Behind the Business Bankruptcy Statistics

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

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.

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