Bankruptcy as a Strategy – Part 2

In the previous article, we have already studied that all bankruptcies are not involuntary.

In many cases, the shareholders and/or the management of the company make a conscious decision to file for bankruptcy.

This happens because the benefits that may accrue as a result of filing bankruptcy are greater than the loss of reputation and money associated with the filing.

Some of the common strategic motives which are used when bankruptcy filing is strategically employed were stated in the previous article.

In this article, we will continue stating the common reasons which are used while filing for bankruptcy protection.

Restructuring the Balance Sheet

Many times, shareholders and investors really want to turn around their business. However, they are unable to do so with the current financial obligations of the firm.

This is because even if they inject new capital into the business, the capital will actually be consumed in paying the interest and principal payments of previous obligations.

Hence, there will be no money left over for working capital or for conducting business.

The situation ends up being irreconcilable since the company cannot address its fundamental challenges and is only falling into a debt trap whereby it is being forced to throw good money after bad.

In such a situation, the shareholders can decide to use bankruptcy strategically. If the company declares bankruptcy, the creditors will only be paid over the long term.

In the short term, the company will get the money required to restructure its business by coming out of the debt trap.

In most cases, filing of bankruptcy is not necessary at all. The mere threat of filing for bankruptcy is enough to bring creditors on the table and negotiate favourable deals, which will help the company overcome the debt spiral.

Preventing Litigations

In many cases, companies have strategically used bankruptcy to delay or prevent litigation against them. The laws relating to bankruptcy filing prevent more litigation from being imposed on a company that is already under bankruptcy.

This is the reason that when a company with a failing cash flow is about to face expensive litigation for a faulty product or for poor service, they often resort to filing bankruptcy.

In many cases, a bankruptcy filing is not enough to prevent litigation as judges are not very liberal towards cases that have been filed on the eve of bankruptcy.

However, in 100% of the cases, it is able to slow down the litigation, and that is beneficial to the defending party.

Lowering the Interest Rate

Bankruptcy laws have specific provisions about repayment of debt to creditors. If the debt in question is secured, then the company is only allowed to repay the debt with market interest rates. It does not matter what the interest rate, which was agreed between the parties at the time of the contract was.

Once the matter is in bankruptcy court, the market interest rate is the highest rate, which is legally allowed. This is beneficial to the incumbent company.

This is because companies on the verge of bankruptcy often take up debt at rates much higher than the market rate.

Once they file for bankruptcy proceedings, the interest rate on this debt is automatically reduced to the market rate.

On the other hand, if the debt in question is unsecured, then the bankruptcy court does not allow for the payment of any interest.

The incumbent company is only allowed to pay back the principal over a period of time without any interest.

This could work out to be a profitable strategy in the long run as the interest costs can be reduced immediately.

However, the creditworthiness of the company is likely to take a severe hit if such a policy is indeed implemented.

Getting Out Of Burdensome Contracts

In many cases, businesses find themselves strangled by burdensome leases or contracts which they have agreed to in the past. This is where bankruptcy laws can come to the rescue of incumbent firms.

Once a firm has filed for bankruptcy protection, it is legally allowed to reject contracts or leases which it believes are burdensome.

However, there are some exclusions to this rule. Many contracts, such as contracts pertaining to labour unions and government parties are not exempted from this rule.

Also, the law makes it mandatory for the incumbent firm to pay some compensation in lieu of rejecting the contract.

Companies seldom reject contracts during bankruptcy proceedings. Instead, the proceedings are used to negotiate more favourable terms.

Changing the Management

In very rare cases, bankruptcy is deliberately filed by the shareholders to change the management of the company. This happens particularly in the case of start-up companies.

This is because start-up companies take money from venture capitalists and also give them a seat on the board of companies.

Many times, this has disastrous consequences as infighting and politics amongst board members leads to the downfall of the firm.

In such cases, shareholders often file for bankruptcy in order to change the management and bring in new people on board who will help end the infighting and bring about a transformation in the firm.

The bottom line is that there a wide variety of reasons due to which a company may decide to file for bankruptcy strategically. In all cases, the reputation of the company does take a severe beating. However, sometimes the very survival of the firm gets threatened, and even loss of reputation seems to be a viable option.