different proceedings and various legislation governing the area of bankruptcy of companies. The obligations of companies and the requirements involved for a company to file for bankruptcy may differ from country to country. The United States has various Chapters and legislation governing the area of bankruptcy, which includes several different levels at which a company may file for bankruptcy. One specific law governs the law of liquidation in which all the company’s assets are liquidized and another chapter of law allows the company to law lower rates of interest and debt to repay its debtors. The specifications vary from situation to situation and from country to country as some countries allow lower rates of debt repayment while some other countries may have stricter specifications for debt repayment (White, 2011).

While in usual cases the notice of bankruptcy is filed by the debtor, creditors may also file notices of bankruptcy when they feel that their debtors are unable to repay their debts and request that the business be put into liquidation so that the creditor can receive his/her outstanding debt. However, in order to do this, the creditor must have substantial evidence that the business needs to be put into liquidation and needs to file bankruptcy. This is because if the business has good enough reason to convince the court that that they can definitely pay off the creditor’s outstanding debts at a later date, the court may allow the business an extended time period to pay off the creditor’s debts (Vinten, 2002).

The case of bankruptcy of a company is similar to an auction where all the assets of a business are liquidized and sold for whatever prices buyers are willing to buy them for as soon as possible. If the company has ordinary shareholders or is a partnership or sole proprietorship, the company usually has unlimited liability. This means that the company’s owners may not only be liable to pay off their debts with the business’s assets but must also use their own personal belongings to pay off the debts of the business. This puts the businessman in a highly insecure position as he/she is likely to lose his/her house, car, personal cash, jewelry, and any other valuables that he/she may possess in order to pay off creditors in times of bankruptcy (Vinten, 2002).

However, limited businesses ensure that their liability is restricted only up to the amount that investors have invested in the business. Thus, in times of bankruptcy, the business is only likely to lose what has been invested into its operations and liability does not extend to the personal possessions of the owners and investors (Armour & Cumming, 2008).

There are various legal scenarios explaining the situation of filing for bankruptcy and it is likely to be a rigorous and complicated process. Businesses are not likely to be freed from their obligations to pay off their creditors very easily and must go through an extensive investigation process. The consequences of filing for bankruptcy are likely to be high, yet in some circumstances, it is the most viable option (Bello, 2011).

The paper will now explore the likely benefits and consequences that a business may face when filing for bankruptcy.

Benefits and Consequences of Bankruptcy

While it has been said previously in the paper, that bankruptcy can be beneficial for some businesses and the economy, the question stands as to how it can be consequential for a business. The situation prevailing bankruptcy is obviously not an ideal situation as it signifies that the business is unsuccessful and is not generating enough revenue. Thus, this also puts the business into bad terms with creditors, bankers, and general customers as well. When a business becomes bankrupt, this means the company must go into liquidation or cease to exist. This marks the end of the business, the business is not allowed to continue from there as all of the business’s assets, and belongings have been sold or auctioned. The business now owns nothing and is nowhere in the global business environment. These are severe consequences for a business. The consequences also continue towards the employees and managers of the firm as it shows that the management was unsuccessful in managing the business properly. Once the business becomes bankrupt, the employees become unemployed and being an employee of a previously unsuccessful firm is not a good sign on an employee’s curriculum vitae. Thus, the consequences for the firm may be quite severe in many terms (Armour & Cumming, 2008).

The entrepreneurs or proprietors of the firm may also suffer highly in their future endeavors, as it may be difficult for them to gain finance from creditors for future projects. Their confidence levels and their reputation in the market may be highly negatively affected. They must think of a completely new idea to begin business again and must make new contacts in order to facilitate their operations. Employees may be reluctant to work for them again and they may have trouble attracting top talent (Armour & Cumming, 2008).

Many large companies going out of business have faced severe consequences and long litigation procedures in which they came into conflict with many of their suppliers and creditors, thus discrediting them heavily in the media and newspapers. Thus, filing for bankruptcy cannot be considered an easy way to discharge oneself from the obligation of fulfilling one’s debts (Armour & Cumming, 2008).

