© 2000 John Petroff
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© 2000 John Petroff |
3)- Bankruptcy potential cost
The potential for bankruptcy is far more costly than the potential for default. A bankruptcy puts the very existence of corporation into doubt. This uncertainty (even if no dissolution eventually occurs) adds another load to the burden. All those who rely on the company to be a going concern (i.e. management, employees, clients and suppliers), will hedge or sever their relationship with the company for fear that their salaries, promotion aspirations, expectations of service after sale, and continuing purchases will be abruptly cut off. The best employees may leave. The best suppliers may seek other clients. And most importantly, customers will hesitate to buy company's products.
The next level of risk is an actual bankruptcy proceeding brought on by creditors because of the company's inability to meet its obligations. There are several possible outcomes under American laws, and most of them are not desirable. However, there have been a few instances where management has used the bankruptcy proceeding as a vehicle of drastic measures for improvement inconceivable in normal operating circumstances. Such is the case of airlines requiring its employees to accept a cut in salary. Other instances involve retail operations forcing a reduction in rent or other charges from controlling interests. These are exceptional cases where the company could resume its operations with a brighter future. In most cases, that is not so. The road back to optimism is paved with restrictions and strewn with wealth reduction for the owners. Assets may be sold, work force reduced, products discontinued, management fired, and control of board of directors put in the hands of creditors. The value of shares and all claims are severely discounted as a result.
Finally, if the corrective measures worked out in the bankruptcy proceedings do not succeed, the last step is a dissolution. The assets are sold or salvaged to pay as many claims as possible. First comes the tax authority, then the employees for past services, then those who lended money during the bankruptcy proceeding on the condition that their claims be considered ahead of others, after that the previous creditors by order of seniority, and last, if anything is left the preferred shareholders and common shareholders. The bankruptcy cost to management and to owners is clearly staggering.
See review questions Q-11C3.1 through Q-11C3.5.
See research assignments R-11C3.1 and R-11C3.2.
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