No company should proceed toward a possible bankruptcy claim without a thorough understanding of the implications of all the available options. Corporate Bankruptcy provides CEOs, CFOs, controllers, and treasurers, as well as financial advisors and other professionals involved with bankruptcy filing, the tools they need to succeed.
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About the Author
GRANT W. NEWTON, CPA, CIRA, CMA, is Professor of Accounting at the Graziadio School of Business and Management at Pepperdine University. He is Executive Director of the Association of Insolvency and Restructuring Advisors, the author of Bankruptcy and Insolvency Accounting, and coauthor, with Gilbert D. Bloom, of Bankruptcy and Insolvency Taxation, both from Wiley.
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Corporate BankruptcyTools, Strategies, and Alternatives
By Grant W. Newton
John Wiley & SonsISBN: 0-471-33268-2
In early times, the proverb "He who cannot pay with his purse, pays with his skin" had a ruthlessly literal application. The law of ancient Rome (450 B.C.) declared that the borrower was nexus to his creditors, which meant that his own person was pledged for repayment of the loan. If the borrower failed to meet his obligation, the creditor could seize him. The creditor then publicly invited someone to come forth to pay the debt, and if no one did, the creditor killed or sold the debtor. A number of Biblical references testify to the fact that one could be enslaved for the nonpayment of debt. In II Kings 4:1 "... a certain woman of the wives of the sons of the prophets cried out to Elisha, 'Your servant my husband is dead, and you know that your servant feared the Lord; and the creditor has come to take my two children to be his slaves.' Elisha said, 'Go, borrow vessels at large for yourself from all your neighbors.' From one jar of oil she filled all the vessels that had been borrowed. Elisha said to her, 'Go, sell the oil and pay your debt, and you and your sons can live on the rest.'" In ancient Greece, under the criminal code of Draco (623 B.C.), indebtedness was classified with murders, sacrilege, and other capital crimes. King Solomon ordered during his reign that the debts that remained after anattempt at restitution should be forgiven, but that the debtor and his heirs had to forfeit their citizenship.
The first English bankruptcy law, passed in 1542, was a law against the debtor. Only the creditor could, under certain conditions, initiate bankruptcy action and divide up the assets of the debtor. If there were liabilities that debtors were unable to pay with their assets, they were sent to prison. The 1542 law applied only to traders, but in 1570 it was amended to include merchants. It was not until 1705 that the English law provided for discharge of debtors from their debts.
Historical Origin of United States Laws
Physical punishment, imprisonment, and other harsh practices were common in England and some colonies, yet were observed by many to be totally ineffective. The American lawmakers saw the need for a national bankruptcy law; however, such a law was not considered until a very late date in the proceedings of the Federal Convention. On August 29, 1787, Charles Pinckney of South Carolina moved to give the federal government the power to establish uniform laws on the subject of bankruptcy as a part of the Full Faith and Credit Clause (Article XVI). On September 1, 1787, John Rutledge recommended that, in Article VII, relating to the Legislative Department, there be added after the power to establish uniform rule of naturalization a power "to establish uniform laws on the subject of bankruptcies." On September 3, 1787, this clause was adopted after very little debate. Only the State of Connecticut opposed the provision; its representative, Roger Sherman, objected to any power that would make it possible to punish by death individuals who were bankrupt. In the final draft, the power to establish uniform bankruptcy laws was inserted after the provision to regulate commerce in section 8 of Article I.
The wording of the provision is: "Congress shall have the power ... to establish ... uniform Laws on the subject of Bankruptcies throughout the United States." Although the right was granted, the states were so opposed to it that national bankruptcy laws existed intermittently for only about 17 years prior to 1900. The meaning and scope of the term bankruptcy as used by the framers of the Constitution are unclear. The English law in existence at the time this provision was added to the Constitution used the word bankruptcy as an involuntary proceeding applying only to traders. However, at this time some states had laws that used the term to apply to all classes of persons and all forms of insolvency. The intent of the writers in using the term bankruptcy served as a focal point of debate each time a bankruptcy law was proposed during a period of more than 80 years.
