Bankruptcy and Entrepreneurs: In Search of an Optimal Failure Resolution System.

Author:Tabb, Charles J.

    Who can forget the childhood thrill of going to the circus and watching the daring flying trapeze artists, as they soared through the air and made seemingly impossible flips, turns, and catches? But even the greatest trapeze acrobats sometimes miss, and when they do, they are saved by the net below--if they use one. When, in their Icarus-like hubris they have eschewed using the safety net, horrific accidents have resulted; recall the tragic deaths and paralyses suffered by the famed Flying Wallendas in 1962. (1) And they were perhaps the most talented trapeze artists in the world. One can only imagine the carnage if novice trapeze artists attempted to fly without a net.

    Metaphorically, that is essentially what would happen if entrepreneurs embarked on business ventures without an efficient, fair, and economical system in place for the resolution of prospective failure. I call such a system a "failure resolution system" ("FRS"), a term I have coined. This paper proceeds on the premise that a legal regime best promotes entrepreneurial activity if it offers a viable FRS. I have identified what I believe are the core features of an optimal FRS. I then apply my general conclusions specifically to the United States context and propose concrete reforms. Note that I have not yet used the term "bankruptcy" to describe the failure resolution mechanism. A federal bankruptcy system, enacted pursuant to the authority of the Bankruptcy Clause in Article I, [section] 8 of the Constitution, might be the optimal means to resolve entrepreneurial failures in the United States and indeed, for reasons explained below, will in many cases be preferred. However, I want to consider first principles, unburdened by preconceived notions or by an assumption that a FRS needs to mirror anything we currently offer in the United States Bankruptcy Code. My inquiry is: what are the core aspects of an optimal failure resolution system for entrepreneurs?

    For creditors and debtors alike, financial carnage, paralysis, and death often would ensue in the absence of a FRS. Inefficient legal rules in this context negatively affect ex ante bargaining between the entrepreneurial debtor and her creditors and also undermine ex post incentives. (2) In almost any endeavor, and certainly in entrepreneurial activity, some degree of failure is inevitable. Even the "unsinkable" Titanic hit an iceberg and sank. False assumptions that it was unsinkable led to the fatal decision not to carry enough lifeboats. When you roll the dice, you might roll a seven or an eleven and win, but you also might roll "snake eyes" or "box cars" and "crap out." Unfortunately, entrepreneurs hit icebergs and "crap out" at a relatively high rate. (3) Studies have shown that as many as half of all startups fail within four years. (4) And the reality is that it is very hard to predict in advance which entrepreneurs will fail and which will succeed. (5) Who will hit an iceberg and who will enjoy clear sailing is very uncertain; the crystal ball is cloudy indeed.

    Given the inevitability of a significant percentage of failures, coupled with the inability to identify probable failures up front, the lack of a workable FRS would impose significant dead-weight losses and create potential distributional injustices among stakeholders. The failing entrepreneur, as well as many of the creditors and investors who backed her, might sink beneath the waves of business failure. Not only would the entrepreneurial debtor and her creditors and investors suffer losses ex post (often shared unequally), but the ex ante recognition that such losses are both (1) inevitable in a large number of cases, and yet (2) unpredictable as to which ones will fail, would chill entrepreneurial activity from the viewpoint of the prospective entrepreneur and her investor-creditors. Conversely, the perception that an effective FRS is in place would largely eliminate that chilling effect and encourage entrepreneurial activity and investment. (6)

    While we use the more positive phrase "nothing ventured, nothing gained" to capture the intuitive premise underlying the value of entrepreneurism, we should not forget the darker side of that phrase. Perhaps "everything ventured, everything lost" would capture the depressing reality. A full and fair measure of the societal impact of entrepreneurism (7) must count the failures as well as the losses. We cannot have one without the other. An optimal legal system should account ex ante for those inevitable failures, provide satisfactory mechanisms to resolve them, and do so in a way that both minimizes inefficiencies and maximizes appropriate incentives, from both ex ante and ex post perspectives.

