LIQUIDATION OF A CORPORATION
Reasons for Liquidating—Partial and Complete Liquidation
There are a number of ways in which a corporation may cease to exist
and a liquidation take place. The charter, if created for a fixed
number of years, may expire. The state may see fit to repeal the
charter in accordance with the right reserved at the time it was
granted. The corporation may of its own accord surrender its charter;
or the courts may decide that the corporation has forfeited its charter
rights by reason of non-performance or because of some wrongful act.
Failure to pay taxes due the state is an instance. The liquidation
of a corporation may take place because of a consolidation resulting
in loss of its original identity. In the case of a merger the merged
corporation ceases to exist under the terms of the agreement made
which may call for a more or less complete liquidation. Sometimes a
reorganization effects the liquidation of an insolvent corporation.
If the new corporation obtains the assets of the previous corporation
under a forced sale, the money received would be applied to the
satisfaction of the old creditors’ claims.
Insolvency is the most usual reason for liquidating a corporation.
Insolvency may be either actual or legal. By the National Bankruptcy
Act insolvency is defined as the condition in which the assets of a
person, firm, or corporation are less than the debts. This definition
emphasizes the economic point of view. A corporation is legally
insolvent when the cash assets are not sufficient to pay debts
when they become due. Either of these conditions may exist without
necessarily disastrous results, though it generally leads to disaster
sooner or later. However, the fact that these conditions do exist
indicates that the business in question is not well managed. It is
well, therefore, to bring out the more prevalent causes leading to
insolvency.
Current Assets Transferred into Fixed Assets
A common cause of insolvency is the tying up of current assets
in plant and equipment. While this may be the actual cause, the
post-mortem assigns the cause generally to lack of “working capital.”
When a business expands and orders are coming in in excess of the
facilities at hand, there is a great temptation to put a large part
of the incoming funds into plant in order to take full advantage of
the opportunities in sight. The result is that eventually the point
is reached where it is impossible to get the cash necessary to meet
maturing obligations. While the need for plant and equipment may
justify the outlay, they cannot readily be converted into cash for they
are usually of such a special nature as to be of small value without
the organization.
Tying up Cash in Stocks of Material
The conversion of the cash resources of a company into stocks of
material is another cause of insolvency, especially if the turnover
is slow or the business is of such a nature as to require large sums
invested in materials. Though capital in this form is generally being
converted into cash or other forms of working capital, the fact that
large sums are invested in material does not always mean that its
cash value measures the amount of working capital. On the liability
side of the balance sheet there may be items such as short-time loans
or accounts payable which must be deducted in order to determine the
net working capital. If the stock carried is disproportionate to
requirements, it is a sign of poor management. When this state of
affairs is allowed to continue for some time, the chances are that
stocks will become obsolete or deteriorate, resulting in a loss. This
will eventually result in the accumulation of current liabilities or
floating debts and so bring about a condition of insolvency.
Unwise Use of Cash for Paying Dividends
Dividends are sometimes paid at a rate entirely out of proportion to
average earnings, or a rate is maintained that is at variance with
current earnings. Profits depend to a large extent upon economic
and financial conditions. Business does not move on an even level
throughout the years. The rule with conservative corporations is that
dividends must not be allowed to rise, even in most prosperous periods,
above a conservative estimate of the average earnings. In periods of
prosperity the demand on the cash resources of a business increases as
the prices of material, labor, and money rise. The result is that while
a company may make large profits it may not be in a position to pay
more than the usual rate of dividends. Many a corporation after paying
big dividends in prosperous times has ended by placing its affairs in
the hands of its creditors. Dividend payments are dependent not only
upon profits but to a greater extent upon the concern’s cash position.
To endeavor to do a large volume of business with a small working
capital is generally a sure and a quick way of landing in bankruptcy.
The prudent way is to withhold dividends until in the normal course of
events cash is accumulated beyond the requirements of the business. The
book surplus must be reinforced by a satisfactory cash balance as a
basis for the declaration of cash dividends.
