bankruptcy for the little people

uses and abuses

John Quiggin commented on the last post:

One corollary development of the growth of debt finance is that bankruptcy has gone from being a personal and commercial disgrace to a normal refinancing option. The financial sector has managed to tighten the rules for individuals, but corporations enter and leave bankruptcy with not much more controversy than if they change their names. As with so much of the modern world, Trump exemplifies this trend, and his moral character is consistent with it.

This isn’t quite how I see things, but like an improv guy, I’m going to say “yes, and”.

Certainly, one of the things I edited out of the book excerpt on Wednesday to get the length down was any discussion of bankruptcy regimes, which are very important.  Bankruptcy is where debt really turns into a technology of control – the creditor has the option to take over the firm, shut it down or provide new finance on different terms.  Or at least, that’s true if there’s a single creditor.  If there are multiple creditors, there is the potential to play them off against each other, some of them will have different interests from others and things get, to use the technical game theory term “really really f*@!#king strategic”.  The bankruptcy code is the baseline rules of the game, and different legal systems do make a huge difference.

But I’d disagree with John that corporations “enter and leave bankruptcy with not much more controversy than if they change their names”.  A lot of the time, they get shut down and the creditors take ownership of valuable assets.  This means that the finance providers are OK, but the little people – the suppliers, employees and other parties who depend on the company carrying on as a continuing economic entity - get hosed.  The bankruptcy process can be made quite frictionless, but it’s never a non-event – it’s something which creates a lot of economic damage and deadweight loss.

Except, except except, and this is why I say “yes and” rather than “yes but” above … some companies (in fact, the statistically overwhelming majority of incorporated entities by simple headcount) don’t actually have any operations or carry out any activity at all.  They are just shells – “special purpose vehicles”, or other limited liability things which have the sole purpose of being the legal person that owns something.

Obviously, something with no operations to disrupt doesn’t suffer any damage at all from the deadweight cost of bankruptcy – it really does, as John says, slip through the process with not much more damage than a couple of book entries and a small lawyer’s bill.  And it can come out of bankruptcy having got rid of a load of inconvenient liabilities; long term labour contracts, pension obligations, even legal judgements from people it gave cancer to.

Which is extremely problematic in my view, because it means that the system of limited liability gives the greatest benefits to the kinds of entities that deserve it least.