    Before examining the necessary components of an optimal FRS, it is worth considering why we care. Obviously, for any particular entrepreneur and her creditors, having a workable FRS is better than not. But as a society, why do we or should we care? The reason is this: the harm from inevitable and unpredictable entrepreneurial failure is not purely private, affecting only those with "skin in the game." (8) Encouraging entrepreneurism, promoting investment, maximizing value, and preserving valuable human capital, by offering debtors a soft landing with an equitable distribution among creditors in the event of failure, directly impacts the economic well-being of the entire country. (9) Entrepreneurship is a driver of economic growth, (10) and an entrepreneur-friendly FRS encourages entrepreneurial ventures. (11) In short, the strictness of a FRS in a country correlates closely with the levels of entrepreneurship in that country. In countries with stricter regimes, (12) failed entrepreneurs are more likely to exit entrepreneurship entirely, and not return. (13) This has a concomitant negative effect on the country's economy. If, however, the consequences of failure are less severe, and new credit is accessible even for failed entrepreneurs, more entrepreneurs will be willing "to experiment with novel (and more risky) business ideas," (14) which could lead to greater economic growth.

    I saw this phenomenon in action while consulting with the government of the People's Republic of China in 2002 in regard to modernizing their bankruptcy laws (which went into effect in 2007 (15). As China moved away from a purely socialist economy to a more market-based economy, (16) its leaders understood that China could not be a viable world economic power without a fair and efficient failure resolution system. They recognized that having such a system in place was necessary both to encourage entrepreneurs to pursue new ventures and to encourage investment in those enterprises.

    It was precisely this same recognition--that bankruptcy laws serve the public good by encouraging entrepreneurial risk-taking--that led the evolving nation-states in the Renaissance period to enact the first modern bankruptcy laws. Sir William Blackstone (1765), writing about the then-extant English bankruptcy law (the Statute of George, 1732), observed that "the laws of bankruptcy are considered as laws calculated for the benefit of trade...." (17) National power depended upon economic strength; a strong economy required vibrant trade and commerce; trade and commerce necessitated the use of credit; once credit was used, failure and the inability to repay debts became possible; and when business failures occurred, the consequences of those failures had to be apportioned fairly. As Bruce Mann has observed: "Crops fail, prices fall, ships sink, warehouses burn, owners die, partners steal, pirates pillage, wars ravage, and people simply make mistakes." (18) The essential function of bankruptcy law as a necessary mechanism to account equitably for credit risk, and accordingly to encourage both entrepreneurial risk-taking and the extension of credit to such entrepreneurs, was brought into stark relief by the fact that the early English laws limited bankruptcy relief to "traders," for whom resort to credit was unavoidable. (19) Blackstone again captured the idea: "Trade cannot be carried on without mutual credit on both sides: the contracting of debts is therefore here not only justifiable but necessary. And if by accidental calamities ... a merchant or trader becomes incapable of discharging his own debts, it is his misfortune and not his fault." (20)

    The United States finally recognized this public interest in a workable bankruptcy system when it adopted a permanent regime of federal bankruptcy legislation over a century ago, in 1898. (21) A House Report in 1897 answered the rhetorical question, "is a bankruptcy law needed?," by first noting the large number of business failures from 1879 to 1895. (22) It then observed that:

    This vast number constitutes an army of men crippled financially--most of them active, aggressive, honest men who have met with misfortune in the struggle of life, and who, if relieved from the burden of debt, would reenter the struggle with fresh hope and vigor and become active and useful members of society.... [T]he passage of a bankrupt law ... will lift these terrible and hopeless burdens, and restore to the business and commercial circles of the country the active and aggressive elements that have met with misfortune and are now practically disabled for the battle of life.... [W]hen an honest man is hopelessly down financially, nothing is gained for the public by keeping him down, but, on the contrary, the public good will be promoted by having his assets distributed ratably as far as they will go among his creditors and letting him start anew. (23) In 1934, the United States Supreme Court confirmed that a bankruptcy system was "of public as well as private interest" (24) in freeing a hopelessly impoverished individual debtor from his debt burden so that he could have "a new opportunity in life and a clear field for future effort." (25) Today, even though the commercial world in many respects...

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