Some End-of-the-Year Thoughts on the Business Bankruptcy System

The end of the year is a time for reflection.  Those of us who are involved in the bankruptcy system on a daily basis are sometimes so occupied with the matters at hand that we do not see the proverbial "big picture".  There are times when, at a business or social gathering, I am asked what I do, and I answer that I am a bankruptcy lawyer.  One of a half-dozen standard replies to this information is that I am profiting from the misfortunes of others. 

Although, like most unpleasant statements, this is not wholly devoid of truth, the matter needs to be put in perspective.  The business bankruptcy system is a method for carrying out the concept of "creative destruction".  The term, coined in 1942 by economist Joseph Schumpeter in his work Capitalism, Socialism, and Democracy, denotes a "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one".  Schumpeter also referred to the "perennial gale of creative destruction" at the very heart of market orders.  Thus, the bankruptcy system is an organized method wherein the forces of creative destruction play themselves out, tempered by rules enforcing fairness and full disclosure. 

It is beneficial to emphasize the creative aspect of creative destruction.  Assets find their way from less productive hands to more productive hands.  This is positive.  One of the factors which lead to the collapse of the Soviet Union was that there was simply no way for inefficient enterprises to be replaced by efficient ones.  No matter how much money an industrial operation lost, they simply "went to the well" for more funding from the State.  The fact that management of the unsuccessful enterprise might have been sent on a tour of the northern regions did not change the equation;  there was no disincentive for inefficiency. 

I had the opportunity to experience this mindset first-hand when I represented a distressed corporation, the shareholders of which were the representatives of formerly state-owned enterprises of a communist block nation.  The company filed a chapter 11 bankruptcy case.  The case was difficult, and a bank, which had a security interest in all of the assets, was being quite aggressive.  After numerous meetings with management and the shareholders about the difficult nature of the case, I realized that I was not getting through to them.  Instead, they truly did not understand that they could "loose" their investment in the enterprise.  It was as if Einstein's law of the preservation of matter and energy was at work, and just as matter can not be truly lost, just transformed, neither could money.  They believed that, just as back home, what was needed here was more meetings with the bank, where bank management would shout, wave their hands, and threaten, but that, after the ritual was completed, somehow money would appear to allow the company to go on its way.   It was only after I was able to dispel this misapprehension,  and convince them that they could loose their entire investment, the bank could end up with the assets of the company, and that a serious reorganization effort was necessary, did the case turn the corner.  The case had a happy ending, a confirmed plan of reorganization, with much learned by all involved.

In conclusion, without a method for creative destruction carried out with fairness, as it is through the existing bankruptcy system in the U.S., the result is either a stunted economic system, as was seen the former the Soviet Union, or a punitive system, as is seen in many of the European Union nations, which allows for recirculation of assets, but punishes the very risk-taking behavior which is necessary for an economy to flourish.