Impact of state exemption laws on small business bankruptcy decision.

• Author: Agarwal, Sumit

1. Introduction

   Small businesses are a primary source of employment in the U.S. economy, employing over half of the private sector workforce. Small businesses are responsible for about two-thirds of all net new jobs created. According to the 2002 Small Business Economic Indicators (SBEI), (1) over 99.7% of the 5.7 million firms in the United States are classified as small- to medium-sized businesses. Hence, small businesses are a substantial contributor to economic growth in the United States.

   Small business owners enjoy more flexibility and freedom to capitalize on profitable opportunities than their larger business competitors. Hence, they challenge the larger firms to be more efficient, which is ultimately beneficial to consumers. Unfortunately, small- and medium-sized businesses have a very low survival rate (SBEI 2002). In 2002 (on the heels of the 2001 recession), there were 550,100 small business births and 584,500 small business terminations. Both academics and public policy analysts have become increasingly concerned about the success of small businesses.

   Recently there has been a surge in small business research, particularly surrounding small business credit supply and demand. Not surprisingly, much of the literature has been focused on changes in lending technologies (relationship (2) versus scored (3)), information processing technologies (soft versus hard), (4) loan size considerations, (5) and loan type considerations (6) as they relate to small business supply and demand. However, very few have actually examined why small- and medium-sized businesses have very low survival rates. Some studies have analyzed the sensitivities of Small Business Administration (SBA) guaranteed loans to macroeconomic changes industry risks, maturity structures (3, 7, and 15 year maturities), as well as lender and debt characteristics (e.g., Glennon and Nigro 2001, 2002; Dunsky and Pennington-Cross 2003). Meanwhile, Agarwal, Chomsisengphet, and Liu (2003) empirically assessed the significant importance of owner and firm characteristics in determining the risk of small business default while controlling for the macroeconomic and industry risks.

   With bankruptcy filings continuing to rise significantly in recent years, many policy makers are turning their attention to bankruptcy laws. Specifically, Congress is considering reforming personal bankruptcy laws that, if passed, will significantly impact the demand for and supply of both consumer credit and small business funding. White (2001) concludes that this bankruptcy reform could potentially reduce small business ownership but increase the supply of small business credit and, in turn, affect the growth of the U.S. economy.

   Small business owners have an incentive to file for personal bankruptcy when their indebtedness exceeds the value of their assets because both their personal and business debts can be discharged. (7) Though the bankruptcy exemption law is primarily designed for consumers, the personal bankruptcy exemption law is a de facto bankruptcy procedure for small business owners because the debt of a noncorporate firm is the personal liability of the entrepreneur/owner (Fan and White 2003). Hence, investigating the potential impact of the exemption law on small business bankruptcy decisions may provide some insight into how the bankruptcy laws should be reformed.

   Further, Fan and White (2003) argue that while the expected return to creditors should be lower in states with higher exemption level upon small business shutdown, it is not entirely clear whether lenders will actually shut down a financially troubled small business. While they empirically find that small businesses in high-exemption states are more likely to be shut down, this positive relationship is statistically insignificant. The authors conclude that "additional research will be needed to determine if a significant relationship exists" (p. 563).

   With micro-level data, we want to test whether small business borrowers act "strategically" in their bankruptcy decision in order to take advantage of the state bankruptcy laws. Our data are a unique panel data set of over 43,000 small business credit card holders over a two-year period (May 2000-May 2002). These panel data include information on small business bankruptcy filings as well as information on the business owners' financial and credit risk standing. These accounts are small business lines of credit with the following characteristics: the lines are under $100,000, contain a personal guarantee by the owner or principal, and were originated using scored lending technology that evaluated the creditworthiness of the business owner and not necessarily of the business. (8) Because small business credit card lending is secured only by personal assets of the owner, this part of the credit market ought to be theoretically most affected by exemption provisions, and any impact on small business' bankruptcy filing decisions as affected by the exemption laws should be quite noticeable.

