A Capitalist’s Love Ballad to Bankruptcy

In Burt’s recent FP post, he takes a hypothetical bankruptcy scenario posed by Randy Harris and teases out the personal and professional ethics of the fictional players. If you haven’t read it yet, you should do so now. Burt’s unerring ability to keep separate the strands of morality, professional ethics, and his knowledge of the law while still weaving them into a whole fabric is one of the great delights of his writing, and he does not disappoint with this latest post.

In part of the threads, however, the conversation veers off of Randy’s hypothetical scenario and takes aim at bankruptcy in general, where it is found morally lacking. I think everyone agrees that bankruptcy is in fact the “opposite of justice.” Well, everyone but me. Bankruptcy has a pretty bad name in our society, and think this has more to do with what we as a people think of the poor than it does with bankruptcy itself.  But bankruptcy isn’t unjust, and in fact it’s something that free-market capitalists should praise.

I think when most people think of bankruptcy, they imagine someone like the woman in Randy’s hypothetical – a person who takes advantage of their creditors and then uses bankruptcy as a calculated plan to have their cake and eat it too. And surely these people exist. (Though probably not people like Randy’s hypothetical ne’er do well. I would argue her acts are criminal, in the same way that if your bank erroneously shows you have a deposit of $10,000 and you spend it, it is considered theft if you do not or cannot reimburse them. Since bankruptcy does not forgive criminal acts or debts arising from fraud, I am not sure bankruptcy would not have protected her debt.) In these cases, where people essentially get away with premeditated fraud, it seems obvious that something on the other side of the spectrum from justice has occurred. But what about for the majority of bankruptcies?

There are a lot of bankruptcies filed each year; in 2010 the number was over 1.5 million; about 60,000 of those were businesses. It is unclear, however, how much bad debt those filings represent. The assumption of most people I know is that despite their lower numerical number, business bankruptcies actually represent a substantially larger dollar amount; but I have to say that I have never seen meaningful data to back up this assumption. The vast preponderance of these bankruptcies, business or personal, are caused by people taking a financial risk that they were unable to capitalize on, which led to debts they were not able to pay. Now, most of us believe that paying our debts is moral obligation, and so it is easy to see why if we do not pay them justice has not been served. But here’s the thing:

Regardless of the Biblical and historic reasons behind bankruptcies, bankruptcy today is not a bleeding-heart liberal forgiveness tool. It is a financial instrument that is built into a system of financial instruments, and it exists to create wealth.

In our society, any business that is a debtor is so voluntarily. There is no legal or moral reason that Nordstroms, Best Buy, General Motors, or your physician cannot become a “cash only” or “pay in advance” provider. There is no reason why VISA can’t keep your credit limit to an amount of money it can verify you have in your checking account.  Any of these actions would certainly reduce (if not completely eliminate) these companies’ risk of bad debt. But they all choose not to do so, and one of the reasons for that is the bankruptcy system which gives them two wealth-creating incentives to take that risk: The first is that allows them to risk their own corporate capital, secure in the knowledge that if they really screw the pooch they will not be held criminally liable and that the shareholder’s personal assets are not at risk. Which, of course, allows more capital investment than would otherwise occur if investing in a 401k meant risking your house or jail time. The second is that it allows for a substantially greater customer base, and therefore substantially greater revenue. You might not buy that new GM car if you thought that, should you lose your job tomorrow, you might end up in prison if a few months for that purchase.

In other words, we have created a system that creates wealth from people and companies being able to risk more than they otherwise would without the universally available mechanism of bankruptcy. Of course, this doesn’t mean that it the system doesn’t sometimes feel unjust. For example, in my business we are currently dealing with the aftermath of a workers compensation carrier that is in bankruptcy. When this carrier went under, it still owed my firm a lot of money in commission revenue. Since there is very little capital after claims reserves to divvy up among the various debtors, and since bankruptcy judges do not usually make commission payments a high priority when dividing up the last of the pie, it is unlikely that we will see a penny of that money. After having personally worked hard for that money, I can tell you that this absolutely feels like the opposite of justice. But it isn’t. Both my firm and I have made a tremendous amount of money because other people have been willing to risk capital to start businesses that they might not have started were it not for the system of inherent forgiveness we all benefit from. They, in turn, have grown from having a large customer base in part for the exact same reasons.  The system that allows this risk taking to take place might have cost me with this “deadbeat” carrier, but that’s a piffle compared to what that same system of risk taking has allowed me to make.

None of this is the opposite of justice.  Instead, working with Randy’s hypothetical universe, I believe the opposite justice would be this:

An insurance carrier is allowed to make huge profits by risking money, in no small part because bankruptcy laws allow their investors and them to do so.  They have a vast customer base, because that same system has allowed others to take risks in a way that has created wealth.  But now, when a client of theirs is unable to meet their obligation, that same mechanism is denied to that person so that the insurance carrier can make just a few more bucks.

Now that really would be unjust.