Under the authority granted it, Congress passed three bankruptcy acts prior to 1898. The first act, passed in 1800 and repealed three years later, applied to traders, brokers, and merchants, and contained no provisions for voluntary bankruptcy. The first act was finally passed as a result of a financial crash brought about by overspeculation in real estate. Many rich and prominent traders were in prison because they were unable to pay their creditors. Robert Morris, the great financier of the Revolution, was in the Prune Street Jail in Philadelphia with liabilities of about $12 million. James Wilson, a justice of the United States Supreme Court, went to North Carolina just before his death, to avoid imprisonment for debts he owed in Pennsylvania.
The first act, by its terms, was limited to five years, but it lasted only three years because of several factors. First, there was the difficulty of travel to the distant and unpopular federal courts. Second, very small dividends were paid to creditors; one reason for this was that most of the debtors forced into bankruptcy were already in prison. Third, the act had been largely used by rich debtors, speculators, and, in some cases, fraudulent debtors to obtain discharge from their debts. Among the debtors who were released as a result of this act was Robert Morris.
The second act, passed in 1841, applied to all debtors, contained provisions for voluntary bankruptcy, and allowed a discharge of the unpaid balance remaining after all assets were distributed to creditors. The second act was not really given an opportunity to succeed. The bill was defeated in the House on August 17, 1841, by a vote of 110 to 97. Because of some maneuvering, the bill was reconsidered the next morning and passed by a vote of 110 to 106. Opponents of the bill started working toward its repeal, and the bill was revoked by a vote of 140 to 71 in the House and 32 to 13 in the Senate. It had lasted just over one year.
The financial problems created by the Civil War caused Congress to consider a third act, which became law in 1867 and was repealed in 1878. This act marked the beginning of an attempt by Congress to permit debtors to escape the stigma associated with bankruptcy by allowing a composition of their debts without being adjudicated a bankrupt.
The Bankruptcy Act passed in 1898, as amended, applies to all cases that were filed before October 1, 1979. The act was thoroughly revised by the Bankruptcy Act of 1938, commonly known as the Chandler Act, which added the chapter proceedings to the basic law. The most profound of all developments in bankruptcy law must have been the passing of the Chandler Act, which gave the courts the power to regulate the disposition of all debtor estates and individuals, as well as business, agriculture, railroads, municipalities, and real estate, whether in liquidation, rehabilitation, or reorganization. The most frequently used of the chapter proceedings created by the Chandler Act was Chapter XI, which was established to provide rehabilitation of the honest debtor with a maximum of speed and a minimum of cost. The various chapter proceedings under the Bankruptcy Act were designated with roman numerals, and arabic numbers are used in the Bankruptcy Code, effective October 1, 1979.
It is interesting to note how the economic philosophy of bankruptcy has changed over the past 400 years. The first laws in Great Britain and the United States were for the benefit of creditors only. Later laws gave consideration to debtors by allowing discharges in exchange for their cooperation. They also gave the debtor some protection against haphazard seizure by creditors; however, this provision became law primarily to protect the interest of other creditors. Very little consideration seems to have been given to the public in the United States until 1933 when section 77 was added to the 1898 act, granting railroads the right to reorganize.
The Bankruptcy Act of 1898, as amended in 1938, consisted of 14 chapters. The first seven dealt with the basic structure of the bankruptcy system and set forth all of the proceedings of so-called straight bankruptcy. Chapter VIII dealt with the reorganization of railroads, and Chapter IX concerned the composition of debts of certain public authorities. Chapter X set forth in great detail the rules for reorganizing corporations with secured debts and, often, publicly held stock. Chapter XI covered arrangements with unsecured creditors primarily for business debtors and for other persons who were not wage earners. Provisions for wage earners were described in Chapter XIII. Chapter XII covered debts secured by liens on real property, and Chapter XIV dealt with maritime liens. Chapters VIII, IX, and XIV were used very infrequently. During the last half of the 1970s, the number of Chapter XII proceedings that were filed increased substantially. Most of this increase was caused by the large number of limited partnerships involving real property ownership that had financial problems.
Bankruptcy law, as it has evolved during the past 100 years, was intended not only to secure equality among creditors and to provide relief to debtors by discharging them from their liabilities and allowing them to start a new economic life, but also to benefit society at large.
The term bankruptcy law is generally used to refer to federal law-title 11 of the U.S. Code, commonly referred to as the Bankruptcy Code. The current law became effective October 1, 1979, after President Jimmy Carter signed the Bankruptcy Reform Act of 1978 on November 6, 1978. This act has been amended on many occasions, the three major amendments being the Bankruptcy Amendments and Federal Judgeship Act of 1984; Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986; and the Bankruptcy Reform Act of 1994.
