Abstract
In this chapter, the authors address a very real issue of current business life, and that is the prediction and prevention of corporate and municipal insolvencies and bankruptcies. The concept of stress testing banks for capital sufficiency under conditions of plausible risks is by now an accepted governmental mandate. Stress testing corporations and municipalities however is relatively new. The authors present a process for both corporate and municipal stress testing together with a review of legal considerations. Over time, it is expected that stress testing corporations and municipalities will become as routine as an annual visit to the family physician. This chapter is designed to establish the ground work for stress testing corporations and municipalities, including supply chains and not-for-profit organizations. This discussion applies equally well to global supply chains.
TopIntroduction
Assuring the likelihood of survival is the fundamental reason for stress testing large banks in Europe and the United States under the mandates called Basel I, II and III, and CCAR respectively. Similarly stress testing corporations, not-for-profit organizations, and municipalities, has become a necessary exercise to prevent insolvency in times of economic uncertainty and shortened corporate life expectancy.
The concept of stress testing is not entirely new. For example, computer software gets routinely stress tested in order to assure it can survive volume fluctuations, data storage requirements and hacking attempts. In the field of engineering, stress testing materials under conditions of extreme heat, cold, or loads has been around for ages. In the banking sector of our economy stress testing means having sufficient capital to meet current obligations and even prevent runs on your neighborhood ATM. So the logical extension of this reasonable practice is to stress test mid-sized or large firms, non-profits and municipalities with respect to solvency, with the intent to preserve public services, commercial products, peoples’ jobs, invested capital, supplier and customer relationships and quite possibly preserve whole communities!
It is very well established in the academic and business literature that both insolvency and bankruptcy are predictable phenomena for the vast majority of cases.2 However, testing for those conditions is not yet customary for businesses and municipalities. During the 1960s managers presumed that a certain percentage of business failures were to be expected and that these constituted the risk of market entry. More recently the Harvard Business Review9, dedicating an entire issue to business failure, postulating that not succeeding constitutes a learning experience which one should embrace and not be ashamed of. The clear message is this: learn from your failure and then try again, only do better next time. That is acceptable in theory, just don’t tell this to a failing entrepreneur with a great idea who has just mortgaged his house and put his entire future at risk. Failure is not a good thing and many types of failures are both predictable and most importantly preventable. The fiduciary responsibility for preventing business insolvency rests primarily with directors and corporate officers, individually and collectively. States are on the line for municipal failures under Chapter 9 of the U.S. Bankruptcy Code irrespective of whether Chapter 9 applies. States do bear a large reputational risk as future borrowing costs may increase.
Key Terms in this Chapter
Stress Testing: Corporations or municipalities for solvency, is a quantitative and qualitative process of showing the likelihood of an organizations’ fiscal survival probability under adverse conditions. It addresses the “what-if” question and leads to better decisions, good governance and reduces likelihood of financial stress.
Chapter 7: Of the U.S. Bankruptcy code pertains to corporate cases, or individual insolvencies, for which restructuring is unlikely to have success and liquidation the is only option.
Scenario: Is a plausible future state of an enterprise or town may find itself in, and it is usually quite different than what is expected under normal operating conditions.
Insolvency: Is defined as the financial state of a person or company or municipality unable to meet its obligations when due. Usually liabilities exceed current assets in those situations.
Chapter 9: Of the U.S. Bankruptcy code pertains to municipalities, and its applicability varies by State. For example, it does not apply to the Commonwealth of Puerto Rico and is creating challenging legal issues in the 2016 financial crisis there.
Chapter 11: Of the U.S. Bankruptcy code pertains to corporate and personal cases for which reorganization or restructuring is a viable option.
Bankruptcy: A successful legal procedure and declaration for seeking protection from creditors. All bankrupt debtors are in fact insolvent. (bankrupt24.co.za AU26: URL Validation failed: bankrupt24.co.za does not exist (connection error "HOST_NOT_FOUND"). , 2012), includes corporations and municipalities. ( Jones, Hilbers, Slack, 2004 ).