Forward Planning: Corporate bankruptcy and credit insurance

Bankruptcy laws are established to protect a failing company from further deterioration by helping it to recover from crippling debts, reorganise and get back to a profitable situation or simply to close.

Investors and shareholders of the failing company are better protected by these laws.
Under the U.S. Federal Bankruptcy Code, a company may use Chapter 11 to reorganise the business and become profitable again, or Chapter 7 where the company stops all operations, goes out of business and a trustee is appointed to sell the company's assets and pay off the creditors, sometimes including investors as well.

Secured creditors such as banks are paid first, unsecured creditors such as suppliers and bondholders follow, and last are the company's stock- or shareholders.

Of course, the investors taking the least risks are always paid first - secured creditors who have provided extended credit based on the company's collateral or assets.

Stockholders get paid after bondholders because they are the owners of the company, thus profiting greatly if the company does well but losing money if it does poorly. Bondholders are the lenders of the company, getting paid the return of their principal and the interest.

Companies usually choose to file for bankruptcy under Chapter 11 rather than Chapter 7 so they can still operate and retain some control on the bankruptcy process. They must then establish a recovery plan to reorganise the business, improve its management and return to profitability.

The Justice Department, through its U.S. Trustee, usually appoints a committee to represent the interests of the creditors, bondholders and stockholders. This committee establishes a reorganisation plan which must be accepted by all three above mentioned parties and approved by the Court.

The Securities and Exchange Commission reviews all documents to determine if the company is telling the truth and to ensure that stockholders have a proper representation through the whole process, as in some cases company officers could be using the bankruptcy law to cover up a security fraud or hide away from lawsuits.

As for the companies which are deep in debt and may not be able to recover, they choose to liquidate under Chapter 7, their assets then getting sold for cash by an appointed court trustee. Legal and administrative expenses are paid first and the creditors are paid the reminder. Bankruptcies are usually announced in the news.

Credit Insurance, on the other hand, opens up more opportunities to grow the business, especially in a tough economic environment. A credit insurance policy insures commercial accounts receivable against non-payment, protecting the company against any insolvent customer and preventing bad debts which may lead to the destruction of the business.

Companies covered with credit insurance can easily explore new market opportunities, offer open credit terms, and gain new customers. It simply protects against insolvency and bankruptcy situations, covers short term receivable and deals with past due accounts by offering international collection services.

What is the relation between the bankruptcy law and credit insurance you may ask? Simple - the more advanced and developed the bankruptcy laws and procedures, the better chances insurance companies will have in issuing credit or export credit insurance.

The UAE, for example, has a bankruptcy law under the Commercial Transactions Law, Federal Law No. 18 of 1993. The law covers procedures for bankruptcy of both individuals and commercial entities. The usual practice here is to dissolve the company and sell the assets, instead of reorganising and saving the business.

In the past, large companies faced with financial problems had the leaders of Dubai getting involved directly to save them. This doesn't need to be the case - the bankruptcy law in general must be amended to meet today's advancing economy requirements, thus allowing for better protection through a more widespread use of credit insurance.

The writer is managing director of Gulf Insurance Consulting and a licensed insurance consultant and financial planner.