Samstag, 5. Oktober 2019

Why do corporations file for bankruptcy?

The question seems easy enough, because in 99% of cases, the answer is clear: they ran out of cash. But: the German insolvency statute actually has 3 reasons for opening a bankruptcy-proceeding: 

1. The debtor is insolvent, which means he is unable to pay its creditors;
2. the company is over-indebted, meaning the debtor's assets no longer cover his obligations to pay, unless it is highly likely, considering the circumstances, that the enterprise will continue to exist;
3. (only if the if the debtor files for bankruptcy himself):  the debtor is imminently insolvent.

So logically, it makes sense to differentiate between cases where the company has to file for bankruptcy and cases where it makes sense to file. I would argue that lots of cases include both. But the latter usually occurs only when there are new stakeholders involved. Not only do they look with a different angel – they also bought into the securities at different (cheaper) prices. 
I. The company has to file for bankruptcy/ creditors file for bankruptcy

As I wrote earlier, in reality, 99% of all bankruptcies are filed because of insolvency (reason 1.). Companies usually do not go to court and say "My assets probably won't cover my liabilites." That is because management is in a very precarious role: file to early and your stockholders sue you. File to late and the creditors (in the form of the administrator) do. 
Also, over-indebtedness (reason 2.) is also very loosely defined, as companies are not required to file, if it is "very likely that the enterprise will continue to exist." As long as management is in some talks over stretching loans, getting a new investor or not having to pay its employees for, they can – and must! – argue that it was likely that the enterprise will continue to exist. If you do a simple test and check for openings of cases on First Data, you will see that the overwhelming majority of cases is opened on the grounds of both insolvency and over-indebtedness, because once you are insolvent, your assets usually do not cover your liabilites (otherwise you would have sold them and paid off your liabilites). 
II. It makes sense for the company to file for bankruptcy

This is relatively new in Germany. It is usually done, because there is new management installed which sees an advantage in taking a bath and restrucutre the whole company. You see, usually the creditor threatens with “filing for bankruptcy”. But of course, management can make the same threat. If you read through the case study of how Buffett took the reign at Salomon, this is basically what he did. He told regulators 

“These are all the solutions I have. If you don’t help us … well, I do not know what else to do. Here are the keys. You take over.”

That worked, because they knew the only worse outcome for the country than having a misbehaving Salomon, is a dead Salomon. They gave Buffett what he needed and the bank was ultimately saved. But it goes both ways and there are all kinds of stories and wild legal battles and I myself have been involved in a case, where creditors wanted to file for bankruptcy in order to get rid of management, because they happened to have 30% of the shares outstanding and they were a simple joke (I will write about that case study in-depth in another post, as it makes a great illustration of the possibilities of bankruptcy if you understand the tools it can provide to you).

But in general, the upside of filing for bankruptcy is that it puts an automatic stay on all stakeholders: every lawsuit is legally required to halt, every foreclosure is put on halt and employees get paid for three months from the government. Basically, the creditors are forced to stop attacking the debtor and sit on the table to work out a plan. If they do not find a solution, the company will be liquidated, which is almost always a worse outcome for all stakeholders, especially employees, suppliers and customers. You can see a liquidation scenario versus a bancruptcy plan in the cases of Beate Uhse and SKW Stahl AG on Debenture Research.

There is another great thing about a structured bankruptcy-plan: it is not necessary to have every creditor to agree, but simply the majority of creditors. That’s what makes a bankruptcy so powerful, if used properly: the company can enforce things against the will of major stakeholders, if it serves the general good. It is why I call it “Bankruptcy protection”. It is neither good nor bad, but just a tool that can be used. It depends on how it is used and handled. 

We will talk more about that in the next post.

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