For those who would like to see the evidence I mentioned that bankruptcy enhances entrepreneurship--well, the Economist article I linked (UPDATE--sorry, link was broken, now fixed), which appears to have been written by a correspondent of unusual depth and perspicacity, is a good place to start. Some other suggestions:
Legislators in Europe have recently sought to promote entrepreneurship by reducing the harshness of the consequences of personal bankruptcy law. Yet at the same time, US legislators have been seeking to make it more difficult for individuals to declare themselves bankrupt. Whilst there is an intuitive link between bankruptcy law and willingness to take entrepreneurial risks, little attention has been paid to the question empirically in the international context. We investigate the link between bankruptcy and entrepreneurship using data on self employment over 16 years (1990-2005) and 15 countries in Europe and North America. We compile a new indices reflecting how 'forgiving' personal bankruptcy laws are, reflecting the time to discharge and other aspects of bankruptcy laws. These measures vary over time and across the countries studied. We show that personal bankruptcy law has a statistically and economically significant effect on self employment rates when controlling for GDP growth, MSCI stock returns, and a variety of other legal and economic factors. The results have clear implications for policymakers.
This paper considers bankruptcy law design in a setting that is appropriate for entrepreneurial firms. These firms are characterized by a dependence on an owner-manager who is essential to the firm and must be given incentive through an ownership stake to maximize the value of the project. The relationship banks that fund entrepreneurs cannot capture the gains from providing the entrepreneur with this stake and this leaves the entrepreneur emerging from bankruptcy with a larger debt burden than is socially efficient. In this setting, a fresh start bankruptcy policy provides greater debt relief than the bank would approve voluntarily, and this generates greater social surplus. The results shed light on the ongoing debate over a separate small-business bankruptcy chapter resembling the current Chapter 13.
Homestead exemption is defined as the level of home equity that a household declaring bankruptcy can keep. This exemption level varies across states in the United States. As entreprenurial activities are risky, small business owners value the insurance the bankruptcy law provides. In their empirical study, Fan and White (2003 find that a probability of homeowners running a business is 35\% higher if they live in the states with unlimited rather than low homestead exemptions. Moreover, Sullivan, Warren and Westbrook (1999) estimate that about 20\% of bankrupts had debts from a failed business. As this numbuer is higher than the fraction of households who own a small business, an unproportionally high fraction of small business owners declare bankruptcy. In this paper, we ask the following question. What are the effects of reducing homestead exemption on entrepreneurship activity, bankruptcy rate, homeownership and welfare? We build a general equilibrium model with uninsurable idiosyncratic risks, where the agents make entrepreneurial, housing and bankruptcy choices. In the model, house is defined as a good that people derive utility from, has frictions in buying and selling, people can borrow against, and the government has special regulations on. The model also features a distinction between unsecure debts and secure debts. The unsecure debts are subject to a waiver when declaring bankruptcy while the secure debts are collateralized by house and not waiverable. We calibrate the model to the US economy and study the effects of eliminating homestead exemption on entrepreneurship activity, bankruptcy rate, homeownership and welfare. Our preliminary findings suggest that, when homestead exemption is eliminated, there will be a decrease in entrepreneurial activity, a decrease in bankruptcy rate and a decrease in home equity but no change in homeownership rate.
In this paper, we investigate how personal bankruptcy law affects small firms' access to credit. When a firm is unincorporated, its debts are personal liabilities of the firm's owner, so that lending to the firm is legally equivalent to lending to its owner. If the firm fails, the owner has an incentive to file for personal bankruptcy, since the firm's debts will be discharged and the owner is only obliged to use assets above an exemption level to repay creditors. The higher the exemption level, the greater is the incentive to file for bankruptcy. We show that supply of credit falls and demand rises when non-corporate firms are located in states with higher bankruptcy exemptions. We test the model and find that small firms are 25% more likely to be denied credit if they are located in states with unlimited rather than low homestead exemptions.
