Why do companies declare bankruptcy?

Tuesday, June 2nd, 2009 at 8:17 pm

Recently, with the onset of the global financial crisis, there has been an increase in the number of companies declaring bankruptcies. But why do companies declare bankruptcy? What causes these companies to declare bankruptcy?

As a research analyst of Chapter 11 bankruptcy filings, I’ve been involved in various Chapter 11 bankruptcy cases. And during the past reports that I’ve made, here are some of the reasons why do companies declare bankruptcies:

Liquidity. Because of low demand of their products, sales and revenue are continuously dropping. With capital expenditures, interests expenses on their loans, payroll expenses for their employees, these companies can’t help but to ask for a restructuring of their loans and seek the help of their creditors to get some funds. Without the needed help, they have no choice but to declare bankruptcy.

Hedging. Some companies hedge against commodities. By mean of hedging, companies buy forward contracts of commodities which are raw materials used in their production. This means that they buy in advance to avoid further advances in the prices of these commodities. This happened to some companies before when they hedged against oil way back last year when oil products reached its peak of almost $160 per barrel. Companies, in their speculation that oil prices will continue to surge, bought in advance oil products to “save” money. Unfortunately, their speculation did not happen and because of low demand, oil products declined. Because of these forward contracts, companies were forced to buy oil at a much higher rate than its current market price. Thus, these companies incurred losses.

Timing of Expansion. Some companies bought other companies or merged with them for their expansion plans. Unfortunately, some of these decisions proved to be wrong. Instead of bringing more profits to these companies, it brought more expenses thus adding to the losses already incurring by these companies.

Default of Loan Covenants. When these companies availed for various loans to fund their operations and expansions, banks and other creditors imposed several loan covenants in their loan agreements with these companies. When these loan covenants were not met anytime, creditors can declare a default and thus are authorized to demand immediate payment from these companies. When companies cannot immediately avail additional sources of funding to pay these defaulted loans, then they are left with a merciful decision of declaring bankruptcy.

Loss of Investor Confidence. From time to time, several analysts and credit rating agencies such as Standard & Poors, Moody’s, and Fitch Ratings review these companies in terms of profitability. These analysts publish their findings in several sources for the investing public. When these companies did not meet analysts’ expectations in terms of profit, then investors will lose confidence in these companies. Stockholders will dump their stocks which will cause an equity dry up for these companies and will eventually lead to delisting of their shares in the stock market.

Some of the largest bankruptcy cases during the past 2 years when this global financial crisis struck were:

1. Lehman Brothers Holdings, the former fourth largest investment bank in the world declaring around US$158 Billion of unsecured debts.

2. General Motors Corporation, one of the largest automobile manufacturers in the world declaring around US$51.5 Billions of unsecured debts.

3. Washington Mutual Inc., one of the largest consumer and small business banking in the US declaring US$6.9 Billions of unsecured debts.

4. General Growth Properties Inc., a real estate investment trust (REIT) company in the US declaring US$6.6 Billions of unsecured debts.

5. Thornburg Mortgage, a residential mortgage lender declaring US$4.6 Billions of unsecured debts.

In effect, when a company declared bankruptcy, a lot will be left unemployed. Creditors will be left unpaid and there will be no more money left to lend to other businesses. This will have a drastic effect in the economy as a whole.

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