Financial Management and the Bankruptcy Process

It may seem a little odd, but the right to go bankrupt is very valuable. There are several reasons why this is true. First of all, from an operational standpoint, when a firm files for bankruptcy, there is an immediate "stay" on creditors, usually meaning that payments to creditors will cease, and creditors will have to await the outcome of the bankruptcy process to find out if and how much they will be paid. This stay gives the firm time to evaluate its options, and it prevents what is usually termed a "race to the courthouse steps" by creditors and others.

Beyond this, some bankruptcy filings are actually strategic actions intended to improve a firm's competitive position, and firms have filed for bankruptcy even though they were not insolvent at the time. Probably the most famous example is Continental Airlines. In 1983, following deregulation of the airline industry, Continental found itself competing with newly established airlines that had much lower labor costs. Continental filed for reorganization under Chapter 11 even though it was not insolvent.

Continental argued that, based on pro forma data, it would become insolvent in the future, and a reorganization was therefore necessary. By filing for bankruptcy, Continental was able to terminate its existing labor agreements, lay off large numbers of workers, and slash wages for the remaining employees. In other words, at least in the eyes of critics, Continental essentially used the bankruptcy process as a vehicle for reducing labor costs. Congress subsequently modified bankruptcy laws to make it more difficult, though not impossible, for companies to abrogate a labor contract through the bankruptcy process.

Other famous examples of strategic bankruptcies exist. For example, Manville (then known as Johns-Manville) and Dow Corning filed for bankruptcy because of expected future losses resulting from litigation associated with asbestos and silicone breast implants, respectively. In fact, by 2001, at least 25 companies had filed for Chapter 11 bankruptcy because of asbestos litigation. In 2000, for example, Owens Corning, known for its pink fiberglass insulation, threw in the towel after settling about 240,000 cases with no end in sight. Similarly, in the second largest ever bankruptcy, Texaco filed in 1987 after Pennzoil was awarded a $10.3 billion judgment against it. Texaco later settled for $3.5 billion and emerged from bankruptcy. The largest bankruptcy ever in the United States was the 2001 flameout of energy products giant Enron.

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