Does bankruptcy give companies an unfair advantage? No.

Why should a mismanaged company or, worse, one that has deliberately cooked the books, be able to waltz through Chapter 11, emerge streamlined and cleansed of its sins, and then be able to outperform its unreorganized competitors? Isn’t that somehow unfair? The simple answer is, no. There are almost no barriers to entering the world of bankruptcy. Even solvent companies are eligible. Virtually any company with the means to hire a bankruptcy attorney and $830 for the filing fee can file its own Chapter 11 and take advantage of the same laws. But they don’t, except as a last resort, and there are many reasons for this.

Your view: Chapter 11 forum

A company in Chapter 11 operates in a fishbowl, under the scrutiny of the court, creditors and officials of the U.S. Department of Justice  who monitor Chapter 11 cases. As a rule, the company must get court approval before it can take on secured debt, hire attorneys or accountants, increase management’s pay, sell off its assets, or do many other things. In many cases, committees of creditors are set up, with the right to hire their own attorneys and other professionals and investigate the company’s affairs, all at the debtor’s expense.

A Chapter 11 company that owes secured debt might have to get court permission before using its cash or receivables. The company must convince the court that its use of the cash is likely to result in recovering even more cash – an interesting problem for the typical company that has been losing money hand over fist before its bankruptcy.

To emerge from bankruptcy, the company must first prepare and obtain approval for a disclosure statement and then formulate a plan for its fiscal diet. Creditors get to vote on the plan, and at least one class of creditors whose claims are compromised must vote to accept the plan. Meanwhile, the company needs to maintain its relationships with its customers and suppliers despite the strains bankruptcy creates, all while competitors are circling to take bites of whatever business they can.

None of this is easy. If you doubt it, ask any executive who has maneuvered a company through the Chapter 11 process how willing he would be to go through it again.

On top of it all, bankruptcy usually wipes out all the old stock – including that held by top executives of the company. So if you need a good reason why Chapter 11 would be a last resort for troubled companies, you need look no further than the enlightened self-interest of management.

Bankruptcy takes its toll on companies passing through it. Fewer than 20% of companies filing for Chapter 11 achieve confirmed plans, and even some of those are liquidation plans. Clearly, companies that can avoid bankruptcy are best off doing so. For firms that need it, it is a valuable tool, providing overextended companies breathing room and tools to regroup – tools that are available to all.