Bankruptcy filings increased in 2002 to an all-time high of over 1.5 million petitions. From 1995 through 1998, the number of petitions increased each year while the U.S. economy continued to grow. The year 1998 represented the eighth straight year of economic growth. In 1999 and 2000, the filings dropped; however, in 2001, the downward trend was reversed. For the 12 months ending in December, the number of petitions filed increased to approximately 1.44 million.
The total filings by decade and the number of filings per decade per 1,000 in population has increased significantly since the Great Depression, when the number was less than 5 and in the 1990s there were almost 40 filings per 1,000 individuals. The administrative office of the U.S. courts estimates the number of filings per 1,000 population during the 1990s to be approximately 38. Exhibit 1.1 summarizes the business filings as a percent of total filings for the last 17 years.
Among the bankruptcy filing in 2001 was Enron, then the world's foremost power and gas trader. It filed for bankruptcy on December 2. Enron, the largest company to file a chapter 11 petition (almost twice the size of the Texaco bankruptcy filed in 1987) was the seventh largest firm on the Fortune 500 list, claiming assets of approximately $62 billion just over 60 days before the petition was filed. The value of a share of the company's stock fell from over $90 per share a year prior to its filing to $.26 per share just a few days before the filing of the petition.
Listed below are the six largest chapter 11 filings in terms of asset value:
Worldcom, Inc. $103.9 Enron Corp. 63.4 Texaco 35.9 Financial Corp. of America 33.6 Global Crossing, Ltd. 25.5 Adelphia Communications 24.4
During 2001, the number of public company filings reached an all-time high of 257 filings exceeding the 2000 record of 176 filings. According to data furnished by BankruptcyData.com, the declared assets associated with the 257 filings in 2001 of approximately $260 billion were almost three times the assets associated with the previous year's filings.
TURNAROUND AND RESTRUCTURING
Two critical aspects of the process of making a business with problems profitable again involve solving the operational problems and restructuring the debt and equity of the business. Turnaround is used to mean the process of solving the operation problems of a business. It involves improving the position of the business as a low-cost provider of increasingly differentiated products and services and nurturing a competent organization with industry-oriented technical expertise and a general sense of fair play in dealing with employees, creditors, suppliers, shareholders, and customers. Restructuring is used to mean the process of developing a financial structure that will provide a basis for turnaround.
Some entities in financial difficulty are able to solve their problems by the issuance of stock for a large part of the debt; such is the case where the company is overleveraged. Others are able to regain profitability by improving cost margins through reduction of manufacturing costs and elimination of unprofitable products. However, the majority of businesses require attention to operating problems as well as changes to the structure of the business.
When a business finds itself heading toward serious financial difficulty, unable to obtain new financing or to solve its financial problems internally, it should seek a remedy through its creditors, either out of court or with the help of the federal Bankruptcy Code. Under either of these methods, the debtor has several alternatives as to the particular way it will seek relief. The appropriate method depends on a number of variables, including the debtor's history, size, debt structure, nature of problems, and future outlook. In examining the alternatives, two major issues must be resolved:
1. Should the business liquidate or reorganize?
2. Should the liquidation or reorganization take place out of court or in bankruptcy court?
If it is determined that the business should be liquidated, an analysis should be made of the ways in which a business can be dissolved. For example, the debtor might decide to make a general assignment for the benefit of creditors under state or common law. In many cases, to provide for an equitable distribution it will be necessary for the debtor to file a chapter 7 petition. Chapter 7, dealing only with liquidations, is designed to provide a framework for the business to be closed, assets to be sold, and proceeds to be distributed to the claim or equity holders.
Excerpted from Corporate Bankruptcy by Grant W. Newton Excerpted by permission.
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Table of Contents
Chapter 1. Introduction.
Chapter 2. Selection of Alternative and Prebankruptcy Planning.
Chapter 3. Impact of Bankruptcy Filing.
Chapter 4. Administration of the Case.
Chapter 5. Claims.
Chapter 6. Recovery of Property.
Chapter 7. Liquidation and Discharge of Claims..
Chapter 8. Business Valuation.
Chapter 9. Chapter 11 Reorganization: Part 1.
Chapter 10. Chapter 11 Reorganization: Part 2.
Chapter 11. Accounting and Reporting Issues.
Chapter 12. Retention and Compensation of Professionals.