(FORTUNE Magazine) – THE UNITED STATES of America is a great place to go broke. Any business in this bighearted country, whether insolvent or not, is free to shortchange its creditors while enjoying the full favor and protection of federal courts. Taking advantage of the world's most liberal bankruptcy code, businesses are failing in unprecedented numbers. In 1990 the assets of public corporations filing for bankruptcy totaled $82.7 billion -- 50 times more than a decade earlier. And those figures greatly understate the problem by excluding such failure-prone groups as privately owned real estate firms. Expect another sizable increase in bankruptcies this year, as recession shoulders more big borrowers over the brink. Bankruptcy penalizes everyone: the company and its shareholders, obviously, but also the lenders who extended credit to it and American industry itself because a tolerance for failure encourages bad management. By drastically reducing the price of going bust, the nation's well- intentioned bankruptcy law has perversely encouraged businesses to fold. The original idea behind the code remains sound, that ailing companies can often prosper again if allowed to start fresh with less debt. But in 1978 Congress liberalized the law, removing many strictures that large corporate debtors found onerous. Among them, the nearly automatic ousting of management and the requirement that only insolvent companies be allowed to file. When major companies found they could go bankrupt without destroying their business, consumers became less fearful of patronizing them and the concerns themselves became less fearful of filing. It was in this relaxed atmosphere that managers began squandering corporate assets in the highly leveraged deals now going bust. Says Sharon Meadows, a restructuring expert at First Boston: ''People borrowed a lot of money that they had no prospect of paying back. It's as simple as that.'' Many attorneys and investment bankers now coping with the carnage agree that the overleveraging of corporate America during the 1980s might never have occurred had bankruptcy law been tougher. The mounting body count is a symptom of a national malady, according to Victor Palmieri, the turnaround expert famed for managing Penn Central's emergence from bankruptcy. Says he: ''This is a marketplace adjustment to the excesses of a prior era. It's not so much a financial issue as a cultural issue, no different from our tolerance for violence on the screen and for all kinds of excess.'' Bankruptcy began attracting a classier clientele once respectable and fundamentally healthy businesses such as Manville, Texaco, and Continental Airlines were able to seek refuge in Chapter 11. By themselves, the ten biggest companies that failed in 1990 accounted for more than 80% of the year's bankrupt assets. Among the casualties so far this year are Pan Am, Bank of New England, Carter Hawley Hale, and the LBO successor to J.P. Stevens. The assets of just these four add up to over $36 billion. Recessions are hard to avoid, but otherwise this mess was unnecessary. Observes the chief executive of one of 1990's biggest failures: ''We have made bankruptcy in this country so painless that people really can walk away from debt.'' Ironically, one of those walking is Drexel Burnham Lambert. Having enticed U.S. corporations into issuing $200 billion of junk bonds, the investment bank declared bankruptcy last year. Under the present law, a corporation may file for bankruptcy in two ways, liquidation under Chapter 7 or reorganization under Chapter 11. Liquidation is just that: Court-appointed trustees seize the bankrupt's assets, sell them, and divide the proceeds among the creditors, with anything left over going to stockholders. The company disappears. In a reorganization, the court protects ailing businesses from creditors in order to keep them going while their managers work out a scheme to settle the debts. Reorganization has been the U.S. policy in bankruptcy for decades. But until Congress changed the code 13 years ago, the law still had teeth: A court- appointed trustee had the sole power to run the company and design the reorganization plan. The law also minimized advisory costs by requiring cut- rate legal fees. Today even perfectly healthy companies may take advantage of longstanding provisions of the law that allow reorganizing businesses to break contracts, including leases -- a major reason so many retailers have recently filed. The obligation to pay interest or principal on any debts incurred before the filing is suspended, doing wonders for cash flow. Management usually remains in charge, at least for a while, and lawyers may charge fees at the market rates established with prosperous clients. The theory behind making Chapter 11 less punishing was that the economy would benefit from reorganizations that preserve jobs and productive assets. Listen to attorney Harvey Miller, a senior