Bankruptcy, Ethical Issues in

Bankruptcy occurs when an individual or a corporation that has insufficient assets to pay all debt obligations is subject to laws that provide some protection from creditors and permit an orderly distribution of assets to satisfy creditors' claims. There are two broad kinds of bankruptcy. In “liquidation” or “straight” bankruptcy, the assets of an individual or a corporation are turned over to a trustee, who liquidates them and distributes the proceeds to the creditors. An individual who goes through liquidation bankruptcy is absolved of many debts and is free to make a “fresh start.” A corporation that is liquidated goes out of business. The second kind is “reorganization” bankruptcy, in which a corporation obtains temporary relief from debt obligations while it seeks to reorganize and regain solvency. Individuals may also use reorganization bankruptcy to work out a repayment schedule with creditors. In the United States Bankruptcy Code, liquidation bankruptcy is governed by Chapter 7 and reorganization bankruptcy by Chapter 11.

Bankruptcy is vital for a well-functioning economy. Without it, indebted individuals may suffer a lifetime under debt burdens that keep them from enjoying a rich, full life. The prospect of possible ruin without promise of relief is likely to deter individuals from risky, but potentially profitable, business ventures. Without the possibility of an orderly liquidation of a failed business, suppliers would be less willing to extend goods on credit or make capital available. Most important, reorganization bankruptcy permits potentially profitable businesses to recover from temporary adversity and remain going concerns. This kind of [Page 144]protection enables business organizations to continue to provide jobs and serve customers and to keep productive assets employed during difficult times. Overall, bankruptcy increases the wealth of any society.

Despite these benefits, bankruptcy poses some ethical issues. One ethical issue in bankruptcy concerns the moral justification of bankruptcy laws. Laws that absolve individuals and corporations from paying debts they have incurred or else allow them to defer payment might appear to violate the ethical principle that all debts should be paid. Alternatively, very stringent bankruptcy laws might be viewed as unjustifiably punitive, especially when they force individuals to pay heavy debts or prevent corporations from reorganizing and returning to profitability.

A second ethical issue is the possible abuse of bankruptcy laws. Individuals might be accused of abusing bankruptcy, for example, when they incur large debts just before filing for bankruptcy. In corporate bankruptcies, all creditors should be treated fairly with respect to their claims. However, in bankruptcy proceedings, it is possible for some creditors to get more than they deserve and others, less. In particular, when corporations reorganize and emerge from bankruptcy, those parties that control the process have an opportunity to enrich themselves at the expense of some creditors and other groups, such as employees. Bankruptcy also affords corporations the opportunity to enter bankruptcy in order to achieve strategic ends, such as avoiding legal judgments or strengthening their negotiating position with creditors. Such “strategic bankruptcy” is often criticized as an abuse of the law.