The new federal bankruptcy law, set to take effect this October, has been shown to be extremely bad news for consumers. As it turns out, it may also stifle entrepreneurship by unfairly punishing small business owners who take on personal debt to finance their companies.
It’s not just debt-burdened consumers who end up in bankruptcy court, snowed under by medical bills and credit card debt, bedeviled by job loss and divorce. Entrepreneurs by the thousands file personal bankruptcy when their businesses go bad.
In fact, business failures are a factor in as many as 17 percent of the 1.6-million consumer bankruptcies filed each year, according to a provocative new study.
“There are as many as nine times more bankruptcies involving a business than the current government data suggest,” says the California Law Review report by law professors Elizabeth Warren at Harvard University and Robert Lawless at the University of Nevada-Las Vegas.
That’s a problem, they say, because Congress was aiming at spendthrift consumers when it tightened bankruptcy laws this year and didn’t adequately consider the entrepreneurs who will be caught in the web of new rules.
The changes, which take effect in October, could end up discouraging business formation, since it will be more difficult for the self-employed to wipe out their debts and make a fresh start, these experts say.
The statistical discrepancy isn’t the result of some vast conspiracy. The profs blame it partly on computer software that courts and lawyers use and on forms that are filled out incorrectly. The underlying culprit, though, is the way most small startup businesses get financed: out of their owners’ savings. And when those are gone, out of their owners’ credit.
“Taking out a home equity loan is often the first thing,” said Shrimatee Ojah-Maharaj, manager of the St. Petersburg Business Assistance Center. “After that, they go on to their credit cards.”
Even if the credit card is in the name of the business, the fine print in the application is likely to say that the person opening the account is responsible for the debt.
……Professors Warren and Lawless present their study as a challenge to conventional wisdom that small-business bankruptcies have been declining even as consumer bankruptcies were rising. Reports from the U.S. Small Business Administration even have cited the statistics as a sign of a healthy economy.
Official court statistics show that business bankruptcy filings hit a peak of 88,278 in 1987 and began to decline, falling to 37,078 in 2003. In the meantime, total bankruptcy filings were soaring, from 567,266 in 1987 to 1.6-million in 2003. As a percentage of total filings, business bankruptcies peaked at 18.6 percent in 1983 and fell to 2.3 percent in 2003.
“We had been told that small-business bankruptcy was basically nonexistent,” study co-author Lawless said. “The truth is that small businesses continue to have problems and fail as they always have.”
And, in fact, other statistics that once tracked business bankruptcy statistics began diverging in the mid 1980s when business bankruptcies began their decline.
“The coincidence in timing is with the computer revolution,” Lawless said. “The software being used to generate these forms defaults to count cases as consumer rather than business.”
Lawless and Warren dug deeper into the data by questioning 1,771 individuals who had filed for bankruptcy in five states and analyzing their court records. Even those who described themselves as business owners had not checked the “business” box on their bankruptcy filings. They concluded that the real number of business-related bankruptcies was closer to 300,000 than to the 37,078 reported in 2003.
……Warren, author of The Two-Income Trap, about the precarious finances of the U.S. middle class, opposes recent changes in federal law that will make it more difficult to shed debts in bankruptcy. The new law takes effect Oct. 17.
“Our economic system needs to encourage entrepreneurs to make new investments,” she said. “Sometimes these investments will fail through no fault of their owners, and when that happens, the owners need to be able to move to other businesses and create new jobs and investment opportunities.”
The new law will require many of them to enter five-year debt repayment plans.
“There are a lot of examples of successful people who have been through bankruptcy and were able to get a fresh start,” Judge Williamson said.
……“The new law is not predicated on a fresh start,” Williamson said. “It’s predicated on repayment of debts over a period of years for anyone making more than median income. . . . They’ll work for creditors for five years. If they’re not successful in the five-year period, they won’t receive their discharge and you’ll potentially have a class of people who will have judgments against them and will not return as productive members of the business community.”
……But supporters of the bankruptcy law say statistics won’t change their minds.
“These folks chose to borrow as consumers and not as businesses,” Philip Corwin, a lobbyist for the American Bankers Association, told the New York Times. “If they have the ability to pay a substantial amount of what they borrow, then why shouldn’t they?”