partner at Weil Gotshal & Manges who has specialized in bankruptcy for 28 years: ''We are a credit-intensive country -- we condition people to borrow. If you have that kind of system, you need an escape valve. In the old days you'd be drawn and quartered, but that doesn't add anything to the economy. We want a rehabilitative process.'' While managers devise plans for debt payment and renewed prosperity, creditors, stockholders, and other interested parties may organize themselves into committees. Each committee must approve the reorganization plan by majority vote. After months or years of costly squabbling, the committees usually do so to avoid the more painful alternative of a ''cramdown.'' That happens when the committees cannot agree on a plan and as a last resort the judge orders the bankrupt company to pay off each class of creditor, starting with the most senior, in full before the next class gets a dime. RECOVERY RATES vary wildly. In a typical bankruptcy involving a large public company, banks and other senior creditors might get 80% or more of their investments back. Suppliers and junior bondholders might recover 50 cents on the dollar -- often in stock. The equity holders, last in line, might see their combined stake in the company reduced to 5% of the total. But as long as everyone takes a whipping like little ladies and gentlemen, the company emerges from bankruptcy and survives as an ongoing business. Reasonable as the legal principle of reorganization appears, there is no proof that it ultimately is less costly than liquidation. The scant evidence that exists is equivocal. While reorganization may indeed save jobs, filing companies routinely slash their work forces. Drexel Burnham, for instance, has cut its ranks from a peak of 11,000 in 1986 to 200 today; Eastern Air Lines' employment rolls shrank from 43,000 to 1,800 while it floundered 22 months in Chapter 11 before shutting down completely in January. As for the preservation of productive assets, market forces alone should ensure that someone will buy them and put them to use. The law surely is wise to let failed companies avoid wasteful fire sales of their valuable properties, but balanced against that benefit are the law's enormous -- and largely hidden -- costs. Among them: increased credit risk for lenders, a major escalation of advisory fees, and incentives that encourage bad management. To the degree that bankruptcy law reduces the penalty for failure, it encourages risk taking. That is solidly in the public interest as long as the risks remain reasonable. But in the 1980s, managers, lenders, and investors went crazy. Martin Whitman earns 30% annual returns investing in the best- secured and most-senior distressed securities he can find, and he's picky about buying junk. Says he: ''A fantastic amount of bankruptcy is junk bond related. Investors have lost hundreds of millions of dollars.'' As more lending went bad, it became obvious that bankers and even junk bond buyers had not been charging enough to cover their increased exposure. Says Wilbur Ross, a Rothschild Inc. investment banker who is considered the country's top bankruptcy tactician: ''People severely underestimated the risk premium that should be charged for lending to LBOs. While making people like Henry Kravis very wealthy, that resulted in billions and billions of dollars in losses for creditors.'' NOR DOES court protection necessarily stop a company's deterioration. On the contrary. According to Karen Hopper Wruck, an assistant professor at the Harvard business school, bankruptcy costs ranging from lawyers' fees to lost market share -- competitors kick bankrupts while they are down -- can strip filing companies of 10% to 20% of their worth. By the time Manville, which went bust in 1982, emerged from Chapter 11 six years later, it had spent $100 million on bankruptcy fees alone. Says CEO Tom Stephens mournfully: ''That's 10% of our net worth.'' Those disputatious creditors' committees, spawned in unexpected numbers by the complicated capital structures of junk bond financing, also boost the advisory fees. The bankruptcies of Federated and Allied department stores, for example, involve seven committees, each with its own team of lawyers and investment bankers, and the fees already exceed $19 million. On top of that, the advisers to Federated and Allied themselves have billed the companies over $31 million. Says investment banker Kenneth D. Moelis of Donaldson Lufkin Jenrette, who nurses wounded companies: ''Everyone sends a lawyer, even the guy who delivers the Twinkies.'' The growth in fees has attracted some of America's best legal minds to an arena once dominated by ambulance chasers. Weil Gotshal's Harvey Miller, a top practitioner, bills his time at $420 per hour. In the past three years his firm has added 35 lawyers to its bankruptcy practice, a 50% increase. Worse than these out-of-pocket costs is the price exacted from the