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Unformatted text preview: WEB APPENDIX 7B Bankruptcy and Reorganization 1 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, dif- ferent 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 when a firm fails. These topics are discussed in this web appendix. 2 Federal Bankruptcy Laws Bankruptcy 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 payments. As the bankruptcy proceedings go forward, the following central issues arise: 1. 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 having fallen below debt obligations? 2. If the problem is a temporary one, 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? 3. Is the company worth more dead than alive that is, would the business be more valuable if it was maintained and continued in operation or if it was liquidated and sold off in pieces? 4. 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 operations? These are the primary issues that are addressed in the federal bankruptcy statutes. U.S. bankruptcy laws were first enacted in 1898, modified substantially in 1938, changed again in 1978, and overhauled in 2005. 3 The 1978 Act, which provides the basic laws that govern bankruptcy today, was a major revision designed to streamline and expedite proceedings. It consists of eight odd-num- bered chapters, the even-numbered chapters of the earlier Act having been deleted. Chapters 1, 3, and 5 of the 1978 Act contain general provisions appli- cable to the other chapters; Chapter 7 details the procedures to be followed when a firm is liquidated; 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. 1 This Web Appendix was coauthored by Arthur L. Herrmann of the University of Hartford....
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