Published: May 04, 2005 in Knowledge@Emory
With the March 10 Senate passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and the likely approval of the House in the near future, one part of the Bush administration’s push for personal responsibility appears closer to reality. Although the legislation is aimed primarily at consumer debt, some observers say it may actually undermine another cornerstone of the Bush administration—support for start-up businesses, whose owners often turn to credit card and other personal debt for initial financing. Lenders, including credit card companies, had been pushing the legislation for years. As supporters see it, many people with the ability to repay at least a portion of the money they owe are simply walking away from all their debts.
The heart of the matter relates to the way that debts are discharged under personal bankruptcy. As things stand now, federal law gives a bankruptcy judge the discretion to decide if a borrower in default can file a Chapter 7 bankruptcy, under which a debtor may be able to sell assets to pay off debt; and any unpaid amount is usually forgiven. Alternatively, a judge may order the parties to enter into a repayment plan, known as a Chapter 13 filing. In that case the debt is not forgiven and the debtor generally makes a series of payments, possibly over a lengthy period, to satisfy the liability.
But the new bill—which has the active support of President Bush—would generally replace a judge’s discretion with a “means test.” If the debtor has income above his or her state’s median level and meets other requirements, he would generally be forced into a Chapter 13 repayment plan. Recent published reports indicate that anywhere from 30,000 to 210,000 people–between 3.5% to 20% of those who discharge their debts in bankruptcy every year–would no longer be able to do so.
Congress passed a similar proposal some five years ago, but President Clinton, in his final days in office, effectively killed it by declining to sign the measure. Today, the anticipated passage of the legislation sends chills up the spine of some observers.
Steve Iacobellis, a 56-year-old “serial entrepreneur” from Blairstown, N.J. is one of them. Since 1978 he’s built and sold seven businesses—including delicatessens and a video store—using everything from on-hand cash to a second mortgage and similar personal financings.
“Entrepreneurs know we’re taking a gamble, but we also know there’s been a way out,” he says. “If the safety net is no longer there, then fewer people will go into business for themselves. I’ve got two grown children and if this law passes, I’d tell them to not even bother thinking about opening up their own business.”
Jeff Morris, a scholar-in-residence at the Alexandria-based American Bankruptcy Institute, which researches insolvency issues, adds that statistics may blur the incidence of businesses that have gone under, understating their failure rate even as so-called personal bankruptcies are overstated. “The bulk of debt incurred to start a small business is often taken on personally by an entrepreneur, so many business failures are actually reflected as personal bankruptcy filings,” he says. “It’s too early to quantify the potential effect of the legislation [if it indeed passes], but I believe it will have some negative impact on entrepreneurial efforts.”
Morris points out that even if an entrepreneur tries to shield her assets by incorporating the business, it’s common for lenders to require some sort of personal guarantee.
“A personal guarantee removes the asset protection that a subchapter S or other kind of limited liability structure might otherwise deliver,” he says. “I believe that many franchise agreements may also require this.” And the alternatives to a formal corporate bank loan–such as personal loans or credit cards–don’t offer any more protection, adds Morris.
That somewhat dismal view of the new bankruptcy law proposal appears to be supported by a University of Cambridge White Paper titled The Legal Road To Replicating Silicon Valley, which was co-authored by John Armour, a senior fellow at the university’s Center for Business Research, and by Douglas Cumming, an associate professor at the University of New South Wales School of Business and a research associate at the Cambridge research center. Among the conclusions drawn from their research—which analyzed data drawn between 1990 to 2002 from 15 Western European and North American countries including the U.S.— countries [and states, within the U.S.] with more ‘severe’ personal bankruptcy laws, measured by reference to the number of years before a bankrupt individual could obtain a ‘fresh start’, have “significantly lower demand for venture capital and private equity.”
The co-authors go on to explain that the severity of the consequences of personal bankruptcy, particularly the timing and availability of a ‘fresh start’ (or emergence from bankruptcy) can reasonably be expected to impact the willingness of hesitant entrepreneurs to follow through with their business plans.
The reasoning sounds compelling, but Jagdish Sheth, a marketing professor at Emory University’s Goizueta Business School, has some serious questions. He says that legislation does not drive entrepreneurship. Instead, he points out that it’s generally the other way around.
“True entrepreneurs don’t look at how they can exit from an obligation,” he observes. “Regarding restrictive bankruptcy laws, the [Cambridge research] causality is reversed. Consider that states that are relatively entrepreneurial tend not to pass restrictive laws. In the Southern right-to-work states, for example, there’s a strong work ethic and few pro-union laws. And consider that California, which has some of the most pro-consumer laws in the nation, also boasts a high rate of entrepreneurial activity.”
Edward D. Hess, an adjunct professor of organization and management at Goizueta and executive director of the school’s Center for Entrepreneurship and Corporate Growth seconded Sheth’s assessment of the limited impact of any change to the bankruptcy rules. “Entrepreneurs don’t go into business thinking about bankruptcy,” he says. “If passed, the new law will have virtually no impact on new-business creation.”
Successful entrepreneurs, he notes, evaluate the potential lifecycle of an opportunity, and consider the industry, structure, market size, ease of replication, and competitor abilities before launching.
“They test the idea without betting the ranch,” he says. Often they’ll first ask, “How do you try it without risking large sums of emotional and/or financial capital?”’
Yet attorney Joan Sirkis Lavery, who’s worked with entrepreneurs and others for approximately 16 years, says, “Many new ventures are financed with second mortgages or other personal guarantees, and until now, bankruptcy law was designed to encourage entrepreneurs to succeed while offering a safety net.” Lavery, a partner in the Hackettstown, N.J.-based law firm Sirkis & Lavery, adds that if the “net” is no longer available, entrepreneurs just “may not take the risk.”
Sheth, however, reiterates that he is not as concerned. “The more-restrictive bankruptcy laws may have a minimal effect on the venture capital community, but won’t strangle it,” he observes. “Some kind of minimal new legislation was needed to protect the public and separate the hucksters from the entrepreneurs who are obsessed with creating value. True entrepreneurs really won’t be affected by it.”