Impact of State Exemption Laws on Small Business Bankruptcy Decision

Abstract

1. IntroductionSmall 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 (relationship2 versus scored3), information processing technologies (soft versus hard),4 loan size considerations,5 and loan type considerations6 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. …