Sometimes corporations may find it sound practice to pay dividends
with the proceeds of temporary bank loans. This is not open to
objection under certain circumstances. For example, the company’s
business may be subject to wide seasonal fluctuations’ or it may be
of such a nature that it nominally operates with a small working
capital. Even in these cases the assumption must be that the loans can
be repaid when due without any undue strain or effort. There is some
question regarding the soundness of the practice, sometimes resorted
to, of issuing long-term obligations or of selling additional stock
for the purpose of obtaining cash to pay dividends. If the profits are
extraordinarily large and the probabilities are that they will remain
so, then the increased capitalization may not be a serious handicap in
itself. However, where the surplus shown on the books is fictitious
or when a legitimate showing of profits cannot be made, then such a
transaction would clearly be fraudulent.
Inability to Secure Cash for Refunding Operations
Corporations sometimes issue bonds because of the fact that a larger
return is gained to the stockholders than if more stock were sold. The
interest rate on bonds is generally much less than the rate of profits
and even less than on short-term loans or notes. The distinction
between bonds and notes is mainly that of time. The proceeds from the
bonds are commonly used for permanent improvements, while the notes are
issued to bridge over the changing of some form of quick assets into
cash. Generally the bonds are issued during a period of easy money but
they may mature when the money market is hard. If a sinking fund has
been provided, all that is necessary is to convert the securities in
which the funds have been invested into cash and take up the bonds.
But the fact that the returns on the securities in the sinking fund
are as a rule much less than can be realized by placing the money in
betterments, operates against its use.
When, therefore, the bond issue becomes due in a period of financial
stringency, or even during normal times if the business has not been
highly successful or if its credit has been impaired, the company may
be unable to liquidate its assets and pay it off. The consequence is
that a foreclosure of the mortgaged property is made.
Excessive Borrowing on Short-Term Securities
A frequent cause of insolvency is excessive borrowing by means of
short-term securities in the form of accounts payable, acceptances,
and notes. The notes may be classified into: (1) notes discounted at
some bank; (2) notes sold to the public; and (3) merchandise notes.
There are three legitimate uses to which they may be put, namely:
(1) to take care of a temporary lack of funds; (2) to extend further
credit to customers; and (3) to increase the stock of easily marketable
goods on hand. Definite provision must be made to meet the notes at
maturity, which in the case of bank loans run from 30 days to six
months—generally 60 to 90 days. The use made of funds obtained in this
manner is a matter of importance to bankers when extending loans.
To use any one of these forms of borrowing for the purpose of financing
betterments and additions is dangerous and essentially unsound. Such
obligations are generally contracted during a period of prosperity and
expanding business for the purpose of taking care of temporary needs.
They frequently become a source of embarrassment when a period of
money stringency sets in. If the borrowings are in excess of the quick
assets, the policy is unsound at all times. Conservative managers make
provision for meeting their notes at maturity before they issue them.
The short-term notes sold to the public usually are for longer periods
than those discounted at the banks—the period ranging from one to
five years. When the time is not appropriate for a bond issue and it
is desirable to defer it, short-term notes are generally issued and
marketed through note brokers, often throughout the country. This is
an effective means of deferring a bond issue until money is easier and
better terms can be obtained for the larger issue. When the bonds are
sold the notes are retired with a part of the proceeds. The danger
of this financial practice is that the notes may mature before the
bonds can be marketed, as would probably be the case if a period
of depression ensued. This would involve disaster if provision for
refunding had not been made, especially as the proceeds of such notes,
like the proceeds of a bond issue, are generally used for betterments
and additions.
Losses in Conducting the Business
A business, through defects of management, does not always fulfill
the expectation of its promoters. The price of the product may be set
without regard to true costs, and losses pile up with or without the
knowledge of the management. Competitive conditions may have to be met
and efficiency of management be an absolute requisite if profits are
to be made. An organization is of slow growth and the price paid for
experience may eat up all the profits. Poor workmanship, duplication
of effort, poor planning in the factory, resulting in a high unit
cost—these are all factors which may bring disaster if not detected and
remedied in time. The promoters may have been unusually optimistic in
regard to the business that could be done, with the consequence that
a plant is constructed much in excess of actual market possibilities.