economy by a lenient system that practically pushes companies into bankruptcy. To encourage lenders and suppliers to help a bankrupt get back on its feet, the law grants the highest-ranking claim on the assets to those who help the concern operate in Chapter 11. This worthy policy backfires when businesses discover the only way they can get a loan is by going belly up. ''Bankruptcy,'' concludes Wilbur Ross, ''is a very inefficient way to solve problems.'' Carter Hawley Hale is a case in point. Unable to borrow more on its junk- bloated balance sheet, the West Coast retailer filed for bankruptcy and then successfully applied for an $800 million credit line from Chemical Bank. Lenders love bankruptcy loans because they command premium interest rates plus a top-ranked claim on assets. A more efficient alternative may lie in out-of-court settlements between troubled companies and their creditors. But as bankruptcy became more attractive, the consensus needed to reach such voluntary agreements became more elusive. Only a bankruptcy court can force public bondholders to give up their rights -- and most junk bonds are publicly traded. Even when a majority of a class of bondholders is willing to accept new payment terms, continuing to pay the original high rates of interest to the holdouts often proves prohibitively expensive. In practice, these deals don't work unless around 90% of bondholders agree to them. That hurdle is almost impossibly high. Most leveraged companies groan under layer after layer of junk debt with each class requiring the same 90% participation rate. Even very minor debt holders can extort disproportionate sums for themselves simply by refusing to play along. Encouraging voluntary settlements is the most promising area for legal reform. According to Wruck at Harvard, bankruptcy costs troubled companies ten times more than out-of-court arrangements. Unfortunately, large corporations are finding the necessary consensus so difficult to reach that in 1990 only two major settlements were completed. Both were LBOs: Forstmann & Co., the largest U.S. producer of woolens, and SCI Television, a broadcaster. In each instance, the LBO sponsors, Odyssey Partners and a partnership of Kohlberg Kravis Roberts and Gillett Group, wooed bondholders by providing new equity capital that the companies used to boost payouts to creditors. The best way to encourage more out-of-court settlements might be to force small groups of intransigent bondholders to accept majority rule when, say, two-thirds of their peers reach agreement. That modest proposal would require an integrated reform of both the bankruptcy code and securities law. According to Leonard Rosen, a Wachtell Lipton Rosen & Katz attorney who chairs the ^ National Bankruptcy Conference, momentum seems to be building -- slowly -- for some kind of congressional action. Until then, Martin Whitman has the right idea. ''Keep negotiations to a minimum,'' he says in his New Yawk accent. ''These settlements work only when you show the junior creditors a lot of downside if they don't go along.'' COMPANIES such as Southland, owner of the 7-Eleven chain, have turned to something called prepackaged bankruptcy. This gambit is similar to regular bankruptcy except that a company doesn't go into court until it has a reorganization plan already approved by sufficient majorities of its creditors. Bankruptcy law makes that approval easier to achieve than in an out-of-court settlement. No need for 90% supermajorities here; simple majorities suffice to force action, so long as they represent two-thirds of each class's total dollar claim. Once the reorganization plan wins that level of approval, the company can present it in court for a judge's rubber stamp and, theoretically, emerge from bankruptcy in as little as six weeks. Southland is the most important test case so far. Its reorganization plan won the assent of most creditors -- a major feat for a company with five tranches of bond debt plus bank loans and two kinds of stock. But Ito-Yokado, the licensed operator of 7-Eleven stores in Japan, greased negotiations by investing $430 million in return for 70% of Southland's stock. The reorganization plan handily won a court-sponsored vote of stockholders and bondholders in February, and the company emerged from Chapter 11 in March. The ingenuity that enables corporations to cope with the ill-conceived bankruptcy law may be admirable. But the country would be better off if the law were changed to make the cost of failure higher and borne more directly by those responsible for it. Until then many of our worst managers -- the luckless, the fools, and the frauds -- will continue to prosper, while the rest of us pay the price.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: THE BOOM IN BANKRUPTCIES In 1990, public companies with assets of $82.7 billion went bust. Earlier this year, four big failures added another $36 billion to the total.