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

Abstract

This paper takes the position that a legal regime best promotes entrepreneurial activity if that regime offers a viable system to resolve the financial affairs of a distressed individual entrepreneur. I call this a “failure resolution system” (FRS). Consciously recognizing the need for and optimal parameters of a failure resolution system tailored to the particular needs of entrepreneurs, and crafting a FRS specifically to those ends, would play a significant positive role in encouraging and promoting entrepreneurial activity, which would benefit the society at large. The paper identifies the core features of an optimal failure resolution system in any legal system. Many of the conclusions drawn can be applied to the personal insolvency regimes of any country. My essential inquiry is: what are the most critical aspects of an optimal failure resolution system for individual entrepreneurs? I argue that the necessary features are that the FRS be: (1) forgiving; (2) human-capital-preserving; (3) not morally hazardous; (4) value-maximizing; (5) equitable; (6) accessible; (7); controllable; (8) participatory; (9) binding; (10) inexpensive; (11) non-gluttonous; (12) simple; (13) clear; and (14) speedy. The bulk of the paper analyzes the first three aspects, viz., that the FRS be forgiving to the entrepreneur, that it preserve the entrepreneur’s human capital, but also that it not enhance moral hazard. I suggest ways to balance these potentially conflicting norms. The paper applies its conclusions specifically to the United States context and proposes concrete reforms. As noted, though, the principles could be applied to any country’s legal system. Some reforms that are proposed here apply specifically to the U.S. federal bankruptcy law. However, the paper proposes other reforms that should be enacted more broadly as a matter of federal law, independent of the bankruptcy law. In the United States today, we are failing our entrepreneurs by not having an efficient FRS, and by failing them, we are failing society as a whole.