Intellectually Bankrupt

Big lenders got their consumer bankruptcy bill. Will it deprive them of corporate business?

Illustration by Robert Neubecker.
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Wouldn’t it be ironic if the giant financial services companies, whose trade group gleefully hailed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (which President Bush signed with equal glee in April), found that the tough bill might deprive them of potential corporate business?

A study by Robert Lawless of the University of Nevada at Las Vegas and Harvard Law School bankruptcy maven Elizabeth Warren argues that the government vastly underestimated the number of personal bankruptcy filings that were due to small-business failures. Warren, co-author of The Two-Income Trap, was an avowed and stalwart foe of the bill, and she hasn’t given up the fight. The study was backed not by a left-leaning advocacy group, but by the Ewing Marion Kauffman Foundation, a champion of entrepreneurship. The report can be seen in brief here and in full here, and it is well worth reading.

The conventional wisdom holds that only a small minority of the 1.6 million personal bankruptcy filings each year are made by businesses. What’s more, the sharp drop in the percentage of business filings over time has changed the popular perception of bankruptcy protection and those who seek it. Bankruptcy filers are seen almost exclusively as chronic overspenders whose appetites exceed their income, and they use bankruptcy as a shelter to avoid paying debts. Alas, Lawless and Warren argue, the conventional wisdom is bull.

Lawless and Warren’s indictment is convincing and pretty devastating. Over the last few decades, bankruptcy filings as tallied by the administrative offices of U.S. bankruptcy courts (see Page 9 of the study) have risen sharply. But the number of business filings has plummeted, both in absolute and relative terms. Between 1986 and 2003, the number of business filings fell from 66,651 to 37,078, and the percentage of business filings fell from 18.6 percent to 2.3 percent. “The AO numbers would have us believe that the twelve months ending June 30, 2003 experienced just about the same number of business filings as the same period in 1980 when the population of the United States was 22% smaller and inflation-adjusted GDP was 50% smaller,” Lawless and Warren write. Indeed, the fall doesn’t make sense intuitively—or empirically. When the authors checked data on business failures from the credit-rating firm Dun & Bradstreet and the Small Business Administration, those figures “show modest increases over the same time.”

Each year, in its report to the president, the SBA trumpets the falling business bankruptcy rate as an indication of success (see Page 1 of the executive summary). But the problem with the chronic underreporting by the bankruptcy courts isn’t political, Lawless and Warren argue, it’s technical and technological. The form widely used in the 1980s asked filers to check business or nonbusiness, but it also asked “which type of debt the debtor ‘primarily’ had.” For people running businesses as individuals—that is, not through corporations or partnerships—spending and borrowing on items like homes, cars, and computers is a mixture of business and personal. And the form in use since 1997, which offers “individual” as the first choice, doesn’t ask filers to specify whether they are filing as an individual because their business failed or for other reasons. What’s more, the software programs increasingly used by lawyers “employ a default setting of consumer bankruptcy,” which has “introduced a systematic bias into the reported bankruptcy data.”

Lawless and Warren surveyed debtors from around the country through questionnaires and telephone interviews. They found that while only 0.5 percent of the debtors they interviewed “checked the box on the cover sheet to say they were business filers,” a much, much larger number of them were “likely to describe themselves as currently or recently in business.” Lawless and Warren concluded that between 13.5 percent and 17.4 percent of the people they interviewed were in fact self-employed and that a business failure was a main reason for their filing. Their conclusion: “Entrepreneurs are in bankruptcy court in substantial numbers, even though the current classification system conceals most of them.” Instead of the 37,000 business failings tallied by the bankruptcy courts in 2003, they argue the number was probably somewhere between 280,000 and 315,000.

So, the recently enacted bankruptcy reform may seem like a classic case of ensnaring dolphins in an effort to catch tuna. America’s economic system is exceptional in part because it encourages, pardons, and excuses failure. Nobody starts a business intending to go bankrupt, but it happens. And when it does, the nation’s bankruptcy system—and its general tolerance of failure—has enabled people to pick up, move on, and try again with relative ease. In today’s economy, which affords people unprecedented opportunities to start their own businesses, credit cards are frequently the preferred method of financing. So, while the new bankruptcy law might deter some people from overborrowing, it might also deter some people from leaving their dreary jobs and opening a store, or selling on eBay, or importing T-shirts. At the margins, lots of mundane businesses, and perhaps even a few great ones, may never get off the ground.

The financial services sector plainly got what it wanted in the bankruptcy reform bill. But as Warren and Lawless note, the provisions that prevent discharge from bankruptcy unless the debtor completes a course in personal financial management, that set up means-testing for payment, and that prohibit repeat filings within eight years, “needlessly penalize entrepreneurs who are in bankruptcy court not because [of] overconsumption but because [of] a failed business.” In their desire to crack down on consumers, Congress and the financial services companies may be cracking down on the sort of people who, when they succeed, create jobs, pay taxes—and become excellent customers for financial services companies.