In corporate America today, Chapter 11 is just another management tool. That's a good thing.
By Justin Fox

(FORTUNE Magazine) – WILBUR ROSS WELL REMEMBERS THE days when bankruptcy meant death. "When I started doing this, when a company went bankrupt, everyone would hang their heads in shame," he recalls of the late 1970s. Now, says Ross, whose W.L. Ross & Co. recently bought and restructured much of the U.S. steel industry and is now preparing a similar assault on auto parts, bankruptcy has "lost its pejorative connotation and is an openly discussed strategic alternative."

The rise of insolvency as a management tool has been great for bankruptcy king Ross: He's now a billionaire. But it's been mostly good news for America too. This is worth taking time to celebrate and ponder as the bankruptcy code turns harsher, with reforms passed by Congress taking effect Oct. 17. Most of the big changes will make life harder for indebted individuals, but corporations will be squeezed too--which helps explain why Delta and Northwest have rushed to file Chapter 11 in recent weeks, and why auto-parts giant Delphi was publicly contemplating doing the same as FORTUNE went to press. Such big defaults often get only perfunctory news coverage these days--they've become that common. But that's okay.

Yes, corporate bankruptcies pad the pockets of lawyers, executives, and vulture investors like Ross. Yes, they keep alive companies that might be better off dead. Yes, they are enabling the sometimes shameful dismantling of the corporate pension system. But the silver lining shines bright: Chapter 11 encourages risk taking, helps the economy adapt to changing times, and helps companies rebound from past mistakes. American business wouldn't be where it is today without it.

Take a glance abroad. Chapter 11, which became law in 1978, is nearly unique among the world's bankruptcy codes in that it's not punitive. The CEO who runs a company into the ground is allowed to attempt to resurrect it. There are problems with this; UCLA law professor Lynn LoPucki argues that corporate managers have so cowed bankruptcy judges that many bankruptcy reorganizations are shoddily done. "Compared to nirvana, it stinks," acknowledges James Sprayregen, a top bankruptcy lawyer at Chicago's Kirkland & Ellis. But the alternative--forcing executives to leave in shame--discourages managers from taking action while their companies are still salvageable. One only need look to Japan, where walking-dead companies zombified the economy for a decade, or Germany and France, where troubled companies count on expensive government bailouts, to see where that road leads.

The American way of handling bankruptcy evolved in the courts in the late 1800s, says David Skeel, a law professor at the University of Pennsylvania and author of Debt's Dominion: A History of Bankruptcy Law in America. It was replaced after the Depression with a more punitive code, but then a 1978 reform resurrected the older legal tradition. This year's corporate bankruptcy reforms scale back the CEO-friendliness a little. It will be harder after Oct. 17, for example, to pay big bonuses to executives of bankrupt companies. But while people in the bankruptcy business say they hate the changes, they'll learn to live with them. Chapter 11 will almost certainly continue to be a big part of American economic life.

Do we depend on it too much? "Bankruptcy is the default solution to numerous social problems in this country," argues Skeel. In theory, elected lawmakers should create a consistent, nationwide policy on how to bear the costs of asbestos poisoning, cover the fallout from airline deregulation, and finance health care for aging baby-boomers. Instead, bankruptcy judges scattered across the country are making different calls in different places. Right now, for example, the cost of pensions is a factor in several big bankruptcy cases. "Congress needs to step in and decide what to do with the remaining old-style pension plans," Skeel says. "But there's just not the political will to do it." So Chapter 11 gets the job. It's a lot to ask even of a great American institution.