Bankruptcy law ensnares businesses
Although recent reforms aimed to crack down on consumers, they may also place a hidden restraint on the creation of small businesses.
By HELEN HUNTLEY
Published July 10, 2005
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.
Many entrepreneurs never incorporate; often they're simply selling themselves, providing a service as an independent contractor. Others incorporate but remain on the hook for business debts.
"The corporate form gives some benefit in the way you can manage ownership of the business," said U.S. Bankruptcy Judge Michael Williamson in Tampa. "There's also a benefit for some types of liability: If a company truck driver has a major accident, tort liability stays with the corporation. But most small-business people have to guarantee bank debt or equipment financing debt personally because their corporations are only worth what they individually have."
If a small business goes bust, there often is no reason to file a corporate bankruptcy. Left alone, a corporation will be dissolved by the secretary of state for failing to file an annual report.
"Just letting it die on the vine usually is good enough," Tampa bankruptcy lawyer Al Gomez said. "Why spend the additional money giving the corporation a decent burial if you're going to end up filing personal bankruptcy anyway?"
By the time the case gets to court, often there's nothing to distinguish it from thousands of other bankruptcies. Although bankruptcy forms have a box for individuals to check that their debts are business debts, relatively few do. The current form forces a choice between consumer debts and business debts.
"All we see is a husband and wife filing a joint case and it looks like a consumer case, but that doesn't mean it wasn't caused by the small business," Judge Williamson said.
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.
To Lawless and Warren, underreporting business bankruptcy is more than just an issue of academic curiosity. They say focusing on bankruptcy as merely a consumer issue overlooks its importance to entrepreneurs and may have harmful consequences for small-business formation.
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 York Times recently cited the case of an Orlando-area entrepreneur, Rick Girard, who started his first landscaping business in 1989 at the age of 19, and ended up in bankruptcy six years later.
"Bankruptcy allowed me to get out of that hole," he said.
Today he runs a $16-million business, Girard Holdings, which has 200 employees, and has even repaid most of the creditors in his original bankruptcy filing.
"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."
The new bankruptcy law also requires consumers to undergo and pay for credit counseling to get their debts discharged.
"It seems ridiculous to send a small-business owner to a counseling class on not overspending and keeping track of credit cards," Lawless said. "It's just a needless expense."
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?"
The study was funded by the Ewing Marion Kauffman Foundation in Kansas City, Mo., which promotes entrepreneurship. A copy is available on the foundation Web site (www.kauffman.org)
Helen Huntley can be reached at 727 893-8230 or huntley@sptimes.com