Behind the Business Bankruptcy Statistics

Posted by: John Tozzi on June 23, 2009

Whenever I write about business bankruptcies, I have to go back to this paper by Robert Lawless and Elizabeth Warren. Published in the California Law Review in 2005, it’s called “The Myth of the Disappearing Business Bankruptcy.”

We just published a story looking at how business bankruptcies are rising. But there’s never enough room to give readers as much background on the statistics as I’d like. So I thought I’d post a bit from their paper.

Basically, the official statistics collected by the federal bankruptcy courts show that business filings dropped from 18% of all bankruptcies in 1985 to 2.3% in 2003. That helped create a narrative that the overwhelming majority of bankruptcies were consumers who got themselves too deep in debt, with a handful of big business failures that ended up in bankruptcy court. “The entrepreneur who gambles on a new business undertaking seems to have virtually disappeared from the bankruptcy system,” Lawless and Warren wrote.

They go on to document how the recording process at bankruptcy courts undercounts business filings. In short, the ambiguous cover sheets on bankruptcy petitions (and software for electronic filing) led to the court stats systematically counting business-related bankruptcies as consumer filings. Lawless and Warren contrast the official numbers to records on business failures kept by Dun & Bradstreet and the SBA, as well as their own independent survey of bankruptcy filers. Their conclusion: the true number of business-related filings is probably closer to 15% or 16%, not the official 2.3%.

Here’s a bit from the paper on why this all matters (page 43 of the PDF):

These data tell a more complex story in which one in seven individuals in the bankruptcy system is a struggling entrepreneur.

Our data are consistent with the picture of entrepreneurs who are trying to cope with their own personal liability on business debts. Regardless of whether they are incorporated, these small businesses may have little or no value without the investment of their owners’ human capital. These data are a reminder that the corporate form may protect large businesses, but in small businesses, incorporation may be largely irrelevant if lenders require the entrepreneur to agree to personal liability as a condition of lending.

Then, three important paragraphs at the end (page 49) that explore the blurring lines between personal and business debts, as small businesses look less like operations distinct from their owners and more like consultancies that are intertwined with their owners’ lives and finances:

The changes in the composition of small businesses in bankruptcy may also suggest an ever-tighter link between the failure of a small business and the failure of its owner. The debts to be dealt with may be largely personal debts, money borrowed to keep the debtor afloat when the income from the business began to falter. Unlike their counterparts with large, clearly separate businesses, small entrepreneurs who falter may have nothing to sell, nothing to offer as collateral, and nothing to cash out. That difference also means there may be nothing for the creditors as well. If there is no business other than the human capital of the debtor, then the creditors have little to liquidate to satisfy their debts. It is only the debtor’s personal assets, such as the house, the car, the checking account, that are the target of creditor actions.

In addition, these data open the possibility that the much-praised corporate form may be failing a growing number of entrepreneurs. Once heralded for its ability to shield owners from personal liability, corporate form may be meaningless for someone who operates as a consultant. The debts are all personal debts.

If the business/personal distinction is dissolving for a growing number of small business owners, then other measures of the economy come into question. Is the consumer debt load really about consumption, or is it about entrepreneurs who are floating their micro-operations and their own survival during low-income periods? Is home mortgage debt about buying houses, or does a significant portion of home-mortgage debt represent refinancing activity supporting a struggling self-employed owner? Even data as basic as who is employed and who is unemployed are blurred in a world of out-sourced consultants with erratic incomes.

It’s an essential paper for anyone trying to understand bankruptcy trends.

Reader Comments

LAO

June 24, 2009 11:13 PM

I appreciate this take on small business. I do not have a personal story to tell, because I cannot persuade myself to risk our mutual retirement to undertake the ventures that pull on me. If I am not mistaken, the salary and benefits and research costs of a large corporation's employee launching those same ventures would be 100% deductible as business expenses, but there is no way for the individual to achieve these startup advantages. It is a system that is stacked against new, small businesses.

Mike from Cash Flow Moe

June 25, 2009 08:44 PM

Always a bad idea to borrow money against you personal residence. Don't lose your home because your business fails.

http://www.ehow.com/how_4889646_save-some-money.html

Sam Thacker

June 26, 2009 03:38 PM

It would seem to me that given the requirements by all lenders (bank and non-banks), when a business files bankruptcy, it pretty much requires any 20% or greater owner to file as well since they have personally guaranteed all secured and some unsecured loans. There is a blurring in business credit between a business owner and his business, but I would think the bankruptcy count would be substantially higher rather than lower.

Sam Thacker
http://www.lesliethacker.com

Ramzi

July 28, 2009 04:56 PM

My rule is: Don't risk money you're not willing to lose...

Set aside an "entrepreneur budget" and stick to it. If it goes south (and 9 out of 10 do last i checked), no big deal.

Move on to the next idea or wait out the lull.

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What's it like to run your own company today? Entrepreneurs face multiple hurdles new and old, from raising capital and managing employees to keeping up with technology and competing in a global marketplace. In this blog, the Small Business channel's John Tozzi and Nick Leiber discuss the news, trends, and ideas that matter to small business owners. Follow them on Twitter @newentrepreneur.

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