Bankruptcy

The Causes of Corporate Failure

Firms fail because they are in difficulty, but bankruptcy implies not only short-term problems with cash flow, but the fact that proceeds from the sale of the firm would be insufficient to meet its debt. A failure to make profits, a root cause of bankruptcy, is cyclical in nature: When the economy moves into a downturn, some firms that were previously profitable cease to be so. Most of these firms are relatively young and thus rarely large. Individually these unprofitable firms seldom make headlines, but cumulatively they represent considerable distress to their owners and perhaps also their workers. Such new firms fail because of incompetence of one form or another or because of bad luck such as an unexpected increase in interest rates, which increases loan repayments.

Firms in declining industries also experience bankruptcy. This type of bankruptcy is necessary to the progress of the economy. Such firms are not profitable because their products are not wanted at a price that covers costs. Because such firms are inefficient, their resources—labor, land, and capital (machines, trucks, and so on)—should be reallocated to other firms that can use them more efficiently. Typically these firms, although probably in the midst of a long drawn-out decline, are still large.

Not all large bankrupt firms, however, are in declining industries. A temporary shock, such as a war that drives up oil prices, can lead even firms with good longterm prospects to become bankrupt.

The Social and Economic Costs of Bankruptcy

When a small firm closes, it can represent significant hardship to the owner, whose life savings may be invested in the firm. Similarly, employees may suffer distress, although, possibly with some retraining, they should find other employment opportunities in the area. Thus the impact on both employees and the community at large is limited.

When a large firm goes bankrupt, particularly if the large firm is a dominant employer in the locality, the results are more drastic. Some employees may choose to remain in the area and wait for new employment opportunities to emerge. In this case, house prices fall, and social capital institutions—schools, hospitals, and roads—are underused. Apart from the social costs, there are macroeconomic costs such as reduced tax revenue for governments and higher welfare payments.

Bankruptcy Systems

A bankruptcy system must achieve several objectives. First, it must return assets to creditors as fully and [Page 82]quickly as possible and identify with certainty which creditors fare best (which are paid most) in the bankruptcy procedure. Second, it must put into effect the creative-destruction role by which the old and inefficient are disposed of as quickly as possible. Third, it must ensure that potentially profitable firms survive the bankruptcy process.

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