   To measure the impact of exemption laws on the likelihood of bankruptcy filings of small businesses using the loan-level data briefly described above, we estimate a proportional hazard model. Our empirical results suggest that an increase of $10,000 in the homestead exemptions will increase the likelihood of small business owners declaring bankruptcy by 8%. Moreover, our results also indicate there is a 4% rise in the risk of small business bankruptcy with a $1000 increase in personal property exemption levels.

   The structure of the rest of the article is as follows: Section 2 provides an overview of the literature; section 3 describes the data and model specification; section 4 presents empirical findings; and section 5 offers concluding remarks.

2. Literature Review

   White (2003) provides a theoretical and empirical literature review about the U.S. personal bankruptcy law. There are two personal bankruptcy procedures available to individuals in the United States. Debtors are allowed to choose between them. Under a Chapter 7 filing, unsecured debts such as credit card debt, installment loans, medical bills, and damage claims are discharged. Owners are not obliged to use any of their future earnings to repay their debt, but they must turn over all their assets above a certain level of state exemption (homestead and property) to the bankruptcy trustee. Because exemption varies widely across states, debtors residing in states with relatively higher exemptions will be able to retain more of their assets. Under a Chapter 13 filing, debtors do not have to give up any assets, but they must offer a plan to repay a portion of their debt with future income, usually over three to five years. Hynes (1998) describes Chapter 13 as the consumer analog of Chapter 11 reorganization. Whereas bankruptcy filers have a choice between Chapters 7 and 13, they have a financial incentive to choose Chapter 7 whenever their assets are less than their state's exemption, and thus can avoid repaying their debts completely (also see Fan and White 2003).

   Homestead and personal property exemptions provide debtors in a bankruptcy filing with relief from creditors. Thus, discharging of debts provides debtors with a chance for a "fresh start." Homestead exemptions vary widely: from zero in two states to unlimited in seven states. About one-third of the states also allow their residents to choose between federal bankruptcy exemptions and state exemptions. (9)

   Personal property exemptions also vary widely. For instance, Texas has the most generous personal property exemption level of $30,000, whereas Hawaii only allows $2000. Many states also allow married couples that file for bankruptcy to take higher exemptions, usually double.

   We now review the literature on the impact of personal bankruptcy exemptions on consumer credit as well as small business credit.

   Bankruptcy Exemptions and Household Credit

   According to White (2003), "Bankruptcy is an important aspect of consumer credit markets, because whether consumers repay or default on their loans depends on whether the legal system punishes debtors who default and, if so, how severely." (p. 1) In this respect, Lin and White (2001) and White (2003) argue that the U.S. bankruptcy system is especially favorable toward the debtor. In fact, we do observe that the number of personal bankruptcy filings has doubled within a short span of seven years (1996-2002) from 700,000 to more than 1,400,000 (see Figure 1).

   [FIGURE 1 OMITTED]

   With bankruptcy filings rising significantly in the recent years, researchers are turning their attention to the potential impact of bankruptcy exemption laws on consumer credit markets. A number of empirical studies have focused on the supply of, as well as the demand for, credit. In particular, whether differences in states' bankruptcy exemption levels affect aggregate household credit (both secured and unsecured) has been studied by Gropp, Scholz, and White (1997); Berkowitz and Hynes (1999); Lin and White (2001); Fay, Hurst, and White (2002); Agarwal, Liu, and Mielnicki (2003); Berkowitz and White (2003); Chomsisengphet and Elul (2004); and White (2003).

   Gropp, Scholz, and White (1997) find empirical support for their theoretical argument that in states with high rather than low bankruptcy exemptions, there is more credit rationing because debtors are more likely to default and file for bankruptcy. Berkowitz and Hynes (1999) argue that because of a positive wealth effect, a financially distressed homeowner filing for bankruptcy will be able to retain more of his assets in high-exemption states, which would enable him to continue paying his mortgage. Hence, we should expect that in states with generous exemptions, there should be lower risk of mortgage default and increased access to mortgage credit. On the other hand, Lin and White (2001) develop a theoretical model to show that in states with relatively higher exemptions...