The Morality of Bankruptcy

Responsa of the Week: The Morality of Bankruptcy

A weekly series by Dr. Meir Tamari about responsa regarding business ethics issues.

In order to demonstrate the work of the halakhic system and its moral considerations regarding a variety of issues in business and economics, I will present a number of responsa drawn from the literature. These represent questions addressed either by laymen or by rabbis or communities to rabbinical authorities and their answers. They cover a period of close to 2000 years and reflect Jewish life in all the countries of the Diaspora. Even though the answers may vary and conflict with each other so that one cannot draw behavioral conclusions from them, they demonstrate Jewish thinking and values in this field.

From a purely economic view, bankruptcy is nothing more than the market’s mechanism for correcting errors in investment or in management. It should be remembered that the market is a profit and loss system, so that bankruptcy is part of the loss aspect. However, there are also social and moral effects that must still be addressed. There is the question of the morality of the debtors not meeting their obligations to their creditors. The bankrupt party may be impoverished if they meet these obligations, but somebody must take resposbility for their welfare and that of any employees affected.

From a halakhic point of view, it should be born in mind that the repayment of debts is a mitzvah (Ketubot, 86a), so there is a moral and religious obligation involved. Furthermore, all the legal codes make it quite clear that the creditor has the full right to reclaim his debts, although we would like him to waive those rights as an act of charity. The creditor’s rights to full repayment exist irrespective of whether the debtor is poor and the creditor is rich.

If necessary, the courts are obliged to seek out and sell the debtor’s assets and leave him with, “clothing for a year, food for 30 days, a mattress to sleep on and a covering, all suitable to his social standard ( Shulchan Arukh, Choshen Mishpat, section 97, subsection 23). [The Chatam Sofer interprets this as being the standard of his peers, and his tallit and tephillin.] The same source shows that there is no justification for leaving him with luxuries such as fancy clothing or jewelry, even those of his wife or his children. This is contrary to the practice in the modern world, where it is common practice for the bankrupt debtor to continue living well at the creditors’ expense. In reality, there is no place for bankruptcy and evading the repayment of financial debts. The only argument that makes bankruptcy permissible is that since it is the law of the land and all the parties to a transaction know this, therefore they agree to the possibility of it occuring.

While all this is true of personal bankruptcy, it may well be that it does not apply to the corporation in view of the limited liability nature which is recognized halakhically, so that it is clear that the creditor may not claim the personal assets of the shareholders. There is, however, a responsum of the London Bet Din on June 20th, 1991 that makes it clear that any fraud on the part of the directors or shareholders invalidates the limited liability nature of the corporation:

“The plaintiffs were engaged by the defendant’s corporation, Alef ltd. to provide accounting services, which they did. Invoices for these services were presented, but to date no payment was received. The defendant acquired another corporation, Bet Gimel. On October 19990, Aleph Lt., transferred all its assets to Bet Gimmel before entering voluntary liquidation on the 27th February 1991. Now the plaintiffs claim payment for their services and the defendant, while admitting liability, argues that Aleph has no assets and he is not personally liable for its debts.”

The Bet Din Rules that:
“Where goods or services were provided to a limited liability corporation in consequence of which a liability has arisen, and the corporation has been subsequently liquidated, there is no recourse in Jewish law to the directors or to the shareholders. This, however, only applies where there has been no action designated to denude the liquidated corporation of its assets, prior to liquidation. If such were made, then the person taking such action would be personally liable for the liquidated corporation’s debts.”

“Having been satisfied that that defendant had indeed acted thus, the Bet Din rules that he is personally liable for the monies owed. We do not uphold his contention that the fees charged were excessive, since no evidence has been adduced that this is so.”

It may be argued that not all bankruptcy is fraudulent and therefore the shareholders have protection of the limited liability nature of the corporation. However, corporate research has shown that all corporate bankruptcies can be foretold, except those caused by fire, war or natural forces, on the basis of the financial reports of the corporation alone, some five years before it happens. The directors would therefore have known many years before pleading bankruptcy so that any funds borrowed without disclosing this information would be fraudulent, and therefore would bring into question the defense given by the limited liability clause to the shareholders personal assets.

It has been pointed out to me, that the creditors are supposed to ascertain the creditworthiness of their corporate debtors and to monitor them; failure to do so should free the debtor from personal liability. That may be the case when professional lenders are concerned, since these have the tools to make assessments and to monitor them. However, where is the justification for applying this argument to suppliers, employees and small creditors? Above all, there is the moral and religious dimension of applying the Jewish values even where the strict letter of the law recognizes the legality of dina de malkhuta dina.

This column presents general principles for approaching business ethics topics. For specific guidelines, please refer to a halachic authority.

Dr. Meir Tamari is the former chief economist of the Office of the Governor at the Bank of Israel, and the founder of the Business Ethics Center of Jerusalem.