Losses of a serious nature then result from the poor utilization
of fixed assets. “Lack of ability” is the phrase commonly used in
describing this cause of insolvency. The usual symptom of the malady
is a reduction in current assets and greater difficulty in obtaining
credit.
Loss through Fraud, Theft, or Unavoidable Causes
The corporate form of business lends itself to exploitations of many
kinds. The public is usually victimized, but sometimes the stockholders
suffer through a breach of trust on the part of officers—as for
example, the granting of contracts or the payment of exorbitant
salaries to the detriment of the large body of stockholders. Another
form of exploitation is the diversion of profitable business to some
other corporation controlled by the untrustworthy officers. Then again
the officers may buy up unprofitable ventures and sell them to the
corporation at a large profit. The juggling of accounts may cover up
fraud and exploitation. The profits may be sacrificed for the purpose
of squeezing out the minority stockholders, or contracts may be
made with a subsidiary whereby it takes most of the profits, or the
profitable features of the corporation may be sold to a new company.
These modes of freezing out the minority are naturally promoted by the
majority stockholders. Whatever may be the means used, these various
methods of exploitation may lead to insolvency, their ultimate effect
depending upon the condition of the company and the extent to which
they are carried on.
Unavoidable causes which may lead to the impairment or complete loss of
a corporation’s assets are the disruption of the organization and its
earning capacity through fire or earthquakes or other natural causes;
or new inventions may kill the demand for its product; or improvements
in machinery and equipment may render obsolete a large capital
investment.
Methods of Liquidation
There are several forms of procedure in case liquidation is found
advisable or necessary, and in general there are three courses open,
viz.: bankruptcy, voluntary dissolution, and receivership.
_Bankruptcy._ This perhaps is the most common method. It is of
two kinds—voluntary and involuntary. If voluntary bankruptcy is
contemplated, the debtor files a petition in the federal court for his
district, stating the number and amount of his debts and the amount of
his assets. Creditors are then served with the notice and copies of
the petition. Further proceedings are similar to those in involuntary
bankruptcy. Involuntary bankruptcy proceedings may be brought if the
debts are not less than $1,000 and an act of bankruptcy has been
committed.
The following are legal acts of bankruptcy:
1. To convey, transfer, conceal, or remove, or to permit
to be concealed or removed, any part of the
debtor’s property with intent to hinder, delay, or
defraud his creditors.
2. To transfer while insolvent any portion of the property
to one or more creditors with intent to give
preference to them.
3. To make a general assignment for the benefit of
creditors, or being insolvent to apply for a receiver
or trustee for the property.
4. For the debtor to admit in writing his inability to
pay his debts and his willingness to be adjudged a
bankrupt on that ground.
5. To suffer or permit, while insolvent, any creditor to
obtain preference through legal proceedings and
not have vacated such preference at least five
days before the sale or final disposition of the
property affected by such preference.
After the petition has been presented the next step is the appointment
of a receiver or trustee for the purpose of protecting the creditors,
and also in the case of the individual to secure the application of
his property to the settlement of his debts so far as possible and so
secure for him a discharge from further liability.
Bankruptcy proceedings are regulated by the National Bankruptcy Act of
1898. The courts of the Federal Government have jurisdiction in these
proceedings. Under the National Bankruptcy Act, a person is insolvent
“when the aggregate of his property, exclusive of any property that he
has conveyed, transferred, concealed or removed, or permitted to be
removed with intent to hinder, delay or defraud his creditors, is not,
at a fair valuation, sufficient in amount to pay his debts.”
_Voluntary Dissolution._ A corporation may or may not be insolvent
when making a voluntary dissolution. The reasons for the decision on
the part of the stockholders to take this step may be various. Perhaps
business is falling off and further profitable use cannot be made of
the capital, or the company while solvent is losing money and drawing
on its surplus. Again the cause may be due to legal complications,
especially when concerns are adjudged combinations in restraint of
trade. Voluntary dissolution in general is due to the fact that the
condition of affairs seems to be unprofitable and the near future
promises nothing better.