However, in some situations filing for bankruptcy seems as the most logical path to take. This may be the required course of action when a business is so fully leveraged with debts that it is impossible for the business to continue to operate as it possibly needs further finance and is already unable to return the debts of previous creditors. Thus, when a business has no possible means to continue its operations and generate enough revenue to pay back its creditors, it may be beneficial for the business to file for bankruptcy and relieve itself of the pending debts in the best possible way. Usually, this course of action is taken when the business has no other choice and is obliged to file for bankruptcy. However, bankruptcy is not an ideal situation (Bello, 2011).

Psychology Of Businesses Filing For Bankruptcy

There are various psychological conditions and processes that the management of a business is likely to go through when deciding to file for bankruptcy. The psychological pressures are likely to be quite heavy and some business managers may be unable to deal with them. Despite some of the benefits of filing for bankruptcy, it can be easily said that there is no company who would file for bankruptcy happily or be ecstatic about the condition of having to file for bankruptcy (White, 2011).

Obviously, the state of bankruptcy is a state that declares and signifies failure and loss. Hence, the business managers and owners are likely to lose their self-esteem, their trust in themselves, and their confidence for beginning life all over again. The mental pressure of mentioning occurrence of the bankruptcy whenever applying for a job, beginning a new business, or asking for financial assistance can be majorly stressful. It gives the business managers and owners a loss of their previous status in society. They cannot regain that lost status as they have been more or less labeled as a failure in the market and in society. Thus, gaining the trust and aid of contacts can be a highly shameful, rigorous, and mentally torturing process (White, 2011).

As business managers are fully aware of the consequences that must be dealt with if bankruptcy is filed, when they are making decisions regarding the operations of the business and how to sustain it possibly, they are usually under severe stress and mental pressure. A business about to declare bankruptcy or considering the declaration of bankruptcy will obviously be quite distraught with the manner in which they must deal with creditors asking for their money. Creditors are likely to send messages, phone calls, and other means of communication in order to pressurize the business to fulfill their outstanding debt. Dealing with the creditors who may at times become quite rude in the process of asking for the return of their money can be a highly stressful and shameful task. In such circumstances, when a business sees no other option except to declare bankruptcy, the psychologically distraught managers may make the decision to liquidate the business (White, 2011).

However, the psychological after effects of having to deal with the pressures of society when one has to begin all over again can be quite severe. In other circumstances, a highly in debt business owner may feel slightly relieved once the bankruptcy goes through as he/she is free from the pressure of creditors (Bello, 2011).

The particular consequences affecting a business owner who has been declared bankrupt will be discussed in the next section.

Consequences And Drawbacks Of Bankruptcy

As mentioned before there are various types of bankruptcy and different countries have different laws governing this process. However, the main principles governing a business owner or an individual who has filed bankruptcy include the following (Baird & Jackson, 1985):

  • No control over your own assets as they become the court’s property
  • No right to act as a company director in the future
  • No limited company can be formed, promoted or managed by a bankrupt business owner without the explicit permission of the court
  • No new business can be opened under a new name unless every person involved is completely made aware of the bankruptcy
  • The right to practice as a chartered accountant or a lawyer are taken away from the bankrupt business owner
  • A person declared bankrupt cannot act as a future member of Parliament
  • The business owner also cannot act as a justice of peace
  • No position of the local authority can be provided to a person who has declared bankruptcy
  • Credit is not given for many years after the bankruptcy is filed
  • Public court examinations and proceedings may be very strict
  • Business owners are not allowed to change their name when conducting business in the future
  • No company may be managed or no involvement is allowed in any organization without the explicit permission of the court

Bankruptcy may be listed for a number of years and in some instances, it may be up to a period of fifteen years that shows that the bankrupt business is likely to suffer for a prolonged period. However, in some cases, bankruptcy is listed for six years and the bankrupt company is not likely to receive proper banking facilities such as the availability of checkbooks or overdraft facilities as the bank is not likely to trust their ability to pay the amount back. This can gravely hinder the potential future progress of a company that seeks to reform and indulge in other businesses (Baird & Jackson, 1985).

In some cases, the penalty for bankruptcy is likely to be highly severe in which case the court imposes several restrictions and limitations upon the company considering that the bankruptcy occurred due to irresponsible or reckless behavior. Thus, the bank may impose many restrictions upon the bankrupt business, which highly limits their options to begin over again (Baird & Jackson, 1985).

