US Airways’ Chapter 11 encore prompts re-examination of exactly what our society wants from bankruptcy laws.
Societies clearly are better off when there is some legal provision for the discharge of unpayable debt. When such provisions, however, allow firms to selectively breach contractual commitments and gain cost advantages over competing firms, society may end up worse off.
Singling out US Airways may be unfair. Similar issues arise with United Airlines, National Steel, and coal-mining Horizon Natural Resources. For all, Chapter 11 bankruptcy may benefit certain groups at the expense of others, but harm society as a whole. That was not the intent of elected officials who shaped U.S. bankruptcy law.
Bad things happen. In every society some firms always take on debt that they eventually will not be able to pay off. When that happens, someone — traditionally banks or a stock or bondholders — has to take a loss. The challenge to society is crafting a legal mechanism that allocates such losses fairly while maintaining incentives for optimal levels of risk in borrowing and lending.
Societies can, of course, minimize losses to lenders by minimizing lending. The harder it is to get loans — or make them — the fewer loans will go bad. Raising legal barriers to lending reduces messy problems of bankruptcy. Draconian penalties for firms who default on debt create similar disincentives.
Both approaches also reduce the flow of capital to where it is most productive and makes it harder for families to efficiently meet their needs and wants over time. A society that unduly discourages lending to avoid losses will inevitably be a poorer society than one that does not.
Still, lending regulation that is too liberal and bankruptcy proceedings that are too easy to use create incentives to waste capital. Lenders end up spending excessive amounts of time investigating loan risks. Money is spent on physical investments that do little for society.
On the whole, U.S. bankruptcy laws have struck a good balance between excessive laxness and rigor. The 1978 introduction of Chapter 11 allowed firms to discharge some debt without going through liquidation. Completely shutting down a going business concern and selling off its assets often causes greater losses to society than if debts are reduced enough so that the firm is again profitable.
The option of reorganization introduces perverse incentives, however. As we see in the airline and steel industries, if courts allow firms in Chapter 11 to shed contractual obligations to unionized employees, firms that opt for bankruptcy can continue to operate with lower costs than competitors that stayed out of bankruptcy.
Overcapacity is a fundamental problem among airlines. Until some capacity is liquidated, the industry faces tough sledding. Legally sanctioned stiffing of certain unions and lenders will not stem ongoing waste of resources through overcapacity. Society in this case will be worse off as a result of Chapter 11, not better.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.