The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as for consumers. When firms are non-corporate, debts of the firm are personal liabilities of the entrepreneur/owner. If the firm fails, the entrepreneur has an incentive to file for bankruptcy under Chapter 7, since both business debts and the entrepreneur's personal debts will be discharged. The entrepreneur must give up assets above a fixed bankruptcy exemption level for repayment to creditors, but future earnings are entirely exempt. Exemption levels are set by the states and they vary widely. We show that higher bankruptcy exemption levels benefit potential entrepreneurs by providing partial wealth insurance. This means that the predicted relationship between the probability of owning a business and the exemption level is positive at low exemption levels, but may be either positive or negative at high exemption levels, depending on whether higher bankruptcy costs outweigh the gain from additional insurance. We test this prediction and find evidence that the probability of owning a business is about 28% higher if potential entrepreneurs live in states with unlimited exemptions rather than low exemptions. We also find evidence that families are significantly more likely to start businesses if they live in states with high or unlimited, rather than low, bankruptcy exemptions. They are also more likely to organize their businesses as non-corporate rather than corporate if they live in states with high exemptions.
Congress is again attempting to reform federal bankruptcy law by making bankruptcy less favorable for households whose incomes are above the median level. Whatever the merits of that legislation, it would have a negative impact on small business and on U.S. workers who receive their income from such businesses. Among the proposed reforms are limits on the current "fresh start" provision that protects bankrupt individuals' future earnings. Data show that small business growth is more vigorous when bankruptcy laws offer more protection of entrepreneurs' assets. That suggests that, if "fresh start" reform is adopted, it could dissuade risk-adverse potential entrepreneurs from starting new businesses.
Overall, the expert with the most work on this is Michelle White, who effectively has a specialty in bankruptcy. Her work is vastly more rigorous than that of Elizabeth Warren, the more famous bankruptcy figure, who is an expert on the law, not empirical method. The important thing to remember is that while these results are not morally intuitive for most of us, they are economically entirely unsurprising. The only real economic issue to be resolved was an empirical question--does the decrease in the supply of credit from easier bankruptcy outweigh the effect of the increase in demand for it? The answer is pretty clearly no: while supply decreases somewhat, overall, easy bankruptcy increases entrepreneurial activity. This, too, should not be surprising. America has always been a nation of entrepreneurs--and it has always been the nation with the most generous bankruptcy laws. We should not find it so hard to swallow that the prudent bourgeois virtues have economic costs--as well as great benefits.
I don't find that hard to believe at all. People almost always want to protect the house.
But then why not use a LLC business organization? That would protect the owner from the unsecured debts of the business, would it not?
So is it really a question of how bankruptcy law informs peoples business organization decision?
I was listening to the "This Week in Tech" podcast from 2/4/08 and there was an interesting discussion of bankruptcy. One of the panelists said that bankruptcy law is the greatest tool for being an entrepreneur in the tech sector. If you have an idea you can incorporate in a day, venture capital is easy to get, and as long as you pay your taxes you can file bankruptcy, fire everyone, and go back to your old job. At least you took your swing. Have a new idea? Do it again - you might hit a home run.
This really is unsurprising. Look, one one end of the spectrum, you can have the state build debtor's prisons for people who default on private sector loans, and on the other end of the spectrum, you can have the state refuse to aid the enforcement of any contract. Towards which end of the spectrum do you think the creditor will exercise the best judgement as to how his capital is deployed? It seems to me that anyone with an appreciation of Hayek would think that the recent bankruptcy legislation was a solution in search of a problem.
That would protect the owner from the unsecured debts of the business, would it not?
No, not if it were sham designed to evade legitimate debts. "Inadequate capitalization" (too few assets in the LLC's name) is a reasons for courts to "pierce the veil" and allow recovery against the debtor personally.
The real answer is for the private sector to build debtor's prisons, and for the government to enforce debt-repayment, either you pay or you go to the private debtor's prison. Otherwise, it's pure thievery of credit. These kind of laws will only cause credit to be severely tightened.