However, in some more lenient cases, the period of bankruptcy lasts for two years and may even likely last for only one year. Some high-risk credit companies may even extend credit to bankrupt parties in order to enable them to begin over again. However, such cases are highly unlikely and contain a large amount of risk (Baird & Jackson, 1985).

The level of restrictions imposed and the options available to a bankrupt company depends upon what type of bankruptcy is filed. According to U.S. law, there are various types of bankruptcy that a business is allowed to file. This will be discussed in detail in the following section.

Types of Bankruptcy

There are basically four different types of bankruptcy that can be filed by companies under U.S. law. The first type of bankruptcy is known as chapter 7 bankruptcy. In this type of bankruptcy, the business goes into complete liquidation. All of the assets of the company become the property of the court or the trustee and they are auctioned off to pay off the creditors and the debts of the company to the maximum extent possible. Any remaining debts after filing for this type of bankruptcy are forgiven and discharged. Any income that the business owner earns from other means after this bankruptcy is not taken away but remains with the bankrupt person. However, this is considered one of the worst types of bankruptcy and is fully avoided, as after filing for this type of bankruptcy, businesses cannot continue to conduct operations (Sheifler & Vishny, 2012).

Chapter 11 bankruptcy is a rather complicated ordeal and is the type of bankruptcy that is filed by businesses that are in the most trouble and are facing severe financial difficulties. In this type of bankruptcy, the business continues to operate and it is not forced into liquidation. The business owner retains all of his assets but has to work out a plan of reorganization in order to form a way in which the business is to pay off its creditors. Thus, the business must properly plan and settle various monthly amounts or arrive at an agreement with their debtors regarding how their debts will be repaid. Businesses that are in deep trouble and are being continuously bothered by their creditors may file this type of bankruptcy. This type of bankruptcy gives the business another chance to flourish and possibly turn their situation around but also keeps the pressure of the pending debts upon the business owners (Sheifler & Vishny, 2012).

The Chapter 11 type bankruptcy requires debtors to devise a plan in 120 days in order to inform them of how they plan to relieve their debts. If they have not submitted a plan within that time, their creditors are given permission to devise and submit their own plans on how they wish to be paid (Sheifler & Vishny, 2012).

Chapter 12 bankruptcy is particularly for farmers and not other business owners. The assets of the farmer are not taken away and he/she still retains control of his assets. However, the farmer must work out and devise an appropriate repayment plan with his/her creditors (Sheifler & Vishny, 2012).

Businesses usually file for chapter 7 or chapter 11 bankruptcy. Chapter 11 bankruptcy means that all money the debtor makes that is above normal living expenditures is paid off to the debtors. However, under Chapter 7 bankruptcy, the debtor has nothing left to pay off as all or most of his assets have already been used to pay off the debt (Sheifler & Vishny, 2012).

The various requirements involved in filing for each type of bankruptcy are very complicated, lengthy, and are a completely different litigation topic, which is not the core topic of this paper. However, there are specific restrictions regarding the types of bankruptcy that a business can file and in which circumstances the bankruptcy successfully goes through (Sheifler & Vishny, 2012).

Before the history of bankrupt businesses is discussed in the paper, the paper will now discuss the various possible causes for a business to meet the conditions of bankruptcy.

Causes of Bankruptcy

There can b innumerous causes that can bring a business to the condition of having to file for bankruptcy. One of the most common conditions for even well grounded businesses is when the business is highly leveraged on debt and is not a fully developed entity yet. Thus, in these circumstances, the business is likely to go slow and generate little or no income. Hence, when the business is very highly leveraged on money from creditors and the business is not generating enough income, the creditors are likely to pile up soon on the business to an extent that they cannot handle. Thus, this situation can cause the business to have to file for bankruptcy (Dubrovski, 2009).

This does not completely mean the business was a total failure but it signifies that it was a high-risk business, which was run on other people’s money. Hence, in the initial period the business was not able to properly settle into the market and develop a customer base and was thus a cause of aggravation for its creditors (Dubrovski, 2009).

