"Capitalism without insolvency is like Christianity without Hell."

Those were the words of former Apollo 8 commander Frank Borman, speaking as chairman of Eastern Airlines in the United States in the early 1980s.

That company later entered Chapter 11 bankruptcy itself, in an attempt to deal with a staggering amount of debt.

We all know what it means to run out of money, but what exactly is bankruptcy? It’s certainly been in the news a lot.

Tupperware filed for it last month. Two Australian airlines have become insolvent this year, and other Australian businesses have been going under at record rates.

So how do companies go bankrupt – and what is bankruptcy protection under the law? What’s the famous Chapter 11? And is bankruptcy the end of the road?

What exactly is bankruptcy?

Sometimes, a person or company can’t pay all of their debts as they arise. In legal terms, we call this being “insolvent”.

Receiving a large bill (such as a large tax bill) that you can’t pay on the day doesn’t necessarily make you insolvent. The law allows for a reasonable time to pay bills after receiving an invoice.

But if large numbers of bills remain unpaid weeks or months after their due dates, it begins to suggest a person or business isn’t paying them because they actually can’t.

Being unable to pay all of your debts makes you an insolvent debtor. Bankruptcy is the legal process that allows insolvent debtors to fairly resolve these debts.

In Australia, insolvent individuals can file a bankruptcy petition with the Official Receiver in bankruptcy, a statutory office that is part of the Australian Financial Security Authority.

A creditor who is owed at least $10,000 can also force another person into bankruptcy, by suing them in court and obtaining an order to make them bankrupt.

For companies that can’t pay their debts, there are several options, including liquidation, voluntary administration and restructuring. More on these later.

We let an expert take control

When a person or company goes bankrupt, an independent external expert (or team of experts) is appointed to manage their assets and debt.

For individuals, we call this person a registered bankruptcy trustee. In the case of corporate bankruptcies, we call them a registered liquidator.

In both cases, the expert will take control of the debtor’s assets and affairs. They’ll be looking closely at why the debtor needed to declare bankruptcy in the first place, and whether anything can be sold to generate cash so at least some of the debt can be repaid.

When a person goes bankrupt, not everything is up for grabs. The law allows them to retain some basic essentials, such as clothes, furniture, tools of their trade, and a car valued at less than $9,400.

Some categories of assets can also be exempt, such as superannuation and compensation for personal injuries.

There are no similar extensions for corporate insolvency. All of a company’s assets are on the table.

However, both types of debtor typically enter bankruptcy with few or no assets. In more than 80% of individual and corporate bankruptcy cases, there are no payments to the creditors they owe.

Why seek bankruptcy protection?

One key feature of formally filing for bankruptcy is that it imposes a “stay” on enforcement action against the debtor. This is a court order that gives the party owing money time to organise its affairs in an orderly way – such as by selling assets to raise cash.

In corporate insolvency, there are formal procedures under Australia’s Corporations Act that aim to give a company the opportunity to negotiate a deal with its creditors.

That might include formulating a plan to restructure, allowing it to exit insolvency and keep trading. But it could also include selling the business to a new owner so it can continue.

Some large Australian companies, including Virgin Australia and Channel Ten, have previously used “voluntary administration” to save their businesses.

Voluntary administration can give a company a chance to reduce its debts through a statutory compromise with creditors called a “deed of company arrangement”.

This involves the majority of a company’s creditors approving a deal – usually, to compromise on some of their debt in exchange for a promise of future payments.

The funds to make these payments might come from selling assets, or be a percentage of promised future profits.

If successful, this can allow a company to keep operating and minimise job losses that would otherwise occur if it were simply shut down and its assets sold off – known as being “liquidated”.

Once liquidated, a company will be deregistered by the Australian Securities and Investments Commission – that is, it will cease to exist as a separate company.

What is Chapter 11 bankruptcy?

You’ll often hear or read about companies filing for “Chapter 11” bankruptcy. This is because in the US, there is one law – the Bankruptcy Code 1978 – that covers both individuals and companies.

Just like we’ve discussed in the Australian context, Chapter 11 of that law is specifically aimed at giving debtor companies a chance to enter into a deal with their creditors – to reduce their debts, sell some or all of the assets and hopefully allow at least part of the business to continue operating.

This is what Tupperware did last month, following years of financial pressure.

Where the law differs between Australia and the US is in the fact that Chapter 11 allows the debtor company’s management to remain in charge of the bankruptcy process. We call this “debtor-in-possession”.

In Australia, in contrast, the liquidator – which acts as the administrator in a voluntary administration – remains in control of the company.

Filing for bankruptcy can signal the end of a company’s operations, but not always. It may be possible for an external administrator to try to save the business or sell some or all of it to a new owner, paying down debt and preserving jobs.

This article is part of The Conversation’s “Business Basics” series where we ask experts to discuss key concepts in business, economics and finance.

Jason Harris, Professor of Corporate Law, University of Sydney

Image credits: Shutterstock 

This article is republished from The Conversation under a Creative Commons license. Read the original article.