In the event of bankruptcy, debtholders have a prior claim to a firm’s income and assets
over the claims of both common and preferred stockholders. Further, different classes of
debtholders are treated differently in the event of bankruptcy. Because bankruptcy is a
fairly common occurrence, and because it affects the bankrupt firm and its customers,
suppliers, and creditors, it is important to know who gets what if a firm fails. These topics
are discussed in this appendix.
Federal Bankruptcy Laws
Bankruptcy actually begins when a firm is unable to meet scheduled payments on its debt
or when the firm’s cash flow projections indicate that it will soon be unable to meet pay-
ments. As the bankruptcy proceedings go forward, the following central issues arise:
Does the firm’s inability to meet scheduled payments result from a temporary cash
flow problem, or does it represent a permanent problem caused by asset values hav-
ing fallen below debt obligations?
If the problem is a temporary one, then an agreement that stretches out payments may
be worked out to give the firm time to recover and to satisfy everyone. However, if
basic long-run asset values have truly declined, economic losses will have occurred. In
this event, who should bear the losses?
Is the company “worth more dead than alive”—that is, would the business be more
valuable if it were maintained and continued in operation or if it were liquidated and
sold off in pieces?
Who should control the firm while it is being liquidated or rehabilitated? Should
the existing management be left in control, or should a trustee be placed in charge of
These are the primary issues that are addressed in the federal bankruptcy statutes.
Our bankruptcy laws were first enacted in 1898, modified substantially in 1938,
changed again in 1978, and overhauled again in 2005.
The 1978 Act, which provides the
basic laws that govern bankruptcy today, was a major revision designed to streamline and
expedite proceedings, and it consists of eight odd-numbered chapters, the even-numbered
chapters of the earlier Act having been deleted. Chapters 1, 3, and 5 of the 1978 Act
contain general provisions applicable to the other chapters; Chapter 7 details the proce-
dures to be followed when liquidating a firm; Chapter 9 deals with financially distressed
municipalities; Chapter 11 is the business reorganization chapter; Chapter 13 covers the
adjustment of debts for “individuals with regular income”; and Chapter 15 sets up a
system of trustees who help administer proceedings under the Act.
Bankruptcy and Reorganization
This Web Appendix was coauthored by Arthur L. Herrmann of the University of Hartford.