Another common cause for having to file bankruptcy is the incurrence of severe losses. Businesses may make investments in projects that they believe will work well but due to a lack of sales or a lack of success in the project, the business loses a lot of money. This situation can also occur when the business begins to face high levels of competition. As the business begins to fail and lose revenue, the business is unable to keep up with its expenditures and is then forced to file for bankruptcy (Dubrovski, 2009).

Natural disasters may also be a cause for a business to lose a lot of money if their assets and property are not insured. Floods, earthquakes, and other disasters that affect employees and the assets of the business may force heavy expenditures upon the business, which the business is unable to pay and is then forced into liquidation (Eckbo et al, 2012).

The mismanagement of managers and taking reckless or irresponsible decisions may also be a great cause for the occurrence of bankruptcy. In such cases, managers are highly defamed and their employability status would be highly endangered for life. Litigation and law procedures may also be conducted upon such managers who have not fulfilled their duties responsibly and have taken decisions that were obviously harmful to the business (Eckbo et al, 2012).

However, managers who have not done this on purpose and no proof of corruption is against them may or cannot be penalized in the same manner. However, they do have to face the loss of their jobs and the questioning of the media, courts, and the business owners as to how such a situation came about (Eckbo et al, 2012).

Many companies become prey to a situation of bankruptcy due to the irresponsibility or lack of expertise of managers. Over expenditure, large allowances for managers, corruption, and misuse of funds, and other such situations may lead a firm to bankruptcy. In such cases, strong cases can be filed against managers (Eckbo et al, 2012).

However, there are also certain instances in which managers are not the ones who are corrupt but the business owners themselves indulge in fraudulent behavior. Such business owners open businesses in order to gather funds from creditors and investors and transfer their funds to places, which are unreachable for the authorities, file bankruptcy, and flee the scene never to return again to pay back their debts in any manner (Eckbo et al, 2012).

Unfortunately, such instances of fraudulent behavior are increasing in countries all over the world and investors are now very careful in deciding where to invest their money, as creditors are highly wary of giving credit to unknown firms (Eckbo et al, 2012). Strong litigation procedures and controls in developed countries have controlled such fraudulent behavior to a large extent but have been unable to extinguish it completely.

The history of bankrupt businesses and a few examples will be discussed in the paper.

History of Bankruptcy Business

The United States market has a number of huge bankruptcies, which mark its history up until the year 2011. The bankruptcy claims and filings range up to billions of dollars and leave a big strain on the American economy. One of the recent Chapter 11 bankruptcies include the bankruptcy of American Airlines in 2011. The bankruptcy nearly substantiated to a claim of $24.1 billion dollars but it still does not quite make the list of the top ten bankruptcies marked in the history of the United States (Dambolina & Khoury, 1980).

Pacific Gas & Electric Co. fell prey to the California electricity crisis and marked the top ten bankruptcies in the history of the United States. The company filed for Chapter Eleven bankruptcy. The crisis entailed all of California suffering from blackouts and a major electricity crisis. Thus, the company was faced with extensive costs and thus was forced to settle for an agreement with its creditors. The company had assets amounting to $36.1 billion (Dambolina & Khoury, 1980).

Another huge mortgage company, Thornbug Mortgage, was put into liquidation because of over-lending to people with good credit. The company failed to generate cash because of its huge amounts lent out to creditors that were mostly unable to be redeemed. Thus, the company was put into liquidation at a value of $36.5 billion (Dambolina & Khoury, 1980).

As the economic crunch affected the economy badly, President Obama forced the car company Chrysler to declare bankruptcy. The company was then given to handle to different managers and after a period of two years after the bankruptcy the company picked itself back up and began to make a profit. The company was valued at $39.3 billion (White, 2011).

Conseco, a large financing company, made incorrect and reckless management decisions that forced it into heavy bankruptcy. Heavy acquisitions and buying off separate financial firms led the company to suffer immensely and file for chapter 11 bankruptcy. The company was valued at $61.4 billion and suffered a huge blow because of its reckless decision-making and rigorous take-over procedures (Vinten, 2002).