_Receivership._ One method of liquidating an insolvent corporation is
by means of a receivership. The appointment of a receiver in equity
is different in purpose from that of a receiver in bankruptcy. The
function of the receiver in equity is to continue the business until
it is wound up. In bankruptcy proceedings a receiver is appointed
temporarily to preserve the property until a trustee can be elected. He
does not conduct the business, but merely takes care of the goods, and
pays taxes and dues, until the election of the trustee. A receivership
in equity is frequently a preliminary step to reorganization. While
the concern is technically insolvent in that the quick assets are
not sufficient to meet maturing obligations, the total assets really
exceed the total liabilities. Were the fixed assets sold, only a small
fraction of their value might be realized. Under these circumstances
the appointment of a receiver in equity is a valuable measure, giving
time to provide for permanent remedies.
Liquidation under Bankruptcy
In involuntary bankruptcy proceedings the creditors file a petition in
the federal courts located in the judicial district where the bankrupt
has his place of business or in which his property is located. A copy
of the petition is served on the bankrupt. The petition generally asks
for the appointment of a receiver to protect the property until a
trustee can be elected. The receiver is appointed by the court and is
given charge of all property of the bankrupt until the first meeting of
the creditors. The proceedings are generally conducted before a referee
in bankruptcy appointed by the court. After the expiration of 20 days,
during which the bankrupt is allowed to make his reply, he is required
to file a list of all claims against him. A meeting of all creditors
whose claims have been allowed by the court is then called and, if the
petition is granted, a trustee is elected. Creditors who have some
security for their claims are not allowed to vote for the trustee
unless the security is insufficient to cover their claims, in which
case they may vote on the amount of claim which is unsecured.
As soon as the trustee has been elected the creditors should file their
claims with him together with the proof of the claims. This may consist
of an affidavit stating the nature and amount of the claim, and the
security held, if any. The bankruptcy proceedings are carried through
unless the creditors and debtor agree to compromise.
The trustee’s first duty on his appointment is to collect all the
property and any debts owing to the bankrupt, and to turn everything
into cash in as short time as possible without unduly sacrificing the
assets. As a general rule it is necessary to keep the business going
for some time in order to get the most out of it. From the receipts
the trustee pays taxes, filing fees, court costs, attorney’s fee and
wages due, and then the creditors. Servants and persons employed for
three months prior to the bankruptcy proceedings are entitled to be
paid before any other claims are settled. After that the secured debts
are discharged to the value of the security. When these items have been
paid, if there remains enough to pay 5% of the total amount of all
other claims, the creditors are entitled to have a dividend declared
within 30 days after the debtor has been adjudged a bankrupt. If not,
they must wait until the trustee has collected a sufficient amount.
Afterwards the creditors are entitled to dividends from time to time
until the entire amount in the hands of the trustee has been paid
out. When the final dividend has been paid the trustee makes up his
accounts, presents them at court, and asks for a discharge. He then
is entitled to his fee based on the value of the funds that have gone
through his hands.
Liquidation under Voluntary Dissolution
A corporation may be dissolved and its affairs wound up by the proper
procedure if all its stockholders consent. In some states a majority
is sufficient, and in certain cases even less. Statutory provisions
prescribe the procedure in most of the states. The process of voluntary
dissolution consists simply of gradually closing down the business by
realizing on the assets, and distributing the funds among the creditors
and stockholders. This usually involves a vast amount of detail work,
such as the transfer of contracts, the sale of parts of the business,
the taking of inventories, the making of appraisals, and so on.
Liquidation under Receivership
The receivership in bankruptcy is only a step in the chain leading
to the appointment of a trustee under whom the process of liquidation
takes place. As already stated, the receivership in equity is sometimes
not a process of liquidation but a means of carrying on the business
pending reorganization. In case the assets are greater than the
liabilities, it may be advisable to effect some sort of reorganization
to continue the business. The receiver can continue the business
in whatever way the court will permit. Any of its unprofitable and
unessential parts may be sold and in this way a partial liquidation may
be effected.
