BUSINESS FAILURE



Business enterprises in the United States, and indeed around the world, tend to fail at a predictable rate that is influenced by national or international business cycles and other factors. In the 1980s and 1990s, U.S. failure rates hovered between 0.7 and 1.2 percent of all businesses each year, according to annual statistics compiled by Dun & Bradstreet Corporation. In 1997 the failure count stood at 83,384 businesses. New business start-ups typically outnumber failures by a 2:1 ratio, and more during periods of rapid expansion.

CONDITIONS LEADING TO FAILURE

While broader economic conditions such as consumer spending, industry sector health, and international trade are often linked to business failures, most also involve some form of management miscalculation or problem specific to the failed company. Rather than resulting from a single incident, however, failures usually stem from a series of events that lead to a company's downfall. Common mistakes include

In his book Why Companies Fail, Harlan D. Platt argued that businesses experience two kinds of failure: economic and financial. Economic failure occurs when expenses overtake revenues, which results in a loss on the company's income statement. This in itself doesn't spell failure, and many large and profitable companies occasionally sustain economic losses, often due to one-time transactions or accounting changes, for relatively short periods. It is also common for start-up companies, particularly those in industries with high research and development overhead, to weather a number of unprofitable years before they break even or profit; again, this doesn't necessarily signal total failure as long as the firm has funding to continue paying its bills.

Economic failure becomes a financial failure when a company can no longer meet its financial obligations. A company can endure a period of economic losses as long as it has cash reserves, loans, or other assets it can draw from to meet its operating expenses. When it runs out of such funds and begins to default on payments, a company is technically insolvent and may be subject to foreclosure, bankruptcy protection, liquidation, or other legal actions.

KINDS OF BUSINESS FAILURES

While bankruptcy is the most frequent outcome of business failure, the two terms aren't synonymous. Depending on how many creditors there are, the amounts and kinds of outstanding debt , and the intentions of a company's management, a company or its creditors may choose to file a bankruptcy petition or some other legal resolution. If a company defaults on its loan payments for a building, for example, and has no other significant bad debts, the only action might be a foreclosure on the property, and bankruptcy may not be pursued. Moreover, creditors may sue the insolvent company for its assets, leading to a court-appointed liquidation of those assets. An additional means of resolution occurs when another company, usually a competitor, acquires an insolvent one before other action is taken. Typically this involves assuming the acquired company's debt, and often there is no selling price for the defunct company beyond the cost of its debt.

BANKRUPTCY

The most frequent and widely known outcome of a business failure is bankruptcy. Bankruptcy provides a number of organized methods by which creditors may receive payment, but more importantly it is a legal device through which debtors can control their losses. It is in the latter sense that it's common to refer to "bankruptcy protection." While bankruptcy doesn't guarantee that a creditor will ever recoup any amounts in default, it protects defunct companies and their owners from liability for debts that are well beyond their reasonable means to pay. Declaring bankruptcy involves filing a petition in court for bankruptcy under one of several chapters, or categories of bankruptcy, recognized by the law. When this petition is filed by the debtor, it is termed voluntary bankruptcy, whereas a creditor-initiated filing is called involuntary.

Historically bankruptcy was a crime punishable by death under English law, but during the 19th century in the United States it evolved toward the modem conception of a mechanism to end a cycle of debt. The first bankruptcy legislation in the United States dates to 1800, and the Constitution also contains language that identifies uniform bankruptcy laws as the legislative domain of the U.S. Congress. State laws also govern certain aspects of bankruptcy proceedings, chiefly the kinds and amounts of assets exempt from liquidation. In the late 1990s, bankruptcy continued to be governed largely by the Bankruptcy Reform Act of 1978, the last major revision of U.S. bankruptcy law. In 1998, though, the House passed a bankruptcy reform bill directed mainly at individual bankruptcies, while the Senate was taking up both consumer and business bankruptcy measures.

