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Harshness of bankruptcy
law will discourage entrepreneurs, scholar says
Business & Law Editor
CHAMPAIGN, Ill. —
In attempting to crack down on irresponsible debtors, the new federal
bankruptcy law is also likely to ensnare entrepreneurs and other self-employed
Americans whose ideas and inventions can become engines for economic
growth and job creation, according to a University of Illinois scholar.
Robert M. Lawless, a professor in the U. of I. College
of Law, says that the government has significantly undercounted
the number of bankruptcy filings arising from failed businesses, leading
to false assumptions about the profile of many debtors.
“The new bankruptcy law does not take into account the phenomenon
of the serial entrepreneur,” he said in an interview. “Most
entrepreneurs go through several business models before they are successful.
Failure is part of being an entrepreneur. The harsh provisions of the
new law will discourage people from opening new businesses and keep
entrepreneurs who do fail in a business from starting anew.”
The Bankruptcy Abuse Prevention and Consumer Protection Act, which went
into effect last October, was designed to place restrictions on thousands
of debtors who allegedly filed for bankruptcy in order to clear away
debts that were caused by their own overspending or self indulgence.
“People should pay their debts to the extent that they are able,”
Lawless said, “but the evidence suggests that bankrupt debtors
already are paying as much as they could under the old law. The new
law simply sets up numerous roadblocks to the traditional bankruptcy
fresh start. Small business owners therefore will not receive as effective
bankruptcy relief as they did before the new law, with the result that
they will be saddled with the debts of an old business instead of starting
a new one.”
In a paper published in the California Law Review last year with Elizabeth
Warren, a professor at the Harvard Law School, Lawless reported that
much of the empirical data compiled by the government regarding the
cause of individual bankruptcy filings was inaccurate.
According to the bankruptcy courts, business-related filings peaked
at 18.3 percent of total cases in 1985, but have steadily dropped to
2.3 percent in 2003. Advocates of the new law have cited the “virtual
disappearance” of business filings as proof that responsible Americans
do not need to resort to bankruptcy relief in order to navigate the
rapid changes in the economy.
“There is a significant problem with this story: It is not true,”
Lawless and Warren wrote in the paper. In fact, as many as nine times
more bankruptcies involve the failure of a business than disclosed by
the statistics of bankruptcy courts.
Why the discrepancy? A major reason turns out to be the software programs
used in filing bankruptcy cases, which typically have a default setting
that automatically classifies filings as “consumer” rather
than “business” cases.
“Automated-form software has introduced a systematic bias into
the reported data,” Lawless said. “As the filed forms shifted
from being filled out by hand to being filled out by computer programs
that presumed that individuals were always consumers, the proportion
of consumer filings rose, while the proportion of business filings steadily
In addition to software bias, bankruptcy courts typically classify debtors
who are self-employed but have not incorporated their business or established
a legal partnership as consumer cases. This underreports the expanding
number of filers who work as consultants or independent contractors.
Questioning a random sample of debtors in California, Illinois, Pennsylvania,
Tennessee and Texas, the researchers found that between 13.5 and 17.4
percent of all debtors reported that they were self-employed and that
a business failure was a major reason for their filing.
“Our findings undermine the assumption that the bankruptcy system
deals with only two kinds of debtors, consumers and corporations,”
Lawless said. “Entrepreneurs are in bankruptcy court in substantial
numbers, even though the current classification system conceals most
of them and paints a rosier picture of the business climate than is
The scholar pointed out that government statistics are at odds with
data compiled by Dun & Bradstreet, the credit-reporting firm, and
the Small Business Administration. Both of their reports show an increase
in business failures.
Lawless and Warren estimated that bankruptcy courts mis-classified between
220,000 and 280,000 filings by independent contractors, entrepreneurs
and other small business operators in 2003.
Lawless, who recently joined the Illinois law faculty, said that there
is a strong correlation between a bankruptcy system that treats financial
failure as a risk of the marketplace – rather than as a moral
issue – and a high level of entrepreneurial activity.
“Historically, this country has established a forgiving bankruptcy
system compared to Europe, but the trend lines seem to be crossing,”
he said. “We are adopting a more European attitude toward bankruptcy,
which traditionally favored creditors over debtors, while Europeans,
especially the Germans, are moving to a system that offers debtors a
fresh start by clearing away most debts.”
“The bottom line,” Lawless continued, “is that this
country needs a safety net for entrepreneurs if it wants to foster conditions
that lead to the creation of new businesses, jobs and technologies.”
The Lawless-Warren paper for the California Law Review is titled, “The
Myth of the Disappearing Business Bankruptcy.”