With permission of the court the receiver may issue receiver’s
certificates to meet immediate and necessary running expenses. The
certificates usually have the first claim on the assets. It seldom
happens that these remedies are sufficient to put the company on its
feet and the receiver in the end will wind up the business by disposing
of the assets and distributing the proceeds as instructed by the court.
A receiver is an officer of the court and acts under its instructions.
In all dubious matters he can protect himself from liability by
procuring an order of court or by refusing to act until authorized by
an order of court.
Status of Creditors in Liquidation
Creditors may be divided into two groups—secured and unsecured. Those
that have a lien upon some specific part of the assets, such as
buildings, machinery, or materials, and holders of bonds are among
those whose claims are secured. Trade credits and bank loans often have
no other security than the standing of the firm.
If the business has been in a receiver’s hands and receiver’s
certificates, have been issued, these may be given priority over all
debts except those for taxes. The bondholders are usually given the
opportunity to appear and present their arguments for or against the
issuance of receiver’s certificates. The court directs the issuance at
its discretion.
Preferred and common stockholders receive what is left after everyone
else has been paid. If the preferred stock is preferred as to assets,
it takes priority over the common stock. Often, however, the preference
is only as to earnings, in which case the two stock issues share
equally in the liquidation. Directors are prohibited by law from
declaring dividends except out of earnings. If it should appear that
dividends have been paid out of capital and not out of earnings, the
stockholders are liable for any amounts thus paid out to them. If the
stock issued is only partly paid, the stockholders are liable up to the
amount which remains unpaid.
Accounting for Liquidation
Accounting for liquidation may be simple or complex, depending upon
circumstances, but it involves practically nothing new in principle.
The main bookkeeping features for a liquidation which takes place
because of bankruptcy or receivership are treated in Chapter XXXV where
some specialized forms of statement are discussed and illustrated.
Here it is purposed merely to point out the accounting procedure
necessary in the case of a voluntary dissolution. Under a voluntary
liquidation the same books of account are used as for the regular
record of business transactions, and the procedure is merely a matter
of recording the conversion of assets into cash. This involves taking
into consideration, in the case of depreciating assets, the adjustment
between the asset account, the depreciation reserve, and the loss or
gain realized upon the final disposal of the asset. It may be desirable
to separate these losses and gains on the sale of fixed properties
from the losses and gains of the stock-in-trade, particularly if
operations are continued up to the point of the final disposal of the
merchandise stock on hand through the regular channels of trade. If,
however, the sale of the whole property, including stock-in-trade, is
effected, there is no occasion for the separation of the results of
the liquidation of the two types of assets. But if this is desirable
a separate clearing account, sometimes called “Liquidation Profit and
Loss,” may be opened to summarize the losses and gains on fixed assets
before transferring the net result of both into surplus. As the assets
are sold and converted into cash the liabilities will be liquidated
in due course, the accounting features here being the same as during
the period of regular operation. After all assets have been converted
into cash and all liabilities liquidated, only the cash and net worth
accounts will remain on the books of the corporation. If the net result
of the liquidation has been to encroach upon the original capital,
the net worth accounts will consist of a deficit account and one or
more capital stock accounts. If, however, a profit has resulted or if
the resulting deficit is not sufficient to wipe out any previously
accumulated surplus, the net worth accounts will consist of a surplus
account and the various capital stock accounts.
The final step in liquidation will be the declaration of a liquidating
dividend of the amount of cash on hand; this will be apportioned,
just as all other dividends, on the basis of the stockholdings of the
various shareholders. The books will be finally closed by charging the
dividend and deficit, if any, to the various capital stock accounts in
the one case; or by charging the dividend against the various capital
stock accounts and surplus in the other case. In practice the closing
of all accounts on the books is seldom carried out, the bookkeeping
ceasing with the declaration of the liquidating dividend which disposes
of the cash. Except as a matter of complete record, nothing is to be
gained by closing off the accounts.