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Grist: Why Bankruptcy is Bad for Business

The other reason entrepreneurs should fear bankruptcy.
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If not an oxymoron, there is still a vaguely contradictory energy that emanates from the phrase "bankruptcy protection." A company goes bust -- perhaps from mismanagement or thievery -- and it should be rewarded with protection for that?

Of course, there is a business and societal logic behind this policy. Government has an interest in allowing a distressed company enough breathing room to reorganize itself, regain its bearings, maintain jobs, and hopefully emerge reborn and able to compete and win in the market.

While the notion of insulating troubled companies from creditors seems like a venerable policy, it wasn't until relatively recently -- 1898 -- that companies were given this kind of protection from creditors. The Great Depression encouraged the expansion of the safety net, given the national need to keep as many companies -- and jobs -- from expiring as possible.

Since then, though, we have witnessed economic shifts that raise serious questions about the fairness and suitability of these laws in today's business environment. The explosion in outsourcing also has greatly expanded the number of small and midsize companies that sell their products and services to these protected corpses. Because small companies often operate on thin cash reserves, they are highly vulnerable participants in the payment chain. They can easily be injured or destroyed even as bankrupt but still wealthy companies remain sequestered behind the shield of reorganization.

Of course, when one of these multibillion-dollar companies seeks protection under the federal bankruptcy laws, the secured creditors are first in line. Unsecured creditors -- many of them small companies for whom these accounts receivable are critical -- wait, palms upturned, in the queue. Deborah Crabbe, who is chairwoman of the small-business subcommittee of the American Bankruptcy Institute, says that long bankruptcies mean "small-business debtors tend to languish. As a result, you're just bleeding the creditors."

Even when companies do manage to hang in there for the several years a bankruptcy proceeding can last, they often end up with pennies on the dollar. But secured creditors -- usually banks and pension funds -- aren't just in a better position to collect. They sometimes push companies into reorganization in the first place, knowing they will get paid from the existing assets.

Other financial maneuvers can be made that hurt small unsecured creditors by leaving less money on the table. Consider so-called "retention bonuses," lump-sum payments designed to prevent valuable employees from jumping ship. Was it right that Enron paid $55 million to seduce 500 employees to stay for just 90 days? That's $110,000 per employee. Meanwhile, Enron's unsecured creditors, including many small and medium-size companies, went unpaid for the products or services they had provided.

The Kmart bankruptcy is another example of the damage that gets done. The Detroit News recently reported that the number of pages of local companies on the Kmart creditors list "is half an inch thick and illustrates the huge swath the bankruptcy case is cutting through Michigan's business community."

Meanwhile, what happens if a small business needs to seek bankruptcy protection itself? The current laws counterintuitively favor large bankruptcies. One reason is that the reporting requirements, such as filing monthly reports with a federal trustee, are often beyond the capability of small debtors. Bankruptcy lawyers don't come cheap, either.

It's time to address this lopsided situation. One possibility: Allow smaller creditors -- for example, those with annual sales below $25 million -- to jump to the front of the line of unsecured creditors. Another: Rewrite the laws to require a special slot on the creditor's committee for a representative of small-company debtors. Or why not a government-funded insurance program -- the same kind that protects pension funds -- to help small companies weather the collapse of large customers?

Those thoughts are only meant to help get the debate started. The larger point we need to keep in mind is that bankruptcy is supposed to protect debtors -- not put creditors out of business.

Adam Hanft is founder and CEO of Hanft Unlimited Inc., a Manhattan-based consulting, advertising, and publishing firm.

Last updated: Jun 1, 2004




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