Posted by: Ravi Saraogi | September 26, 2008

Chapter 11 Bankruptcy….

Great! Lehman has filed for chapter 11 bankruptcy. If the losses that the jewels of American financial stalwarts was not enough, we now have bankruptcies also. In this short note, lets have a close look at the term ‘bankruptcy’ and its different implications. A chapter 11bankruptcy is not an immediate liquidation. That is covered under chapter 7 of the American bankruptcy laws in which the assets of the firms are sold off and the money distributed to the creditors of the company. In a chapter 11 bankruptcy, the company is not liquidated but allowed to operate with restructuring and reorganizaion. A chapter 11 bankruptcy is a case when the bankruptcy court decides that it will be pareto optimal (i.e. will be a better solution for the creditors, owners and employees of the firm) to not let the firm die and give it a chance to reorganize itself and get itself out of the mess. This reorganization is carried out under the aegis of the bankruptcy court. The existing management may be asked to vacate and a new management may be installed by the bankruptcy court in consultation with the creditors. The new management may be from the side of the creditors or bankruptcy court or both.

Giving it a hard thought, a chapter 11 bankruptcy makes a lot of sense. If a firm is allowed to reorganize, say by, terminating badly negotiated contracts which are a drain on the firm’s resources (did we say terminate a contract? But how can the firm terminate a contract unilaterally that it entered into with some other party before? Well, under chapter 11, the bankruptcy court can invalidate any contract the firm has entered into which is very taxing to the firm’s profit’s and is inimical to its future survival), or by entering altering its structure , it may again start churning profits which will benefit the creditors (they wont have to accept discounted payments in settlement of their claims), the employees (they wont become jobless) and the owners (the profits will accrue to them).

As to whether Lehman should have filed for chapter 11 or for chapter 7, only time will tell.

Published by Ravi Saraogi

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