News May 13, 2009, 6:07PM EST

Failure: A Bankrupt Idea

Why the bankruptcy process that sorted out the mess when companies failed no longer works

By Peter Coy

Failure can be a beautiful thing. Maybe not if you work for General Motors (GM), which seems to be stumbling toward bankruptcy. But for the U.S. economy as a whole, the swift and clean disposition of weak companies is an essential part of the formula for getting growth back on track.

However, for this cleansing to occur, the U.S. needs a well-functioning Chapter 11, the part of the U.S. Bankruptcy Code that determines whether failed businesses can be revived, in full or in part, or need to be dismantled. Last year, 30,000 troubled businesses took the Chapter 11 route, and the number should soar this year as the recession grinds on.

Lately, though, this crucial tool for coping with failure has…failed. Some weak, mismanaged companies are being propped up longer than they should because they're considered too big to fail. Meanwhile, potentially viable companies are being thrown too quickly onto the refuse heap, victims of misguided changes in bankruptcy law and financing practices. Perhaps most worrisome, derivatives—those complicated securities that helped cause the financial crisis—are giving some banks and other creditors the perverse incentive to kill companies that ordinarily they would want to save. The implications: more job losses than necessary, coupled with a slower recovery and a less vibrant economy.

The failure of failure became starkly evident last year when Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke stood by as Lehman Brothers went bankrupt. Although they said afterward that they lacked the authority to save the investment bank, the truth is that many people at the time thought letting Lehman go into Chapter 11 bankruptcy was the right thing to do. In theory, the Bankruptcy Code had all the tools to allow a bankruptcy judge to sort out the bank's affairs cleanly and fairly. Meanwhile, a signal would be sent to other financial institutions that they would pay a heavy price for mismanagement.

The result of letting Lehman's bankruptcy play out, as everyone knows, was a spasm in the global financial system that helped trigger the first worldwide recession since World War II. Banks around the world refused to do business with Lehman or each other because they didn't know who was exposed to losses—and couldn't wait for a drawn-out bankruptcy proceeding to find out. Changing course abruptly, the government stepped in to stop American International Group (AIG) from going into bankruptcy and to prevent any further failures at "too-big-to-fail" institutions.

If 2008 highlighted the flaws in dealing with financial firms that failed, 2009 seems to be showing that resolving the affairs of troubled nonfinancial companies can be nearly as difficult. The problem is finding the appropriate balance between the needs of creditors and what's good for employees, suppliers, and the rest of the economy. Chapter 11 accomplishes this by giving companies breathing room to cut a deal with the people to whom they owe money. First dibs on a company's assets are supposed go to secured creditors: those who were pledged certain assets, such as buildings or machinery, as collateral for the loans they made. Common shareholders are last in line and usually get nothing. Bankruptcy judges, who must approve any settlement, have a certain amount of latitude to produce a workable solution.

The Last Chapter?

The concept is elegant. Elizabeth Warren of Harvard University and Jay Lawrence Westbrook of the University of Texas wrote in the Michigan Law Review this February that Chapter 11 deserves a prominent place "in the pantheon of extraordinary laws that have shaped the American economy and society and then echoed throughout the world."

These days, though, no one seems to trust the results of a straightforward bankruptcy. The crises at Chrysler and General Motors have turned into high-stakes games of chicken between secured creditors and labor unions. President Barack Obama himself leaned heavily on Chrysler's secured creditors to back down from their claims about the sacredness of their contracts, a clear indication that his Administration has no confidence in the bankruptcy courts to achieve the correct result on their own. GM Chief Financial Officer Ray G. Young told reporters and analysts on May 7 that he wants to keep the automaker out of bankruptcy, or at least make its stay in Chapter 11 as brief as possible. He predicted that entering bankruptcy would hurt GM's sales. "Once you start losing revenues, you get yourself into a vicious cycle from which you cannot recover," he said.

Young's concern is legitimate. Advocates for creditors and debtors agree that companies that enter Chapter 11 are less likely to emerge intact than they were years ago. The high-water mark for debtor protection was the passage of a sweeping bankruptcy reform in 1978. But those protections were eroded by amendments in 1984 and 2005, says Brad Eric Scheler, chairman of the bankruptcy and restructuring department at the law firm of Fried, Frank, Harris, Shriver & Jacobson. Many companies invited trouble by pledging nearly all of their assets for loans, giving them no flexibility when things went wrong.

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