The fundamental philosophy of the U.S. bankruptcy system has not changed for more than a century. This philosophy, which was first codified in the 1978 law but has guided bankruptcy regulation since the early nineteenth century, is the idea of a “fresh start” after bankruptcy. Under Title 11 of the modern bankruptcy code, businesses can file for bankruptcy under Chapters 7, 11 and 13. Chapter 7 bankruptcy is a liquidation procedure most frequently used by individual debtors and small businesses. The advantage is that debtors can protect their “exempt” assets from being used to repay debts, and they get an immediate debt discharge after non-exempt assets are distributed.
The debtor is then released from any future obligation to repay the debt. These exemptions relate to different types of assets, but the most important is the exemption for equity in an owner occupied home. This is termed the homestead exemption. Bankruptcy exemption levels are set by the states (since the Federal Bankruptcy Code of 1978) and vary widely across states and over time. In seven states, the homestead exemptions are unlimited.
In other states, such as Maryland and Delaware, they are zero. All other states lie somewhere in between. There are also personal property exemptions for items like motor vehicles, jewellery etc. Chapters 11 and 13 are reorganization procedures. Chapter 13 is available to consumers and sole proprietors, and Chapter 11 to any type of business entity. Both procedures require the debtor to come up with a repayment plan out of future income. However, the amount of debt discharged approaches that under Chapter 7. In effect, the bankruptcy procedure provides failed entrepreneurs the ability to get back on their feet by reducing or eliminating their pre-bankruptcy debts.
Given the protections that the bankruptcy system affords to entrepreneurs, it is not surprising that it has implications for entrepreneurial activity. For example, Fan and White (2003) and Mathur (2009) exploit the variation in the homestead exemptions (the largest type of exemption) across states and find that the predicted probabilities of starting and owning a business are higher in states with more generous exemptions. Further, Mathur (2009) also suggests that entrepreneurs are more likely to start businesses in states whose neighbors have less generous exemptions. Therefore, the bankruptcy system is a significant predictor of entrepreneurial activity. At the same time, however, bankruptcy systems that are too pro-debtor impose costs on borrowers. Credit markets react adversely to these generous provisions by raising the cost of credit or reducing the availability of credit.
For example, Gropp, Scholz and White (1997) and Berkowitz and White (2004) show that the existence of generous homestead and personal property exemptions across states could have a negative impact on low-income households and small businesses by reducing the availability and amount of credit, and raising interest rates. Lin and White (2001) similarly show that applicants for mortgages are 2 percentage points more likely to be turned down for mortgages and 5 percentage points more likely to be turned down for home improvement loans if they live in states with unlimited rather than low homestead exemptions. Hence the literature clearly suggests costs and benefits of bankruptcy regulations on entrepreneurship.
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Beyond Bankruptcy: Does the Bankruptcy Code Provide a Fresh Start To Entrepreneurs?
