Bankruptcy is one of the natural states which a company may find itself in. Entrepreneurship is primarily about taking risks. When companies take risks, some of them succeed, whereas others fail. Hence failure is a natural part of the business. However, many critics of bankruptcy laws believe that there isn’t a need for an elaborate law to deal with the phenomenon of bankruptcy. Just like other contracts between the company and its creditors are left between the two parties, the bankruptcy situation can also be dealt with in the same way. According to these critics, the legal system only adds complication and expense and provides very little in return.

In this article, we will argue that this is not the case. The bankruptcy law is neither redundant nor wasteful. Instead, it is the existence of the bankruptcy law, which allows companies to function during a financial crisis.

What Would Happen if there was no Bankruptcy Law?

• In the absence of bankruptcy law, a large number of firms would face premature liquidation. This is because every creditor would be extremely wary about the financial health of the debtor company. They would be continuously monitoring the financial health, and at the slightest sign of trouble, they would start pulling out their finances.

• Lack of information would create a panic. Each creditor would want to cash in their money before the others get wind of the situation and try to recover their claims as well. As a result, secured creditors would want the firm to sell their collateral as soon as possible so that their money could be recovered quickly. On the other hand, trade creditors would stop lending more money. This would mean that the roll-over of short term loans would stop, and suddenly the working capital requirement would increase. This would mean that the working capital requirement would increase. This could cause further duress to a company already under financial strain.

• The rush to recover their own money would create a bank run type of situation. The mistrust between the different creditors would force the early liquidation of the company. Also, since the company will be liquidated immediately, the compensation received will be less.

• Bankruptcy laws prevent this situation from happening. Because of the bankruptcy law, creditors now know that all creditors with the same seniority will receive the same amount of money. Hence, there is no rush to liquidate the assets before the others. Also, when a company is facing bankruptcy, the court freezes the situation as it is. It first allows the business to improve its financials by continuing as a going concern. Only after the firm fails to continue as a going concern does the option of liquidation come into play.

• In the absence of bankruptcy laws, many perfectly good firms facing temporary financial duress would be shut down.

Example: The Great Recession of 2008 is the perfect example to showcase the efficiency of the bankruptcy laws. Five big banks in the United States were about to go bankrupt. However, since their bankruptcy would cause a systemic crisis, the government lent money to them. At that time, it was highly criticized. It was considered to be subsidizing private excess with taxpayers’ money. However, this money kept the banks in going concern. Today, all the banks continue to survive, and the taxpayers who lent money have also been able to make a decent profit.

• In the absence of bankruptcy law, debt could only be renegotiated when a consensus is achieved. This means that even a small creditor would have excessively large bargaining power. This is because they could hold up the interests of everybody else. The absence of bankruptcy law would create a situation in which blackmailing and horse-trading would be rampant. Bankruptcy law provides some negotiation back to the debtor. Under the bankruptcy law, a unanimous vote is not required. A simple majority will do! Also, if creditors act unreasonably despite fair offers being given by the debtor, then their interests can be crammed down as well.

• Bankruptcy law mandates continual monitoring of the business of the firm. It also puts the responsibility on those running the firm, that liquidation, if required, should happen at an optimal time when the firm is likely to receive maximum value. Bankruptcy law defines the exact trigger point when the firm must be sent into liquidation. As mentioned above, it prevents premature liquidation. However, it also prevents late liquidation, which could lead to massive financial losses to the people involved.

• Lastly, if the bankruptcy law was not present, the legal and financial resources wouldn’t be saved. This is because each creditor would have the responsibility of finding what could go wrong and including those situations in the contract. This would mean that expensive legal resources would have to be hired to draw up an air-tight contract, which would later be used to recover money in the event of a default.

Hence, bankruptcy laws definitely add value. The business world would not be a better or more efficient place without them.