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Toys R Us. Circuit City. PanAm. Lehman Brothers. All major corporations that no longer exist due to liquidation in bankruptcy. GM, Texaco, Delta Airlines, all live on today but went broke once upon a time. It is the ability of the US economy to withstand and even promote the extinction or reorganization of corporations that is essential to our economic success.

some text Christopher A. Hopkins

America was always a nation of risk takers. It was this spirit of entrepreneurship that propelled us from colonial outpost to the world's superpower. Yet this phenomenal success would not have been possible had not the Framers anticipated the need for an orderly discharge of debts in circumstances where the debtor had no hope of repayment. Article I of the Constitution explicitly grants Congress the authority to establish uniform laws governing bankruptcies, intended to replace a pastiche of disparate state statutes. Within a document so remarkable in every aspect, the doctrine of corporate bankruptcy ranks high for its salutary effect on the development of capitalism in the New World.

Congress made several early but abortive attempts to codify that authority throughout the 19th century, most of which were ultimately viewed as too lenient toward debtors. Progress was made and lessons learned (federal debtor's prison was abolished in 1833), leading up to the Bankruptcy Act of 1898, essentially the basic framework under which modern debt restructuring occurs today.

Capitalism has proven to be the most dynamic force in world history for raising living standards and promoting peaceful coexistence. The triumph of this intangible but powerful force depends upon the allocation of capital to its best and highest use, a process that Adam Smith referred to as the "invisible hand". There are of course other mechanisms for allocating capital, involving government planning or coercion, but none has held a candle to the miracle of market forces in promoting economic well-being.

Yet by definition, directing capital to an untested venture is a risky proposition. Roughly half of all new business ventures fail within their first 5 years, erasing the shareholders' equity investment and often leaving the enterprise with debt it cannot repay. The reasons are varied, from insufficient cash or poor management to bad timing and economic cycles. But who would willingly undertake such risk if the result of failure was a lifetime of penury or even imprisonment? Part of the genius of the American system is the recognition that risk taking must be encouraged and failure is not a death sentence.

The list of household names generally considered wildly successful is replete with tales of failure. Walt Disney, Milton Hershey, Henry Ford, all started business enterprises that failed before ultimately finding the right combination. Imagine if none had been able to start again.

The early 20th century economist Joseph Schumpeter praised the inexorable rise and fall of business endeavors in a market economy, coining the term "creative destruction" to describe the essential, almost biological process of business germination and demise in response to misallocation of capital and the market's dispassionate reward or punishment. It is this process that animates the Western economies (and is increasingly penetrating the East, including China to a limited degree).

But innovation could not proceed without an orderly process for unwinding the debt of failed establishments and freeing their creators to try again (and again).

Obviously, a major bankruptcy liquidation is disruptive to investors, employees and communities of the vanquished firm. But when you read about the sad tale of a Sears or its ilk, know that the market is hard at work correcting a poor allocation of capital to a more productive and beneficial end.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

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