Personal Finance:  Bankruptcy Filings Are Essential To Capitalism

Personal Finance: Bankruptcy Filings Are Essential To Capitalism

Toys R Us. Circuit City. PanAm. Lehman Brothers. All major corporations that no longer exist due to liquidation in bankruptcy. GM, Texaco, Delta Air Lines, all lived on today but went broke once upon a time. It is the ability of the U.S. economy to withstand and even promote the extinction or reorganization of corporations that is essential to our economic success.

America was always a nation of risk takers. It was this spirit of entrepreneurship that propelled us from colonial outpost to the world’s superpower. Yet this phenomenal success would not have been possible had not the framers anticipated the need for an orderly discharge of debts in circumstances where the debtor had no hope of repayment. Article I of the Constitution explicitly grants Congress the authority to establish uniform laws governing bankruptcies, intended to replace a pastiche of disparate state statutes. Within a document so remarkable in every aspect, the doctrine of corporate bankruptcy ranks high for its salutary effect on the development of capitalism in the New World.

Congress made several early but abortive attempts to codify that authority throughout the 19th century, most of which were ultimately viewed as too lenient toward debtors. Progress was made and lessons learned (federal debtors’ prison was abolished in 1833), leading up to the Bankruptcy Act of 1898, essentially the basic framework under which modern debt restructuring occurs today.

Capitalism has proven to be the most dynamic force in world history for raising living standards and promoting peaceful coexistence. The triumph of this intangible but powerful force depends on the allocation of capital to its best and highest use, a process Adam Smith referred to as the “invisible hand.” There are of course other mechanisms for allocating capital, involving government planning or coercion, but none has held a candle to the miracle of market forces in promoting economic well-being.

Yet by definition, directing capital to an untested venture is a risky proposition. Roughly half of all new business ventures fail within their first five years, erasing the shareholders’ equity investment and often leaving the enterprise with debt it cannot repay. The reasons are varied, from insufficient cash or poor management to bad timing and economic cycles. But who would willingly undertake such risk if the result of failure was a lifetime of penury or even imprisonment? Part of the genius of the American system is the recognition that risk-taking must be encouraged and failure is not a death sentence.

The list of household names generally considered wildly successful is replete with tales of failure. Walt Disney, Milton Hershey, Henry Ford, all started business enterprises that failed before ultimately finding the right combination. Imagine if none had been able to start again.

The early 20th-century economist Joseph Schumpeter praised the inexorable rise and fall of business endeavors in a market economy, coining the term “creative destruction” to describe the essential, almost biological process of business germination and demise in response to misallocation of capital and the market’s dispassionate reward or punishment. It is this process that animates the Western economies (and is increasingly penetrating the East, including China to a limited degree).

But innovation could not proceed without an orderly process for unwinding the debt of failed establishments and freeing their creators to try again (and again).

Obviously, a major bankruptcy liquidation is disruptive to investors, employees, and communities of the vanquished firm. But when you read about the sad tale of a Sears or its ilk, know that the market is hard at work correcting a poor allocation of capital to a more productive and beneficial end.

Christopher A. Hopkins, CFAVice President and portfolio manager
Barnett & Company

Chris Hopkins

Chris Hopkins, CFA, is Vice President and Portfolio Manager for Barnett & Company. He is a native of Whittier, California and has lived in Chattanooga since 1988. He began his career in finance in 1998, following twenty years in manufacturing management. Chris joined Barnett & Company in 2004. He served for twelve years an adjunct professor of Finance at UTC, and writes a weekly column for the Chattanooga Times Free Press on finance and economics. He is currently president of the CFA Society of East Tennessee, and is a member of the North Carolina and South Carolina CFA Societies as well as the National Association for Business Economics. He presently serves as city council representative on the Chattanooga fire and police pension board, and is member of the finance committee for the AIM Center. Chris holds the Chartered Financial Analyst (CFA) professional designation. He received Bachelor’s degrees in Physics and Economics from California State University at Fullerton, and earned his MBA from the University of Tennessee at Chattanooga.
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