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Danger - Bankruptcy Laws General Motors is a large car manufacturer in US. The GM logo is widely recognized world over. The problem is that GM is bankrupt. In 2009 they went to court for bankruptcy protection in what in the US is called a Chapter 11 filing. This is a process that allows a company to pay a portion of its debts, ignore the rest and continue operating. In short, this is legalese speak for we screwed-up and demand a second chance.

The court obliged and declared GM bankrupt… which then proceeded to sell some of its assets, get new investors (mainly governments), change its name and keep doing business as usual with the end result of having 17 consecutive profitable quarters. The whole technical story can be found in Wikipedia searching for "General Motors Chapter 11 reorganization".

And the creditors? Thank you very much.

The "old GM" now renamed Motors Liquidation Company issued a statement saying that

"Management continues to remind investors of its strong belief that there will be no value for the common stockholders in the bankruptcy liquidation process, even under the most optimistic of scenarios."

"…leading to its conclusion that the common stock will have no value."

This is, the shareholders, the actual owners of GM got screwed.

Of course, as it could not be otherwise, other problems arouse as The New York Times reports in its article "Hoping to Fence-Off Suits, G.M. Is to Return to Bankruptcy Court". It so happens that it would seem that GM…ejem!…"forgot"…ejem! to mention to the judge that they had a huge potential liability because of a faulty ignition switch that prompted the recall of 2.6 million cars and allegedly killed 13 people. Ups…

But not to worry, the government (through the Justice System) is near. GM is returning to the Bankruptcy court to ask the judge to toss the lawsuit out because it belongs to the "old GM".

Why is this example important? Because all countries have such laws. In essence, the laws operate as this:

  • Bankrupt person makes a declaration to the judge
  • Judge decides if the person or corporation is still "viable"
  • If it is (in the eyes of the judge), the judge decides who gets paid and how much
  • Past this point, the person or corporation is allowed to stay in business
  • If the answer is that the person or corporation is not economically "viable" the judge decides who gets paid and how much; the judge gives said person/corporation a no-business ban for a limited time and passed this point all issues are forgotten.

The general idea of such laws is to "save" the jobs that would be "lost" should a person or corporation go bankrupt. This is done to the expense of legitimate creditors (i.e. persons owed money to) and to benefit workers, who are not owed anything.

This is a scam pure and simple. Think about it.

There is a forced transfer of wealth from creditor's property (money in the form of debt) to people that are owed nothing. This is pure socialism, plain and simple. And the excuse? To "protect" those people who have less just because other people have more.

Fair enough, and who is going to protect the employees of creditors? When a creditor is not paid, how many of its employees are going to be fired? How many of its shareholders (i.e. owners) will receive less or nothing in dividends? What will the economic impact be of having a plethora (bunch) of creditors in financial troubles or going bankrupt?

But there is something infinitely worse. The concept of "moral hazard" at work. You have heard this term in relation to the bailouts to banks in 2008. The idea is that certain banks are "too big to fall" and therefore no matter what they do the government will always be there to prevent their bankruptcy.

The term "moral hazard" means that morally speaking if there is no potential punishment, people will behave like asses. This makes sense since people have nothing to lose.

Most people believe that this "moral hazard" thing is a government/big-business sort of deal. Well, it's not. It is an everyday deal that goes on routinely all the time in all countries. It's called bankruptcy laws and we showed you above with GM's example how they work.

These laws are a problem because if business owners can isolate themselves from potential liabilities, they will go into ill-researched business and will operate will notorious carelessness. A consequence of this fact is that a great deal of business are started but only few survive wiping out investor's money without major consequences.

But this is only a side effect. The real problem is that bankruptcy laws prevent the free market from operating. The whole point of having a free market is allowing it to determine people's needs through trial and error. Negating this error prevents its operation.

If a company provides goods and services that are not desired by customers, it must go broke because if it continues to operate it will continue to mis-allocate resources. People and machinery who could otherwise be making stuff that people want, are now making stuff that people do not want. There are only so many resources and they must be allocated wisely. Bankruptcy laws prevent this allocation.

How about the GM example? GM restructured and now it is financially viable. Does this prove that bankruptcy laws work? In a word, no.

What the so-called restructure did was to take profitable GM divisions away from the creditors and give them to new owners. But if the free market would have been allowed to operate, all GM divisions would have been sold to pay creditors. Most (if not all) of profitable divisions would have been bought by other companies at a bargain base price who would now be operating them with increased profits. Creditors would have received what they were owed, the divisions would still be operating and people would be employed. In other words, the best of all choices.

Furthermore, the people in command of GM would have been properly and duly punished by the free market for their screw-ups instead of receiving a golden parachute.

It is this kind of laws that foster irresponsibility. If owners are limited in their liabilities by the government (instead by voluntary agreements), the net result is incorrect business practices. This lack of correctness is not legal, it is practical. It simply means that owners will take unreasonable chances since they have little or nothing to lose and in so doing, we all lose.

If such laws would not exist, debt would be settled but, more importantly, wealth would not be destroyed. Real wealth can only be found in real economic goods and services. Just because a company is sold to pay for its debts, this does not mean that all its machinery and know-how will go puff! in thin air and disappear. Somebody purchased those goods and services and will do something with them. If they serve customers, they will be put to use because they are a source of wealth. If they do not serve customers, they will probably be scrapped for its true wealth value. In the end, real bankruptcy does not destroy wealth; it simply brings wealth down to its real value according to customer's desires.

CONCLUSION

The free market is a ruthless evolutionary machine that is constantly determining what people want and trying to satisfy those needs in the most efficient way. Every time a government tampers with this machinery, we all lose. One of the ways in which the government messes around with this process is through bankruptcy laws which prevent the clean-up effect of free markets on failed companies. As such, they prolong the mis-allocation of resources which in term makes markets less efficient with the direct consequence of our needs being less satisfied. If bankrupted companies are still manufacturing gadgets that nobody wants, this prevents other companies from using these resources to manufacture gadgets people do want. This directly translates in lower standards of living; your standards of living.

Moral hazard is a widespread socialistic notion and as such dangerous to your wealth.

You may choose to believe this or not, however bankrupt this notion may be.

Note: please see the Glossary if you are unfamiliar with certain words.

 

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