Bankruptcy – Definition, Types, Features & History
Meaning of Bankruptcy
Bankruptcy is an economic situation in which a company, organization or an individual finds itself when, due to the inability to face its debts with the available resources, has to permanently cease its activity.
In other words, when the net worth is negative, a company is bankrupt. When this situation occurs it means that with all the assets they could not respond to the total debt they owe to the creditors.
The bankruptcy situation must be distinguished from the suspension of payments situation. Thus, a company that suspends payments at a certain time cannot meet the payments at a certain time, but it is not necessarily bankrupt. This occurs in situations of absence of liquidity. But this does not mean that it receives sufficient liquidity the following month to continue meeting its payment obligations.
Now, we should not confuse liquidity with bankruptcy.
In contrast, the bankruptcy situation is characterized by the fact that current payments cannot be made and future payments cannot be made either. As we have already indicated, it is a situation of permanent cessation of activity.
It is worth mentioning, before going deeper into the term bankruptcy, that the word liquidation, currently used as a synonym for bankruptcy, is not bankrupt in a strict sense of the term.
History and Origins of Bankruptcy
The origin of the word bankruptcy dates back to the 15th century in Italy. From an etymological point of view, it comes from the union of two words of Latin origin: “bancus (bank)” and “ruptus (broken)“.
The word bankruptcy, currently used as a synonym for liquidation, describes a situation of insolvency on the part of a natural person, institution or organization. However, even though they are used synonymously, they really might not be.
To uncover the reason why the words bankruptcy and liquidation have similar but historically different meanings, one has to draw on economic and commercial history.
The Origin of Bankruptcy
Since around the 15th century it was common to organize international fairs in some of the main cities of the time, the need arose to exchange foreign currency for local currency. Without the local currency, you couldn’t buy items or pay for a meal in a restaurant.
Thus, those who would later bear the name of money changers – although it is true that money changers already appear in some passages of the Bible and in texts of the Roman Empire, although not with that name, they realized and did business of the affair. At first, they were just buying a currency and selling it more expensively. For the difference they earned a small exchange commission.
As the business became more popular and people began to trust that way of proceeding, the money changers also became a kind of bankers. On occasion, visitors would leave part of their money to the money changer or banker, and the latter would give them an interest in return. That way, they could generate more profit. In other words, someone deposited their money and as long as they did not claim it, the money changer used it as cash to offer foreign exchange.
Of course, the latter had the danger that if the borrower came back and his money was not there, then the money changer could not pay, he is in a bankruptcy situation. At that time in history, since there was no such advanced Commercial Law, it was difficult to see the difference between a moratorium (suspension of payments) and a bankruptcy. That said, and ignoring this difference, the money-changer declared bankruptcy.
What Happened When a Money Changer Went Bankrupt?
Here comes the crux of the matter. When a money changer or banker went bankrupt, if it was shown that he had not acted with caution and caution, he was sentenced to break the bank with which he worked. The bank was something like a kind of table where they had the coins and that served them to carry out their work.
He was forced to break it publicly so that the entire plaza would know that he was insolvent and also a criminal. This had two consequences: on the one hand, he could not work because he did not have his work tool (the bank) and, on the other, everyone stopped trusting that person who was humiliated in the eyes of the whole city.
Alternatively, there are other origins of the word bankruptcy. An example of this is described by Fermín Pedro Ubertone in an essay that states that, on occasions, other merchants left their money deposited with the money-changer as a safe. Later, they went on a revelry and the money changer, on occasion or other, did too. When he returned, he might find that someone had drilled a hole in his bank in order to make it easier for passers-by to be tempted to take some of the money.
The next day, the merchants return to the banker to get their money back. It is then, when the money changer tells them that he cannot return the money to them. As proof that he was acting in good faith, he showed the merchants a hole (the broken bank). And so he pretended, despite being bankrupt, that he was innocent.
Features of Bankruptcy
Bankruptcy has some characteristics that make it a unique situation and, therefore, different from others. The characteristics of a bankruptcy are as follows:
- It is an irreversible situation: Once a company declares bankruptcy, that company is doomed to disappear. Therefore, other new companies may be born, but that one will not work again. Bankruptcy is permanent.
- Assets are less than liabilities: Total assets (furniture, buildings, cash, warehouses) are less than debts owed (loans, mortgages, outstanding payments).
- It affects the entire company: Which means that in a bankruptcy, this legally affects the entire company. Regardless, of course, that subsidiaries can be sold that pass into the hands of other owners and avoid the situation of generalized bankruptcy.
- It is legally typified: Since bankruptcy is a situation that could be used for fraudulent purposes, it is included in the law. In this way, the bankruptcy situation is intended to be an objective situation, not a subjective one.
Solutions to Bankruptcy
In general, we can establish two possible solutions to bankruptcy:
- Get a capital increase so that assets equal or exceed liabilities.
- Let the creditors forgive the debts. That is, a debt relief.
As we can see, bankruptcy is a complex situation since by definition, the resources are not enough to cover the debts. In order to prioritize payment to creditors, a bankruptcy procedure is generally established where an administrator is appointed who will be in charge of managing the available resources and determining the order of payment to creditors.
Types of Bankruptcy
The importance of bankruptcy being included in the legal or commercial code of each country is fundamental. Thanks to that, we can distinguish three types of bankruptcy:
- Fortuitous bankruptcy: Occurs when everything possible has been done to avoid this situation. However, due to market conditions, personal or other situation, the company has declared bankruptcy.
- Guilty bankruptcy: This case is condemned in all countries that have specific regulations in this area. It takes place when the administrator, owner or entrepreneur carries out activities without ensuring the proper functioning of the organization. In other words, it is poorly managed.
- Fraudulent bankruptcy: It is an even more serious case. The administrator of the organization, knowing that he is carrying out activities that go against the stability and sustainability of the organization, performs them with malicious intent. This malicious intention is more technically known in law as a malicious attitude.
The difference between these types is very important, we said, since it can choose one result or another in favor or against the creditors. Many times, in cases in which it is possible to prove that the bankruptcy was fraudulent, the creditors manage to recover part of the investment, since they are compensated.