Dogma Premise # 7

Firms will respond to the risk of bankruptcy by sustaining high efficiency.

Dogma Premise #5 and Dogma Premise #6 showed how the threat of competition based on price or quality might not cause firms to respond with more efficient processes or better products.  Dogma Premise #7 involves another feature of the competitive landscape that is supposed to discipline weaker competitors but does not always deliver as promised: the risk of bankruptcy.

In the popular imagination, bankruptcy may seem like a death-sentence for a business -- the dissolution of its affairs and the distribution of any remaining assets.  It is easy to picture a CEO telling her staff, “If we don’t fix this soon, we’ll have to declare bankruptcy.”  If profits are a carrot motivating firms to do good things, bankruptcy might be seen as the stick that motivates firms to not do bad things.

In the real world, however, the bankruptcy laws may not have this effect.

First, the risk of bankruptcy at most encourages firms to become more profitable.  Because there are both good ways and bad ways to increase profitability (see Dogma Premise #5 and Dogma Premise #6), the threat of bankruptcy does not necessarily encourage good behavior.

Second, Bankruptcy rules protect both creditors and debtors.  For creditors, bankruptcy provides an orderly method of satisfying debts to the extent possible.  For debtors, bankruptcy eliminates the most onerous effects of liquidation and provides for a fresh start.  In other words, bankruptcy laws actually make it safer for a company to fail.

Third, not every bankruptcy is a death sentence.  Although Chapter 7 liquidations represent the dissolution of the business, Chapter 11 reorganizations actually allow debtors to recover from bad economic circumstances by restructuring or reducing their debt.  A Chapter 11 bankruptcy can relieve a debtor from some of the burden of poor business decisions without dissolving the business, and can be used as a weapon against creditors, instead of the opposite.

Fourth, the risk of bankruptcy might be a business strategy. A business might be used to hide assets, launder money, or scam customers with bankruptcy being an indication of an occasional unsuccessful attempt.  But if a misadventure’s odds of success or high, or the potential profit very great, then the risk of bankruptcy may not have much effect.

Finally, bankruptcies can be engineered as part of a capital flight strategy.  If a company’s capitalization were temporarily less than its liquidation value, an investor could purchase the company and liquidate it for a short-term gain, rather than attempt to manage it better.  The negative social and economic effects of the resulting business dislocation (e.g., lost jobs, decreased competition) might make the transaction a bad thing overall, but profitable to the investors.

Alternately, if a company’s market position allowed it to extract very high monopoly profits, investors might purchase the company and rapidly cut costs and raise prices to obtain spectacular short-term profits, and then invest the profits in another industry or overseas, abandoning the destroyed business to the bankruptcy court.

In other words, some weak firms may improve their behavior to avoid liquidation, but the bankruptcy laws were created mostly to protect creditors, not to protect competition, and there are many ways to use the bankruptcy laws that are actually harmful to competitive markets, not helpful, and increased efficiency may or may not be the outcome.

Dogma Premise 8

All Dogma Premises