Puzzle 4: Why Are Small Business Bankruptcies So Rare?

Federal bankruptcy filings are increasingly rare among failing small businesses. For every hundred small businesses that fail, fewer than twenty file for bankruptcy. And bankruptcy filings have become more rare over time. Business failures have hovered around 650,000 since 1989, according to the Small Business Administration. But the number of business bankruptcy filings has fallen from about 60,000 in 1989 to 35,000 in 2003, a 42% drop. These statistics are taken from the federal government’s case filings database (PACER).

Why are business bankruptcies rare and increasingly so?

Maybe the data tell the wrong story. Faulty government record keeping -- not changes in the behavior of small businesses -- may explain the diminishing incidence of business bankruptcy filings. This is the thesis put forward by Robert Lawless and Elizabeth Warren in their recent article, The Myth of the Disappearing Business Bankruptcy. They note that bankruptcy statistics are assembled by the Administrative Office of the U.S. Courts (AO). How does the AO know whether to classify a particular case as a "business filing" or a "consumer filing"? It asks the debtor. Every debtor is asked to indicate, on its bankruptcy filing, whether its debts are predominantly consumer or business debts. The problem is that most debtors submit their bankruptcy filings using software in which the default setting is to treat all debt as consumer debt (or the debtors use forms that encourage proprietors to treat debt as consumer debt). Because the classification of liabilities -- business or consumer -- matters little to most debtors (and their lawyers), few alter the default settings. Put differently, even when a debtor has significant business debt, his or her lawyer will typically use software (or forms) designed for debtors with primarily consumer debt. The result is that many business cases are classified as consumer cases.

This under-reporting problem is surely important, but I'm not confident that it is a complete explanation for the increasing rarity of business bankruptcy. Bankruptcy lawyers began using consumer-oriented software in the early 1990s, which could explain why business bankruptcy filings suddenly dropped from about 70,000 in 1992 to 62,000 in 1993 (an 11% drop). But the use of such software does not seem a complete explanation for the continuous decline in business filings during the 1990s and early 2000s.

Moreover, the data-collection theory doesn't seem to explain why we've seen a decline in a particular class of bankruptcy filings -- Chapter 11 filings. These are primarily business filings (and are often used by corporations). PACER data show that the annual frequency of Chapter 11 filings fell from 23,000 in 1991 to 9,200 in 2003, a 60% drop. The AO may be undercounting business bankruptcy filings generally, but it is probably not undercounting Chapter 11 cases.

Similarly, it seems unlikely that the AO are undercounting bankruptcy filings by corporations.  If the debtor is a corporation, it will probably indicate this fact. Yet corporate bankruptcy filings fell from 16,000 to 9,500 (a 41% drop) between 1994 and 2001. These statistics are derived from the AO's micro-dataset on closed bankruptcy cases, Federal Court Cases: Integrated Database Bankruptcy Petitions, available at ICPSR.

Government bankruptcy statistics, then, do show that something puzzling is occurring. Business bankruptcy filings are rare. And they are falling, both in raw number and as a percentage of total business failures. What's going on?

In a working paper (early draft; please do not cite), I investigate this phenomenon using data from Dun & Bradstreet, a credit-reporting bureau. Consistent with the government statistics, I find that bankruptcy is indeed a rare phenomenon. At most 17% of failing small businesses file for bankruptcy.

Why is bankruptcy rare? I offer the following answer: most failing small businesses use state insolvency law, not the federal Bankruptcy Code.

What is state insolvency law? It is a collection of procedures, ranging from foreclosures to bulk sales to assignments for the benefit of creditors (ABC), which perform the same functions as federal law. Using these procedures, a business can liquidate or reorganize. And, according to many lawyers and businesspeople, state insolvency law is faster, more private, and often cheaper than its federal counterpart. The downside of state insolvency law is that it offers much less protection, relative to federal law, for the interests of unsecured creditors. In most states, for example, there is no reliable mechanism for forcing insiders or favored creditors to disgorge ill-gotten gains.

This points to yet another puzzle: if state insolvency law is so attractive, why do any small businesses invoke the federal Code? This is a hard question, and my working paper only begins to answer it. Using several data sources, I present evidence consistent with the following story: a distressed business faces a choice between state and federal law, but the choice is not freely made. State procedures require the consent of secured lenders (usually a bank) and large unsecured creditors (usually the IRS). Consent is offered only if the debtor has maintained a working relationship with these senior creditors. If the debtor has previously defaulted on obligations to its bank or the IRS, or engaged in suspicious behavior, these creditors may not consent to state procedures. These procedures create opportunities for the insider to conceal self-dealing, and the senior creditors may do nearly as well in federal bankruptcy court as under state law procedures (especially if the creditor is fully secured).

Debtors choose federal bankruptcy law, then, only when negotiations with senior creditors have failed. More importantly, because federal law is unattractive to debtors, senior creditors can use the law as a threat in negotiations. The small business owner must cater to the bank -- at the expense of unsecured creditors -- if he or she hopes to obtain its consent to state procedures.