Enron is a company who appeared in the American newspapers numerous times during the scandal in which its accounting team was accused of fraudulent accounting practices. As this led to misinterpretation of the current financial position of the company, the company was highly leveraged and was thus forced to file bankruptcy (Vinten, 2002).

General Motors was also victim to the major economic crisis and because of its fast deteriorating sales; the company was nearly succumbed to filing for bankruptcy. Yet, the company was luckily bailed out through government aid. Otherwise, the years old carmaker would have currently been out of business (Vinten, 2002).

Looking back at the large amounts of money lost by large businesses in the US, it is evident that many large and well-established companies are sometimes faced with bankruptcy circumstances. These circumstances prevail because of new management teams who suddenly make rash decisions or over spend the firm’s current budget or managers who over invest in a project which is not likely to be profitable. Other firms are faced with scandals that harm their reputation and force them into complete liquidation. However, others are sometimes bailed out of the situation if they are promising and trustworthy companies that are currently facing tough circumstances because of deteriorating sales or tough competition (Vinten, 2002).

However, whatever the scenario may be, bankruptcy is a highly negative option for all businesses. The paper will conclude with a short analysis of how businesses can avoid situations of bankruptcy.

Avoidance of Bankruptcy

As the paper above has explained in detail, the causes for bankruptcy, and the way various firms in the US experienced it, there is now a need to mention how such a situation can possibly be avoided briefly.

While analyzing the causes of bankruptcy, it is evident that one of the main reasons for bankruptcy is over-spending. Thus, a clear and transparent accounting process must dictate to a business how much it would be wise to spend on various projects and how much cash they have available to spend upon their operations. Excessive buy-offs and acquisitions can tie up a firm’s cash flow substantially (Gormley et al, 2011).

Management decisions should be made wisely and consultations should be made with executives at all levels. Important decisions should not be made on the spot and all officials involved in the process should be consulted before a big decision is made (Gormley et al, 2011).

The policies of the firm regarding hiring managers and audit procedures to supervise the performance of managers and accountants should be very strict and regular. Thus, it should be highly difficult for accountants or managers to indulge in corruptive practices or use fraudulent accounting procedures (Gormley et al, 2011).

While there are a number of measures that can be taken or should be taken to avoid situations of bankruptcy, they may occur at times of financial hardship or economic crisis. At times, such situations may be unavoidable and the firm must undergo the pressures involved.

However, it is important for firms to take precautionary measures and try their utmost best to avoid this situation. The situation of bankruptcy is highly undesirable and shameful for any organization, although the circumstances may differ from organization to organization.

References:
  • Armour, J. & Cumming, D. (2008). “Bankruptcy Law and Entrepreneurship” Law Economic Review. Vol. 10, No. 2, pp. 303-350.
  • Baird, D. & Jackson, T. (1985) Cases, Problems, and Material on Bankruptcy. New York: Little Brown.
  • Bello, D. (2011). Corporate Failure: Accounting and Auditing Resolution. Retrieved on December 08, 2012: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1947369
  • Dambolena, I. & Khoury, S. (1980). “Ratio Stability and Corporate Failure” The Journal of Finance. Vol. 35, No. 4, pp. 1017-1026.
  • Dubrovski, D. (2009). “Management Mistakes as Causes of Corporate Crisis: Managerial Implications for Countries in Transition” Total Quality Management and Business Excellence. Vol. 20, No. 1, pp. 39-59.
  • Eckbo, B., Thorburn, K. & Wang, W. (2012). “How Costly is Corporate Bankruptcy for Top Executives?” Tuck School of Business. Vol. 2019-2020.
  • Gormley, T., Gupta, N. & Jha, A. (2011). Corporate Bankruptcy and Creditor Incentives. Retrieved on December 08, 2012: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1572797
  • Sheifler, A., & Vishny, R. (2012). “A Survey of Corporate Governance.” The Journal of Finance. Vol. 52, No. 2, pp. 737-783.
  • Vinten, G. (2002). “The Corporate Governance Lessons of Enron.” Corporate Governance. Vol. 2, No. 4, pp. 4-9.
  • White, M. J. (2011). “Corporate and Personal Bankruptcy Law.” National Bureau of Economic Research, Paper No. 172037.

You may also like

Leave a Comment