The Bankruptcy Reform Act of 2005 and Entrepreneurial Activity

• Date: 01 June 2013
• DOI: http://doi.org/10.1111/jems.12011
• Published date: 01 June 2013
• Author: Yongwook Paik

The Bankruptcy Reform Act of 2005 and

Entrepreneurial Activity

YONGWOOK PAIK

Marshall School of Business

University of Southern California

3670 TrousdaleParkway, BRI 306

Los Angeles, CA 90089

Yongwook.Paik@marshall.usc.edu

This paper empirically investigates the effect of the Bankruptcy Reform Act of 2005 on en-

trepreneurial activity. We find that this act had virtually no noticeable effect on the overall level

of entrepreneurship, measured by self-employment, partly because potential entrepreneurs were

more likely to seek limited liability to offset the reduction in wealth protection imposed by the new

law. That is, the incorporation rate increased for small businesses after the new law was enacted.

This increase emphasizes that limited liability provided by incorporation is an important strategic

variable that potential entrepreneurs utilize in response to changes in personal bankruptcy law.

This study implies that incorporation is an important parameter to consider in understanding

the relationship between bankruptcy law and entrepreneurial activity. The policy implication of

this study is that entrepreneurs do respond to changes in personal bankruptcy law, even though

it is intended for consumers, so this potential side effect should be considered when designing a

new law.

1. Introduction

Bankruptcy is the legal process by which financially distressed firms and individuals

resolve their debts. The bankruptcy system is important with regardto entrepreneurship

because it dictates the financial consequences of a business failure, which effectively

characterizes the cost of exit and affects the likelihood that a bankrupt entrepreneur

will begin anew (Ayotte, 2007; Armour and Cumming, 2008; Lee et al., 2008). In effect,

bankruptcy law can determine the cost of entry into entrepreneurship and the degree of

risk involved in conducting business.

In the United States, there are two types of bankruptcy procedures, personal and

corporate bankruptcy; which entity files for protection determines which of the two is

utilized. Although corporate bankruptcy is the bankruptcy of large or medium-sized

incorporated firms, personal bankruptcy is the bankruptcy of individual households

and small businesses (White, 2007b). Small business bankruptcy is treated as personal

bankruptcy because many small businesses are not incorporated, which means that a

business’s debts are considered personal liabilities of the business owner. When their

I thank Clair Brown, Ulrike Malmendier,David Mowery, Douglas Cumming, and Daniel Spulber and seminar

participants at the Searle ResearchSymposium on the Economics and Law of the Entrepreneur, Entrepreneurial

Finance and Innovation Conference, and Marshall School of Business at the University of Southern California

for their helpful comments. I also thank the editor and two anonymous reviewersfor their insightful comments.

I gratefully acknowledge financial support fromthe Ewing Marion Kauffman Foundation, and the Grief Center

for Entrepreneurship at University of Southern California. All errors are mine.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 2, Summer 2013, 259–280

260 Journal of Economics & Management Strategy

businesses fail, owners often file for bankruptcy so that their businesses’ debts will be

discharged along with their unsecured personal debts. Even when small businesses are

incorporated, personal bankruptcy law is important when they fail because a lender that

provides a small incorporated firm with a loan often requires the owner to personally

guarantee the debt and may also require that the owner provide the lender with a second

mortgage on the owner’s house. Lenders know that the firm does not possess adequate

assets to back the debt and that the firm’s assets can be diverted to the owner. In effect,

lenders do not view small businesses as separate corporations or entities (Berkowitz

and White, 2004). That approximately 20% of all personal bankruptcy filings in the U.S.

include some business debt indicates the importance of personal bankruptcy policy for

small businesses (Sullivan et al., 1999; Lawless and Warren, 2005). In this sense, the

U.S. personal bankruptcy system is the de facto bankruptcy procedure for small firms,

regardless of whether they are incorporated, although it is primarily intended to be a

consumer bankruptcy procedure (Fan and White, 2003).

This study investigates the effect of the Bankruptcy Reform Act of 2005, which

represents the largest overhaul of the bankruptcy code since its enactment in 1978,

on entrepreneurial activity. Much concern was expressed because the reform renders

personal bankruptcy law more pro-creditor (i.e., the new law was designed to protect

creditors more than borrowers or consumers) and would eventually have a substantial

effect on entrepreneurial activity (White, 2006).1Therefore, the purpose of this study

is to address such concerns and investigate how the new bankruptcy law has affected

entrepreneurial activity.

How does bankruptcy law affect entrepreneurship? There is a strong tie between

the two because entrepreneurs facing liquidity constraints inevitably seek external credit

before engaging in a new business. Empirical findings that support this tie abound in

the existing literature (Evans and Leighton, 1989; Evans and Jovanovic, 1989;Holtz-

Eakin et al., 1994b; Black a nd Strahan, 2002). For example, Evans and Jovanovic (1989)

demonstrate that most individuals who enter self-employment face a binding liquidity

constraint and, as a result, use a suboptimal amount of capital to establish their busi-

nesses. Using data from a group of people who received inheritances, Holtz-Eakin et al.

(1994b) find that the effect of inheritance on an entrepreneurial firm’s survival is small

but noticeable, which provides evidence that entrepreneurs are credit constrained and

that receiving an inheritance loosens this constraint.2

In theory,given that entrepreneurs face liquidity constraints, personal bankruptcy

law affects entrepreneurial activity in primarily two ways. On the one hand, personal

bankruptcy law provides partial insurance against business failure by discharging unse-

cured debt and providing a fresh start (supply-side effect). On the other hand, personal

bankruptcy law affects the borrowing cost of capital, as financial institutions charge

higher interests on loans as the personal bankruptcy law becomes more pro-debtor

(demand-side effect).

Recent studies on the relationship between bankruptcy law and entrepreneurship

have studied these two effects in various forms. For example, Fan and White (2003)use

the variation in homestead exemptions across states during the period of 1993–1998 to

demonstrate that higher bankruptcy exemption levels benefit potential entrepreneurs

who are risk averse by providing partial wealth insurance and, therefore, that the

1. A number of experts have stated that the new bankruptcy law was deeply flawed and would have

many negative consequences. For example, see: http://www.abiworld.org/pdfs/LawProfsLetter.pdf

2. That entrepreneurs are undercapitalized is consistent with the results of Fazzari et al. (1988), who

suggest that even corporations are constrained in capital markets.