When a person or a firm is unable to pay their ever-increasing debts, they can file for bankruptcy. Let us say Mr X filed for bankruptcy. This means Mr X’s existing assets will be liquidated and he will be relieved of any liability. The reason why most people file bankruptcy is that their debts have reached a level where they cannot pay them back and only way out of it is a fresh start.
Last year in U.S. more than a million filed for bankruptcy. That number will increase this year due to
- Bad housing market (which leads to foreclosures & delinquencies)
- Bear stock market (with housing & subprime lending stocks leading the way)
- Possibility of a recession (as per Greenspan’s comment)
- Energy prices (ever increasing oil prices putting extra burden on everyone)
- Increased inflation (driving up the prices of goods and services)
- Americans save less money leading to high debt to income ratio
Types of Bankruptcy
Chapter 7: Mr X can file for Chapter 7, which basically means that all his assets will be liquidated except few exempted ones depending on which state he lives (car, clothing, household appliances, life insurance, pension and work related stuff). The liquidated assets will be handed to the creditors. A trustee is appointed, who ensures that any assets of Mr X that are secured are sold and that the proceeds are paid to the specific creditors. Generally the secured creditors (banks) are the first one to get paid. After all secured creditors are paid, the remaing cash is distributed to any outstanding creditors with unsecured loans (bondholders and preferred shareholders).
Chapter 11: If Mr X had his own business, he could file for Chapter 11, which is designed largely for businesses. Under this chapter, a business will be continued to operate while a court approved plan is setup to repay the creditors back. A trustee is appointed just like for Chapter 7, but rather than selling of all the assets to pay back to the creditors, the trustee supervises the assets of Mr X and allows business to continue. Chapter 11 differs from Chapter 7 since in Chapter 11 the debt is not pardoned, but only the terms of the debt is restructured.
Chapter 13: If Mr X still has a regular source of income, he could file for Chapter 13 bankruptcy protection, which allows him to keep certain property while he pays off his debts under the supervision of a court-appointed trustee. The time-frame alloted is generally anywhere between 3 to 5 years. In 2003, U.S. citizens filed for Chapter 13 bankruptcy almost 500,000 times, making it the second-most popular form of bankruptcy behind Chapter 7.
The Good, The Bad and The Ugly About Bankruptcy
There few positives and negatives Mr X need to know before filing for bankruptcy.
- Distressed debtors can get rid of their debts, especially with Chapter 7.
- Bankruptcy may get rid of unsecured debts (A loan not secured by an underlying asset or collateral).
Bankruptcy can stop foreclosures for homeowners, repossessions, deducting money from wages, utility service cancellations and activities of debt collectors against the debtor.
- Chapter 7 and 13 bankruptcies provide exemptions that allow debtors to keep certain assets, though those exemption amounts vary greatly from state to state.
- If a company is successful in chapter 11, it will typically be expected to continue operating in an efficient manner with its newly structured debt.
- The law forbids discrimination against those who have filed for bankruptcy, so a debtor cannot be denied a job, public housing or a driver’s license on this basis.
Some debts (student loans, alimony, child support, fines and penalties) will not be discharged.
- Chapter 7 relief is available only once in any 8 year period.
- The rights of secured creditors to their collateral continues even though their debt is discharged.
- Debtor need to file the claim and pay a fee (adding extra expense). Debtor also need to pay a bankruptcy lawyer, and it can be difficult to find a good one, since some try to maximize their profits by handling cases as quickly as possible instead of giving debtor’s bankruptcy the attention it deserves.
If a company is not successful in chapter 11, then it will have to file for chapter 7 and liquidate.
Debtor if found guilty of certain types of inappropriate behavior (concealing facts related to financial condition) will not be granted a discharge of debt and could possibly face jail time.
- File for bankruptcy will remain on your record for up to 10 years. This may make it difficult or impossible to obtain a credit card or a loan.
How Does It Affect Investors
Let us say Mr Y and Mr Z are investors with some stakes in Mr X’s company Danger Inc. Mr Y is a shareholder and Mr Z is a bondholder of Danger Inc. Later on Danger Inc filed for bankruptcy. So what happens to Mr Y and Mr Z’s investments ? There is a very high possibility that Mr Y and Mr Z will end up making a sizable loss over the investment.
Generally nobody invests money in a company facing bankruptcy. Add to that when the company declares bankruptcy, its stocks and bonds usually continue trading at extremely low prices. Mr Y will see a substantial decline in the value of his shares. Mr Y will stop receiving dividends if any. Mr Y will also not have any more say or voting rights in Danger Inc’s restructuring plan. Mr Z would be holding bonds that are considered as junk. Mr Z will probably stop receiving interest and principal payments. Ouch…!!
List of Bankrupt Companies
Few known companies that filed bankruptcy are: WorldCom, Enron, Kmart, Silicon Graphics Inc., US Airways, Recently 4 subprime lending companies that filed bankruptcy are: People’s Choice Home Loan Inc., Mortgage Lenders Network USA Inc., Ownit Mortgage Solutions Inc. and ResMae Mortgage Corp.
Conclusion: A debtor should understand the pros and cons of bankruptcy before filing one. In general, bankruptcy should be used only when there’s no other solution. The 3 important types of bankruptcy are Chapter 7, Chapter 11 & Chapter 13. An investor should stay clear of companies declaring bankruptcy unless they have a solid reason to back their investments. There is more to bankruptcy that has not been covered in this post. I will address those topics in a follow up post. So stay tuned
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(Source: Investopedia, Wikipedia)