Corporate Bankruptcy: What Investors Need to Know
By Rachel Beck, The Associated Press
That means they can't pay their bills or creditors in a timely fashion. In many cases, they turn to the bankruptcy court for cover—either to liquidate or reorganize their businesses.
The plethora of corporate bankruptcies lately could put this year in the record books. There have been 100 public company bankruptcy filings during the first five months of this year, just shy of the 2002 high for the same January-through-May period, according to BankruptcyData.com.
So it's probably a good time to understand what a corporate bankruptcy is and how the process works. Here are some questions and answers.
What is bankruptcy?
Bankruptcy is a legal procedure set forth by the U.S. Bankruptcy Code for use when a debtor isn't able to make payments. That could happen when a company (or individual) can't pay debts as they come due, or has overwhelming debt obligations.
In the case of GM, the nation's largest automaker had $172.81 billion in debt and $82.29 billion in assets, according to its bankruptcy filing on Monday.
Bankruptcy is a safe haven because it gives companies protection from their creditors, which can no longer demand to be paid once bankruptcy is declared.
What are the different kinds of bankruptcy?
The vast majority of corporate bankruptcies are filed under Chapter 7 and Chapter 11 of the Bankruptcy Code.
When a company files for Chapter 7 bankruptcy, it typically leads to a liquidation of its business. This means the company does not intend to continue operating and plans to sell off its parts. Proceeds from the sale are then distributed to creditors in the order of their priority.
A company can thwart liquidation during a Chapter 7 proceeding if it settles with its creditors.
A Chapter 11 filing usually involves the company reorganizing its business through the bankruptcy process in the hope that it will survive. This action shields a company from creditors' demands for payments and from lawsuits while it restructures its finances. Contract terms can also be rewritten under the Bankruptcy Code—something that can't easily be accomplished without a bankruptcy filing.
That is why it is often said that a company filing for Chapter 11 gets bankruptcy court protection.
"Bankruptcy supplies some breathing room to companies because it stops all collection efforts," said Theodore Eisenberg, a professor of law at Cornell University.
What power do creditors have during bankruptcy cases?
During Chapter 11 proceedings, the debtor's reorganization plan must be accepted by a majority of its creditors.
But there are exceptions. Section 363 of the Bankruptcy Code requires only court approval for asset sales. This means creditors don't get any say if a company wants to sell off certain parts.
Chrysler won such approval in late May. A bankruptcy judge gave the No. 3 U.S. automaker consent to sell most of its assets to Italy's Fiat. That set the stage for Chrysler to emerge from bankruptcy protection after a two-month reorganization.
GM also plans to use Section 363. The company intends to sell its healthy assets to a new entity, Vehicle Acquisition Holdings, which is 60% backed by the U.S. government.
It is up to the bankruptcy court to decide when Section 363 can be used, Eisenberg said. In Chrysler's case, the judge likely feared that Fiat could withdraw its offer, so there was an incentive to permit the quick asset sale, he said.
Are companies filing for bankruptcy considered insolvent—meaning that they can't pay their debts when they come due?
That may be so for many companies facing bankruptcy, but it's not always true.
Bankruptcy experts point to the 1987 bankruptcy filing by Texaco. The oil company lost a lawsuit in which Pennzoil claimed Texaco had interfered with a planned merger between Pennzoil and Getty Oil. The judgment against Texaco was for nearly $11 billion in damages, which Texaco argued it lacked the assets to pay.
This led Texaco to file for Chapter 11 bankruptcy protection. The company later settled with Pennzoil for $3 billion.
But Texaco's bankruptcy case didn't have anything to do with a lack of demand for its oil.
"Texaco couldn't come up with enough cash, but it wasn't insolvent in any balance sheet sense," Eisenberg said. "It was an isolated problem that was solved through bankruptcy."
Are there any risks for companies entering the bankruptcy process?
A company that files for Chapter 7 bankruptcy might not be able to easily liquidate its parts, especially if the products or services it provides have become obsolete. Those that file for Chapter 11 could get stuck in bankruptcy if creditors can't agree on a reorganization plan.
"There is always the chance that the case will get bogged down in court, and during that time the business will deteriorate even more," said David Skeel, a professor at the University of Pennsylvania Law School.
That seems to be one thing the Obama Administration wants to avoid in the cases involving GM and Chrysler. Legal experts say a quick reorganization for both automakers would mean demand for their cars wouldn't be further hampered by the bankruptcy process.
Moreover, a company that seeks bankruptcy court protection might not rid itself of all of its financial troubles, which could lead to a subsequent filing in future years.
"Bankruptcy protection might not work. The company could emerge from bankruptcy but still might struggle because of operational and financial difficulties," said Edward Altman, a professor of finance at New York University's Stern School of Business.
In the case of GM and Chrysler, Altman points out that even their restructured operations might not be enough to revive their businesses if sales remain weak. "They still need to get consumers buying cars," he said.
There's been a lot of talk about pursuing a "controlled bankruptcy" for both Chrysler and GM. What is this—and what's the value of this approach?
Instead of starting to negotiate with creditors once a company files for bankruptcy protection, concessions are made ahead of time. This means that when a company files for Chapter 11, the reorganization of its business could presumably go faster and be more orderly.
With GM and Chrysler, for example, months were spent trying to get creditors on board so that once the companies filed for bankruptcy, they could emerge more quickly.
With the approval of the sale of Chrysler's assets to Fiat, the automaker could emerge from Chapter 11 bankruptcy protection as soon as this week. The Obama Administration expects that the new GM could emerge from bankruptcy in as little as 60 to 90 days.