Under the U.S. Bankruptcy Code, three kinds of business bankruptcy exist: Chapters 7, 11, and 12 (although Chapter 12 applies only to family farms). The designation "Chapter" followed by the respective number simply refers to the technical structure of the Bankruptcy Code, which like all U.S. law is organized in a series of chapters, subchapters, and sections. As measured by figures compiled by the Administrative Office of the U.S. Courts, in the period 1990-96 an average of 61,779 businesses petitioned for bankruptcy protection each year. The vast majority of these were voluntary, meaning they were initiated by the company instead of its creditors.

CHAPTER 7.

Known as "liquidation bankruptcy," Chapter 7 is the predominant and arguably the most basic form of bankruptcy. Liquidation refers to the sale of a debtor's assets in order to raise funds to pay creditors, and is overseen by a trustee who is appointed at the time bankruptcy is filed. In Chapter 7 bankruptcy, which may be filed by either individuals or businesses, debt is divided into two categories: secured and unsecured. Secured debt is the amount owed on specific pieces of property, such as those from financing agreements on real estate or equipment. Unsecured debt, by contrast, is a more general form of debt because it isn't based on a contract for any particular asset of the debtor. This kind of debt results from general lines of credit , loans, or fees for services that aren't directly tied to any physical asset. Secured debts may be recovered through foreclosure or repossession as well as cash received from liquidation of the company's assets, while unsecured debts are dependent solely on funds from liquidation.

Chapter 7 protects debtor companies and their owners from creditor claims that vastly exceed what the debtor can be reasonably expected to pay given current assets. The law distinguishes between exempt and nonexempt property and other assets; all nonexempt assets may be liquidated or turned over to creditors, but exempt assets can't be taken from the debtor. Thus, creditors collectively normally can't pursue any payments beyond the total value of the debtor's non-exempt assets. State laws vary on which assets are considered exempt, but exemptions generally allow the debtor to keep a certain minimum of property and personal benefits of the company's owners. After all nonexempt assets are disposed of, any amounts still owing are written off as bad debt by the creditors, and the debtor has no further liabilities .

CHAPTER 11.

Chapter 11 bankruptcy is only available to businesses. It allows a firm to restructure its finances and arrange to pay off debt without going out of business. If a reorganization under Chapter 11 is successful—and many aren't—the company may recover from bankruptcy and return to fiscal health. Part of the filing involves submitting a detailed plan of how the company plans to meet its financial obligations. Such a plan must be approved by creditors. While Chapter 11 bankruptcies usually aren't subject to oversight by a trustee, a board of eligible creditors supervises the company's management to ensure the plan is carried out. As in Chapter 7, bankruptcies under Chapter 11 may be filed either by creditors or the business in debt, but most are initiated by debtors.

BANKRUPTCY REFORM

Critics of U.S. bankruptcy laws in the late 1990s alleged that they permit inefficient and mismanaged companies to perpetuate such practices or even to take advantage of the system. These observers claim that Chapter 11 protection, in particular, is most often used to simply stall for time and that only a small minority of Chapter 11 bankruptcies result in the intended financial recovery and retirement of debt. Proposed changes to Chapter 11 include:

Reform initiatives were given additional momentum by a surge in consumer bankruptcies during the first half of the 1990s. In 1994 Congress created the National Bankruptcy Review Commission (NBRC) to study trends in consumer and business bankruptcy cases and recommend revisions to the national bankruptcy laws. The commission released its report in 1997, but the recommendations didn't encompass many of the creditor-oriented reforms that some critics called for.

FURTHER READING:

Altman, Edward 1. Corporate Financial Distress and Bankruptcy: A Complete Guide to Predicting and Avoiding Distress and Profiting from Bankruptcy. New York: John Wiley & Sons, 1993.

Bhandari, Jagdeep S., Lawrence A. Weiss, and Barry E. Adler, eds. Corporate Bankruptcy: Economic and Legal Perspectives. Cambridge University Press, 1996.

Delaney, Kevin. Strategic Bankruptcy: How Corporations and Creditors Use Chapter 11 to Their Advantage. University of California Press, 1992.

Gross, Karen. Failure and Forgiveness: Rebalancing the Bankruptcy System. Yale University Press, 1997.

Platt, Harlan D. Why Companies Fail: Strategies for Detecting, Avoiding, and Profiting from Bankruptcy. Lexington Books, 1985.



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