American companies are declaring bankruptcy at the highest rate since 2010, according to S&P Global Intelligence, as they struggle to deal with high interest rates, supply chain breakdowns, and slowing consumer spending. Employees often get the short end of the stick when their companies go bankrupt, taking a place towards the end of the line with other unsecured creditors as the remaining assets are divided up.

This means that the average American employee, who has already endured decades of stagnating wages and who will suffer unemployment following a bankruptcy, may not get all they are owed for time worked, vacation time accrued, and pension contributions. Meanwhile banks, bondholders, and the IRS get paid much higher percentages of what is owed to them, and sometimes are paid in full. 

In his July 2024 address to the Republican National Convention, Teamsters President Sean O’Brien proclaimed that bankruptcy laws currently favor the capital side in the capital/labor divide and this points to the need for “meaningful bankruptcy reform.” His comments, though, are just the tip of the iceberg. The idea of pro-worker reform of bankruptcy law should gain the support of people across the political spectrum, whether or not they are affiliated with labor unions.

Recall that in 2009 both General Motors and Chrysler declared bankruptcy. Rescuing those companies without dismantling them required the federal government to finance the bailouts. The price the Obama administration exacted for bringing the resources of the federal government to the undertaking was that the United Auto Workers and its members received far more than they would have received under the usual processes of federal bankruptcy law. The exact amount is subject to debate, but we can say with some credibility that they received billions of dollars more than they might otherwise have done. Conservative commentators lamented the fact that financial creditors were denied the results that they expected, and that the Obama administration was paying a political debt to its election supporters with money that legally belonged to someone else.

In at least one respect, the observations of these commentators are vitally important. If parties to contracts cannot rely on the consistent application of settled law to those contracts, economic activity in a modern economy will grind to a halt in a hurry. It is no exaggeration to describe loss of predictability as the potential death knell for an economy in which people exchange products and services by the choices they make in markets. While it is true that Obama administration in 2009 was pro-union, it is important also to note that it was not pro-worker—at least not in an even-handed manner. Pensions were obliterated for non-union workers but saved for UAW members; and non-union facilities were closed so that union factories could stay open. 

The automobile industry bailout, however, shines a spotlight on something that has received little attention. Why should amounts owed to banks and some other financial creditors have a higher priority in the first place than amounts owed to employees—regardless of their union status? There are details and alternative scenarios that complicate any discussion of the subject. It is nevertheless undeniable that in many business bankruptcies, employees get paid only a fraction of what is owed to them.

When a bankruptcy liquidation includes the sale of inventory, that inventory’s value was created in part by the past efforts of its employees. Yet federal bankruptcy law often takes much of that value and gives it to banks as preferred compensation for their having extended credit, while woefully undercompensating employees for the value that they added in creating that inventory. Perhaps worse yet, bankrupt corporations can often walk away from pension obligations, leaving a federal government organization (the Pension Benefit Guaranty Corporation) to pay some, but sometimes not all, of the pensions that had been promised. 

This should not be happening. This “creditor priority” in the law is an economically arbitrary bias in legal treatment that favors capital to the detriment of labor. It effectively says, “Gee, since we can’t parse out the relative contributions of capital and labor to the creation of this inventory, what shall we do with it? Ahhh. With minor exception, let’s hand it all over to the capital side.” 

More broadly than just liquidation of inventory, the current creditor priority in bankruptcy should be reversed, and the proceeds from the liquidation of all assets should go first to labor, and only then to lenders. Why? Not just because it’s the economically and socially fair thing to do. It also corrects for an information imbalance in markets, and changing these rules will not create any problems for the long-term health of the economy.

Many people in the workforce are not mobile, and they are often the last to know about a company’s impending demise. Management is usually the first to know, and bankers have information sources (violations of loan covenants, for example) that give them early warnings of business troubles. Stockholders are represented by members of boards of directors and are often well positioned to pursue legal claims if their interests are not properly protected. Providing an absolute priority for compensation that is legally owed to workers would merely offset the information and other inherent advantages of capital, and therefore would be sound, even-handed policy.

Any serious attempt to address societal income inequality must give compensation to employees—especially including contributions to unfunded or underfunded retirement plans—absolute priority in bankruptcy over the claims of any other creditors, including claims of the IRS (which is sometimes able to muscle past banks in bankruptcy proceedings). Meaningful changes to income inequality levels and trends will require many politically challenging reforms. This is but one of many that should be pursued. 

Business failure is a double-edged sword. Allowing it to happen is an essential part of the creative destruction that makes dynamic capitalism successful. Yet in most instances it is a tragedy for company founders, for workers, for the community, and yes, for the investors and the lenders whose financial contributions were also vital to the enterprise. The issue is whether this change to bankruptcy law “priority” rules, which should then be enforced in predictable ways, will help to contribute to more widespread economic prosperity. 

Congress, in an attempt to help workers who do not have as much information as management when a workplace is about to be shut down, passed the Worker Adjustment and Retraining Notification Act (the WARN Act) in 1988, and some states enacted local versions of the law. Such laws require that management give advance notice of plant closings. Much can be said about the actual operation of such laws; managements are often loath to comply with them. For present purposes though, the implications are simple enough: when management does not comply with WARN Act notifications, the amounts by which workers are damaged should be added to the employee compensation that should be given priority in bankruptcy.

These changes to bankruptcy law, admittedly, are proposals around which it will be difficult to inspire a rallying cry. As to the odds of getting any bankruptcy reform through Congress, the political power of banks and of senators from Delaware should never be underestimated.

Changes to bankruptcy law, like the ones here proposed, will affect the amount of risk capital and cash that companies will be required to maintain, and the availability of bank loans. The effect will be that when companies are sadly forced into bankruptcy, employees will no longer be the ones stiffed for their unpaid wages, pensions and other compensation, as they often are under current law and business practices.

Some may object to this change by observing that it will cause banks to be more conservative in their lending, potentially lowering economic growth and job creation. That observation has some validity, at least in the short term. There are two important responses, however. One is that what is being taken away is the privileged position of banks to make loans that are riskier than they should be. As things now stand, they are shifting the risks of lost incomes to the company’s employees—but that is a privilege that should never have been given in the first place.

The second response is that the American economy has far more debt than it should—government debt, corporate debt, and individual debt—so that a structural change to the legal underpinnings that requires companies to raise more money as investment rather than as loans is a change that is in the long-term interest of American society. Banks will continue to lend; they will just factor the new rules regarding creditor priorities into making lending decisions. And when a business, its employees, and the surrounding community are faced with a company’s bankruptcy, the remaining money will go first to its employees. That means it will stay in their community, and only then will it be paid to banks and other creditors.