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On bankruptcy

Nortel Networks filed for bankruptcy protection earlier today. Given the current state of the world economy, bankruptcies are expected. Believe it or not, changes to bankruptcy laws can help the world get out of the recession. To do so, they must make it easy to get restarted or keep going.

There are two general forms of bankruptcy: liquidation and reorganization. In liquidation, an individual or business’s assets are sold, and the individual is discharged from their debts and the business ceases operations. Under reorganization, the business changes operations, ownership is turned over to creditors, and the business remains a going concern; for an individual reorganization, budgeting is changed and disposable income is used to finance a repayment plan, and eventually debts are discharged.

Why does a forgiving bankruptcy law help the economy? It makes it less risky to start up a business. If a potential entrepreneur runs the chance of losing everything and being shackled with twenty years of payments if their business fails, they are less likely to start. Similarly, having struggle to recover after a personal bankruptcy hurts their health, makes them less productive at their job (thereby hindering their financial recovery), and contributes to poverty. Similarly for a business, lenient reorganization allows people to keep their jobs.

Of course, some regulation and rules are necessary. Actions should be enabled so that there is as little fraud as possible and so that individuals have an incentive to manage personal finances responsibly. Upper management at a reorganizing company should be fired so that bankruptcy is not an “escape hatch” for bad managers, and executive pay in bankrupt companies should be limited. This ensures managers have an incentive to manage well. And in some cases, especially when there are many bankruptcies in an industry, market distortion may result. In such a situation, in the long run it may be better to let the business(es) in the worst financial position fail. And lastly, steps should be taken to help alleviate the causes of bankruptcies; in the United States, half of all personal bankruptcies are medical related (at least partly), so decreasing the expense of medical care will reduce bankruptcies. This makes access to credit easier as more people will eventually repay, making lending less risky on average.

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