Toxic: Think of it this way. Let's say you had $250,000 sitting around. One of you buddies says "I would like to borrow that $250,000 to start a business." You might then say... hold on... don't you own your $500,000 free and clear? "Yes," your friend says "but I don't want to risk loosing it."
We'll, if you don't belive in your business enough to put up your house, why should I belive in it. Also, if you loan the guy $250,000 and have his house as collateral you know he's going to work his ass off to avoid loosing his home. If all he has to loose is your money, he may not work as hard.
and that should read $500,000 house
These kind of laws will only cause credit to be severely tightened.
Say what? Credit isn't exactly tight now, you know.
A lender who needs a debtor's prison to run his credit business profitably is by definition a dunce, and should not be a steward of capital, especially in this day and age, where predictive methods of ability and likelihood to pay are so much more advanced than in the past. The same reason it makes little sense to have the state heavily involved in the allocation of industrial capital applies to why it makes little sense to have the state heavily involved in allocating financial capital via physically forcing repayment from people who are heavily upside down. A creditor who is too stupid to avoid lending in significant numbers to people who are unlikely to repay should get out of the lending business.
Not that Will's point isn't a good one, but the really stupid thing about a debtor's prison is that if the guy couldn't pay you back when he was out working, he's rather unlikely to earn the money to pay you back while in prison.
should get out of the lending business.
Preferably by seeking bankruptcy protection first.
he's rather unlikely to earn the money to pay you back while in prison.
No, but the idea is to force his family to bail him out. That worked better in the days when everyone had 12 kids and 20 uncles.
Yep, if easier bankruptcy terms incents the dumb creditor to get out of the business of stewarding capital more quickly, society as a whole likely benefits. Of course, if too many creditors turn dumb at once, then things get ugly. Interesting that this may be happening now, a few years after bankruptcy became a more difficult proposition.
Good grief, people.
I never watch those Bloggingheads things, but I would probably sit down to watch McArdle vs. that credit-card-company-____ Todd Zywicki over at the Volokh blog, on the supposed perils fixed by the bankruptcy bill.
Funny, I thought the thrill of the free market and profits were what inspires an entrepeneur. I guess when our Founders created this government they did not really mean that it is a government for the common good of the people but to further inspire the capitalist machine which by osmosis (call that trickle down) would help the individual.
By the way, I have a bridge you could buy, but I am waiting for my federally subsidized guarantee of profit.
Toxic asked "But then why not use a LLC business organization? That would protect the owner from the unsecured debts of the business, would it not?"
No. LLC status is unrelated to the ability to obtain credit. Creditors are not required to loan to LLCs, or any other business. Small business owners who wish to obtain loans or lines of credit are typically obligated to personally guarantee or co-sign for any business debt they incur. If the principal has insufficient assets, the lender may require additional co-obligors before granting credit.
The LLC form of doing business is normally used because of the convenience and benefits of tax planning and assesment, which are similar to those available to partnerships or subchapter S corporations. Other legal advantages vary among the states and may not be available for some types of businesses or services.
Small businesses in the US have traditionally depended on betting the farm, or the house, to start or keep them going. States that have seen the greatest economic (and small business) growth during the last 30 years have tended to have the most generous homestead protections. (e.g., California, Texas, Florida) States with little or no homestead protection have been economically lethargic by comparison (e.g., Pennsylvania)
MESSAGE
Speaking as an entrepreneur (SmartFlix.com and HeavyInk.com) who recently borrowed $250k from a bank, much of the discussion about the corporate veil is purely theoretical - until a firm is sufficiently large (I've heard $10 mill / yr in revenue bandied about as a threshold), most banks require the primary stockholder to cosign the loan.
Our corporate debt all rests on me, personally.
...which I point out, from time to time, when employees complain that they don't have as much stock as I do. ("You want more stock? Absolutely! Let's use *your* house as collateral!")