The threat of federal law may even induce the debtor to collude with dominant creditors to squeeze out the claims of junior, unsecured creditors. Under federal law, unsecured creditors can expect payment (i) after secured creditors receive the value of collateral and (ii) before the business owners receive any payment or interest in the reorganized business. This is called the "absolute priority rule." Outside federal courts, this rule can be circumvented fairly easily. The debtor and its bank can agree to a procedure (usually an assignment for the benefit of creditors) in which the business is assigned to a trustee, who auctions it off and uses the proceeds to pay creditors. The high-bidder at the auction receives the assets but none of the preexisting debt. If the bank and lender cooperate, they will choose a trustee with whom they have an ongoing relationship. The trustee will give the auction limited advertising. When the auction occurs, there will be few bidders. Indeed, the previous owner may be the only bidder. If so, he or she can repurchase the business on the cheap, perhaps with a loan from the bank. As part of the deal with the bank, the debtor will give the bank a new lien on the reacquired business' assets. The result is a "poor man's reorganization": the owner retains ownership of the business, but has eliminated all the unsecured debt.

In my working paper, I begin to draw out the policy implications of these observations. At the very least, they call for reevaluation of federal policy regarding small business bankruptcy. To date, commentators and legislators have assumed that the Bankruptcy Code is the primary outlet for distressed small businesses. That's clearly not the case. Sensible bankruptcy policy should consider the interplay between state and federal law.

This project is at an early stage and I welcome comments.

Comments

[Marc]

Very interesting article. I wish I could offer some insight as the above commentors did, but honestly I have none beyond whats been mentioned. Maybe small business owners just don't have the know how to file, or maybe they're afraid it'll hurt them in the future.

[mlgreen8753]

Small business can reduce some of their reliance on bank lending by cutting their advertising expenses by using online advertising such as http://www.adwido.com

[Michael Judkins]

I'm trying to gather statistics/information on the number of home improvement companies that failed in the US. Information on the financial status of existing companies affect thier perfomance, so information on that would be helpfull too. Can you help me gather any info??? Thanks Mike.
milw4545@yahoo.com

[Tanner Jones]

Professor Morrison:

Why aren't the junior creditors bidding against the owners at these auctions?

If this is in fact occurring, it would seem to be in their best economic interests to bid-- at least up to the value of the unsecured debt. I am not familiar with bankruptcy law, but the most efficient solution would seem to be for the unsecured creditor or a group of unsecured junior creditors to bid on the assets, at least up to the amount of unsecured debt, and then simply trade the unsecured debt for payment.

It seems as though a legal requirement of notice of auction to junior creditors, if such a requirement does not exist now, would be a more efficient setup. Perhaps such a requirement exists in some state laws or not others. Or perhaps junior, unsecured creditors have significant barriers to cooperating with one another. Empirical research appears needed on this point.

[Dennis E. Quaid]

Several reasons explain the use of "state insolvency laws" in preference (pun intended) to federal bankruptcy law. The author correctly states that state procedures are faster, cheaper and more private, allowing "deals" to be consummated without the knowledge or opportunity for opposition of unsecured creditors.

But there are other significant factors that are more important. First, bankruptcy filings follow the economy, not the default provisions on the computerized wordprocessing programs. Lenders virtually ceased lending after 9/11/2001, resulting in far fewer mistakes to wind up in the bankruptcy system. Furthermore, our economy has seen an explosion of liquidity which serves to re-finance almost any mistaken loan and company. While the degree of liquidity is now falling, it has given a second or even third life to many potential debtors, thereby keeping these businesses out of court.

Finally, these is the cost differential between a private or state procedure and chapter 11. For professional fees, the differential can be between $25,000 to $500,000. Many of the small to medium businesses cannot afford the cost of chapter 11 (and may not even owe as mush as the fees!). Therefore, cheap is good. Add to the cost the dismal record of rehabilitating busseses in chapter 11, at maybe 10% (20% if you are optimistic), and you can see that a $500,000 bet for a 20% chance of winning is a bad bet. Considering (as the author correctly states), that most of these businesses are really sole proprietorships wherein the owner wants to avoid or minimize his/her own exposure to liability FIRST, before saving the company, and the cost factor often becomes the deciding factor.

[m. hedayat]

Ed:

i agree with Mr. Henderson's comment. systems don't change that fast or that much without external and extraordinary forces acting on them. the inquiry is therefore whether the underlying data reflects true change or is itself the subject of new collection and calculation methods.

consider for example that business bankruptcies at the micro level are often redundant, hence seldom worth filing. many times private corporations are just glorified sole proprietorships: the corporate shell might as well not exist because entrepreneurs are forced into personal liability so the fledgling entity can obtain credit. the result: a landscape littered with "out of business" signs and personal, but few business, filings -- instead of taking the business down everyone simply takes their marbles and goes home (or on to the next adventure).

finally, i allude to your post on my bankruptcy blog at http://dcbabk.wordpress.com/. hope you don't mind the reference.

[William Henderson]

Ed, this is a fascinating theory. In this case, I would be inclined to conduct some interviews with members of the bankruptcy bar, or counsel for banks who deal with small business loans.

On a more macro level, I find it odd that the current state and federal insolvency law operates in such a large empirical vacuum. It is hard to argue policy when some basic facts remain unknown, such as why Chap 11 biz filings are trending down. Presumably the changes that are taking place are benefiting repeat players. Indeed, courts and bureaucrats might be happy with the reduced workload. Why ask hard questions when things are trending your way?

So opening the lid on this area strikes me as important.