For two clients, it was rain: The soggy spring kept customers away from their nurseries, and it had a “devastating effect” on their finances. They turned to their credit cards to cover daily expenses, and soon the debt was overwhelming.
Bankruptcy lawyer Christopher M. Lefebvre meets them all the time – entrepreneurs whose businesses aren’t quite strong enough to withstand a rough spot, and who lose control of their personal finances just trying to save them.
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“You see it from florists to people in arts and crafts, to caterers, to all sorts of things,” Lefebvre said. “Everyone has this dream of trying to be an entrepreneur, and the untold story is that there are many people who are caught in bankruptcy as a result of a failed attempt.”
Half of new businesses close within four years, the U.S. Small Business Administration has said, and one-third fail; in 2002, the latest year for which the SBA has posted detailed figures, 584,500 U.S. firms shut down, about 10 percent of the total, while another 550,100 opened.
But you’d never know it from U.S. Bankruptcy Court statistics. Even as personal bankruptcies have skyrocketed – from 364,536 in 1985, to 858,104 in 1995, to 1.64 million last year (12 months ending June 30), business bankruptcies have sharply declined, from 66,651 in 1985, to 51,288 in 1995, to 32,406 last year.
Rhode Island statistics mirror that trend: Total bankruptcies rose from 750 in 1985 to 4,449 last year, but business filings declined from 134 to 75. Put differently, while 20 years ago businesses accounted for 17.8 percent of bankruptcies, last year they were 1.7 percent.
Are U.S. entrepreneurs that different from the consumer population? How do you reconcile Lefebvre’s clients’ stories with this?
Well, a recent article by two veteran bankruptcy scholars argues: The statistics are wrong. After reviewing 1,250 cases from five different bankruptcy court districts, in California, Illinois, Pennsylvania, Tennessee and Texas, they concluded that the system, for various reasons, is labeling many bankruptcies triggered by the failure of a business as regular consumer bankruptcies.
Extrapolating to all filings, they estimate that in 2003, the last year for which they reviewed data, between 220,000 and 280,000 entrepreneurs, self-employed individuals and independent contractors who sought bankruptcy relief were classified as regular consumers.
In Rhode Island, that would mean 600 to 750 entrepreneurs a year were going into bankruptcy court classified the same as people who just spent too much money (or, as other studies have shown, were overwhelmed by costs related to an illness).
For the failed entrepreneurs, the article’s authors, Robert M. Lawless and Elizabeth Warren, argue this means being forced into a system that can’t address their problems.
“Is work that traditionally would have been done by salaried employees now outsourced to the same individuals who are labeled ‘consultants’ and who now bear more risks than they did as employees?” they ask. “Has the line between consumers and businesses blurred where the failure of a small business necessarily means the failure of its owner?”
Some of the reasons for the low bankrupt entrepreneur count are purely technical, Lawless and Warren say: The wording of the bankruptcy petition cover sheets has changed, and commonly used filing software classifies cases as “consumer” by default. (Neither of these factors, one local bankruptcy lawyer said, should make a difference if the lawyer and the court staff are doing their jobs carefully.)
But the bigger socio-economic dynamic, local experts agreed, is inescapable: Consumer credit, especially credit cards, is increasingly being used to support small businesses. Especially at the biggest banks, they note, it’s virtually impossible for many entrepreneurs to get a business loan – a small firm’s assets are often not enough collateral. So people are steered toward second mortgages, home equity loans, or – for daily expenses – credit cards.
“The credit card is just an unbelievably tempting source of cash,” said John Boyajian, a Providence lawyer considered an expert in bankruptcy. “You don’t have to explain anything to anyone, and you don’t even have to take out a large cash advance – you can just finance your personal living expenses” while using cash for the business.
Borrowing against one’s house is “not necessarily a bad solution,” Boyajian said, especially when compared with credit cards (6 percent vs. 20 percent interest is a big difference). But entrepreneurs and their families need to be careful, he said.
“Someone’s got to do a real analysis of whether the business can be saved with this infusion of cash, or is it a bottomless pit?” Boyajian said. “If it’s a longer-term systemic problem with the business, then neither (a secured loan nor credit card spending) is going to solve it.”
Another common reason why entrepreneurs’ business and personal finances get entangled, said Lefebvre, is that almost any credit application for a small business – whether it’s for a loan to finance an equipment lease or for a wholesale supplier – now requires a personal guaranty from each of the principals, even if the company is incorporated.
Thus the notion that an LLC or corporation will shield your personal assets, Lefebvre said, “is fiction. There’s no such thing anymore.”
The new bankruptcy law that goes into effect next Monday, some believe, will make things even harder for struggling entrepreneurs, because it will make it more difficult for people to file for Chapter 7 bankruptcy, which wipes out debts and allows a fresh start.
Instead, debtors whose last six months’ income is above the state median, and whose income exceeds living expenses, will be pushed into Chapter 13 bankruptcy, and required to pay at least part of their debts over five years.
As Lawless and Warren noted in their study, “The Myth of the Disappearing Business Bankruptcy,” the new law’s means test assumes the debtor will continue to earn as much as before bankruptcy, yet when a business shuts down, the income stops with it. Thus the repayments could be a particularly heavy burden for them.
Steven H. Kropp, a visiting professor of law at Roger Williams University with an expertise in bankruptcy, said he agrees with the gist of Lawless and Warren’s article, and he predicted that the new law could have “a very negative effect” on entrepreneurship.
“It will not stop new entrepreneurs – nobody starts a business thinking they’re going to fail,” Kropp said.
In the past, people who failed “could go file for bankruptcy and get a fresh start and try again,” Kropp noted. “Many individuals, the second or third time, have the experience and knowledge to succeed – and sometimes do spectacularly well. But now I think the effect will be that many will be discouraged and in debt, and unable to start again.”
