Martin Fridson

A backward step on bankruptcy

Here is an important business story you probably did not read about in the financial press – at least not at the time the event took place. Early this year, a variety of special interests engineered a radical overhaul of United States corporate bankruptcy procedures. When the legislation becomes effective in October, it will likely become substantially harder to rehabilitate financially strained companies, as an alternative to liquidating them.

During the April 20 signing ceremony for the Bankruptcy Abuse Prevention, Consumer Protection Act, US president George W. Bush proclaimed that the legislation restored integrity to the bankruptcy process. The new law, he said, addressed abuses of the system by requiring people with the financial wherewithal to pay back at least a portion of their debts. By the same token, the legislation compelled credit card companies to inform borrowers upfront of the penalties for failing to fulfil their obligations.

At no point in his remarks did Bush even mention the Act's corporate component. Major newspapers similarly focused their coverage exclusively on the personal bankruptcy issues. Here are a few of the provisions that you consequently never became aware of, unless you read certain professional journals or memos prepared by law firms for their clients:

• Vendors enhance their ability to reclaim goods in the troubled company's inventory, potentially ending its ability to continue operations.

• Landlords can compel companies to decide more quickly than in the past whether to accept or reject leases. A retailer, for example, must choose which stores to continue operating before it has devised an overall operating plan.

• Utilities can exert greater near-term financial pressure on a company than formerly, even if the company is sufficiently liquid to pay its post-bankruptcy-petition bills.

• Taxing authorities can require payment over a shorter period, starting from an earlier point in the bankruptcy, than under the old rules.

By cutting special deals for themselves, the various interest groups have undermined the principle that distinguishes the US from most other countries in its approach to corporate bankruptcy. The whole idea is to relieve a troubled enterprise of immediate demands on its cash. This breathing room enables the company to devise a plan for restructuring its finances, continuing its operations and, not incidentally, preserving its employees' jobs.

Pulling the plug and paying off the banks is unquestionably a simpler and cleaner approach. It has certain drawbacks, however. For one thing, it means that an entrepreneur who gets knocked down has no chance to get back up and fight again. That is hardly a message that encourages risk-taking. In addition, forcing liquidation for the benefit of secured lenders discourages anyone from lending to a company on an unsecured basis.

US economic growth has benefited from the fact that companies have alternatives to being entirely dependent on commercial banks for their financing. Other countries are increasingly recognising the need to adopt such a system. It is therefore ironic that with the Bankruptcy Abuse Prevention and Consumer Protection Act, the United States is taking a big step back from the approach that has served it so well. Worst of all, special interests have got the US government to do their bidding without serious scrutiny by the media.

Martin Fridson is the founder of FridsonVision, an independent provider of high-yield research (www.leverageworld.com)