What Is Bankruptcy? An Orderly Way to Fail

Insolvency is the underlying financial condition and bankruptcy is the legal process, and the two are not the same thing: a company can be insolvent for months without any proceeding beginning. Two tests define the condition. The cash flow test asks whether the debtor can pay debts as they fall due, and the balance sheet test asks whether liabilities exceed assets, and a business can fail one while passing the other, since a profitable firm can run out of cash and a firm with negative net worth can keep trading. Proceedings begin either when the debtor files voluntarily or when a creditor petitions the court. Directors face a specific hazard at this point, because most systems impose personal liability for continuing to trade and incur debts once there is no reasonable prospect of avoiding insolvency, which is why boards take formal advice early and why a company often stops abruptly rather than winding down.

Every system offers two broad routes and the choice turns on whether the business is worth more alive than dead. Liquidation appoints an official to take control, sell everything, and distribute the proceeds, after which the company ceases to exist. Reorganisation keeps the business operating while its debts are restructured, protected by a moratorium that stops creditors enforcing, on the theory that a firm with a viable business and too much debt should lose the debt rather than the business. American Chapter 11 is the best-known reorganisation procedure and is unusually debtor-friendly, leaving existing management in place as a debtor in possession; the British equivalent, administration, hands control to an insolvency practitioner instead. The choice matters enormously for outcomes, since liquidation destroys jobs, contracts and the intangible value of an operating business, and reorganisation can keep a failing firm alive at creditors' expense.

The ranking of claims is the heart of the law and is broadly consistent across countries:

• •Secured creditors first, up to the value of the specific assets pledged to them, which is what a mortgage or a charge over machinery buys
• •The costs of the insolvency process itself, including the practitioner's fees, which come out before anything else is distributed
• •Preferential claims, typically unpaid wages up to a limit and certain taxes, which vary by jurisdiction
• •Unsecured creditors, including suppliers, landlords, customers holding deposits and bondholders without security, who share whatever is left in proportion to what they are owed and who frequently receive a few pence in the pound
• •Shareholders last, and usually with nothing, which is the price of the limited liability that protected them while the business was running
• •Within each rank, creditors are treated equally, which is the principle that prevents a debtor paying favoured creditors in full while others get nothing

For individuals the purpose is different, because a person cannot be liquidated and dissolved. The modern approach, strongest in the United States and adopted in varying degrees elsewhere, gives a discharge: after a defined period and the surrender of non-exempt assets, remaining debts are cancelled and the person begins again. The rationale is partly humane and partly economic, since a population permanently burdened by debts it cannot pay has no incentive to earn, and since a society that punishes failure harshly gets less entrepreneurship. This is a modern arrangement. Debtors were imprisoned in England until the nineteenth century, and Dickens's father spent time in the Marshalsea, which is why debt runs through his novels. Discharge is not unlimited: student loans in several countries, child maintenance, court fines and debts incurred by fraud usually survive it, and bankruptcy carries restrictions on credit, on holding company directorships and on certain professions for a period.

There is no bankruptcy procedure for states, which is the largest gap in the system. A country cannot be liquidated, its assets are mostly beyond the reach of foreign courts, and no tribunal can bind all its creditors, so a sovereign default is resolved by negotiation, usually taking years, with the International Monetary Fund and creditor groups involved and with holdout creditors able to refuse a deal and litigate, as a group of funds did against Argentina for over a decade after its 2001 default. The workaround is contractual: modern sovereign bonds include collective action clauses under which a supermajority of holders can bind the rest to a restructuring, which reduces the holdout problem without solving it. Proposals for a formal international insolvency mechanism for states have been made repeatedly, most prominently by the Fund itself in 2002, and have not been adopted, largely because creditor countries see no advantage in one.

Insolvency law replaces a destructive race between creditors with a single collective process, freezing enforcement and distributing what exists in a set order: secured creditors, then the costs of the process, then preferential claims such as wages, then unsecured creditors, with shareholders last. Businesses are either liquidated or reorganised depending on whether they are worth more operating, individuals receive a discharge of remaining debts after a period in order to restore their incentive to earn, and sovereign states have no equivalent procedure at all.