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Harshness of bankruptcy law will discourage entrepreneurs, scholar says

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[JULY 14, 2006]  CHAMPAIGN -- 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.

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"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 declined."

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 warranted."

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 misclassified 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."

[University of Illinois news release]

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