Chapter 18. Bankruptcy and Dissolution of Companies

INTRODUCTION

In any area of economic activity, many companies are established which for various reasons will cease to exist. Some companies will close down due to a portfolio of products inferior to that of their competitors, some companies will be unable to recruit workers, and some will fail to convince their potential customers of the superiority of their products, even if such products are indeed superior to the ones offered by the competition. Other companies will close down due to unfortunate capital-raising timing. Even if their product suite is good, companies may be unable to secure financing due to a temporary or long-term crisis in the capital markets, as a result of which they will find themselves at a relative disadvantage compared to similar or inferior companies which raised capital in more favorable times. From an economic point of view, dissolution is an efficient market's screening mechanism for "disposing of" second-rate companies. However, since the capital market is not always efficient, the companies which survive are often no better than those that close down.

Various studies have examined the drivers of corporate bankruptcies. The research company Dun and Bradstreet, for instance, reports that about 40% of corporate bankruptcies was due to economic reasons (including industrial weakness), 30% was due to financial reasons (including lack of sources for financing operations), and 20% was due to managerial inexperience. Note, though, that it is obviously difficult to make a clear distinction between the categories.

The same studies also indicate that only 10% of bankruptcies occurs in the companies' first year of activity. Approximately one-third of bankruptcies occurs during the first three years, and around 45% occurs during the first five years of the business.

Since a company is a separate legal entity, a legal process is required to "end its life." This process is known as dissolution or bankruptcy (we will use the terms interchangeably). It can be performed voluntarily by the company (voluntary dissolution) or be forced upon it by creditors when the company is unable to pay its debts (dissolution by the court). Involuntary dissolution usually takes place when the company is insolvent, i.e., when its liabilities exceed its assets (the balance sheet test), or when it is unable to pay its debts as they become due (the cash flow test).

The purpose of the dissolution process is to amass the company's assets, to release them from prior debts and liabilities, to liquidate them, and to distribute the proceeds among the company's creditors in accordance with the statutory priorities prescribed by law and the provisions of the company's organizational documents. Other dissolution activities include looking into the conduct of the company's officers and the connection between it and the company's collapse, and examining transactions preceding the dissolution in order to increase the assets of the company which are available for distribution.