Konkurs, Klein- und Mittelunternehmen, Insolvenzrecht, Rechtsreform, Vereinigte Staaten, Bankruptcy, Small and medium-sized enterprises, Bankruptcy law, Legal reform, United States

Michelle White

English

Research Papers in Economics

BANKRUPTCY AND SMALL
BUSINESS – LESSONS FROM
THE U.S. AND RECENT
REFORMS
MICHELLE J. WHITE*
Small business is an important part of the U.S. econ-
omy – about 11% of U.S. households include one or
more self-employed workers.1 Among the govern-
ment policies that encourage small business and self-
employment is bankruptcy law. U.S. bankruptcy law
makes it more attractive for individuals to start and
own small businesses by providing a soft landing if
businesses fail: business owners can file for personal
bankruptcy,their business and personal debts will be
discharged, their future earnings will be exempt
from the obligation to repay,and they may be able to
keep their homes and other assets. The fact that
about 17 percent of all personal bankruptcy filings in
the U.S. include some business debt suggests the im-
portance of bankruptcy policy for small business.2
In this article, I first describe small business bank-
ruptcy law in the U.S.Then I discuss research on the
effect of bankruptcy law on individuals’ decisions to
become self-employed and on business credit mar-
kets. Finally I discuss the effects of the bankruptcy
reform legislation that went into effect in the U.S. at
the end of 2005. The reform changed the treatment
of small business owners in bankruptcy and may dis-
courage self-employment.
U.S. bankruptcy law and small business 
Because many small businesses are unincorporated,
the business and its owner are legally the same.This
means that debts of the business are personal liabili-
ties of the business owner.Therefore when an unin-
corporated business fails, its owner is liable for a
mixture of business and personal debts and the rele-
vant bankruptcy law is personal bankruptcy law.
Personal bankruptcy law is also important for many
small corporations that fail. This is because lenders
that make loans to small corporations often require
the owner to personally guarantee the debt and/or
allow the lender to take a lien on the owner’s house.
These guarantees and liens abolish the legal distinc-
tion between the corporation and its owner for pur-
poses of the particular loan.
Chapter 7 of the U.S.Bankruptcy Code provides sev-
eral important protections for small business owners.
First, owners of failed businesses are allowed to file
for personal bankruptcy under Chapter 7, where
both their unsecured personal and business debts are
discharged. Second, debtors’ future earnings are
completely exempt from the obligation to repay pre-
bankruptcy debt,so that they can start new business-
es or take jobs working for others without having
their future earnings taxed to repay their old debts.
The 100 percent exemption for future earnings ap-
plies all over the U.S. and is referred to as the “fresh
start.” Third, business owners (like other debtors in
bankruptcy) must use all their wealth above an ex-
emption level to repay pre-bankruptcy debt.Exemp-
tion levels are set by the 50 U.S. states and they vary
widely. Higher exemptions encourage individuals
– particularly those that are risk-averse – to become
self-employed, since they will be allowed to keep
more of their assets if the business fails. In high ex-
emption states, owners of failed businesses may be
able to keep their homes and other assets, while in
low exemption states they keep little more than their
clothes, furniture and cooking utensils.
Most states have several bankruptcy exemptions for
different types of assets, but the most important is
the exemption for equity in an owner-occupied
home – the “homestead” exemption (see Table). As
of 2006, six U.S. states – including Florida and Texas
– have unlimited homestead exemptions. Unlimited
exemptions allow individuals or couples who file for
bankruptcy to shelter millions of dollars of assets
from creditors,as long as the assets are converted in-
CESifo DICE Report 1/2006 22
Forum
* Michelle J.White is Professor of Economics at the University of
California, San Diego, Research Associate at NBER and a CESifo
network member.
1 See Fan and White (2003).
2 See Lawless and Warren (2005).CESifo DICE Report 1/2006 23
Forum
to equity in an owner-occupied home before the
bankruptcy filing occurs. Other states have exemp-
tions that are high but not unlimited – for example,
Massachusetts and Minnesota have homestead ex-
emptions of $500,000. At the other end of the spec-
trum,four states have no homestead exemption at all
and 13 other states have homestead exemptions of
$10,000 or less. Besides the homestead exemption,
most states exempt clothing, furniture, and cooking
utensils, and some have small exemptions for equity
in a motor vehicle, other types of personal property,
and some types of insurance and retirement ac-
counts.3
The effect of bankruptcy exemptions on small 
business 
How does variation in bankruptcy exemption levels
across U.S. states affect small business and entrepre-
neurial behavior? One hypothesis is that, in states
with higher exemption levels, individuals are more
likely to own businesses because generous exemp-
tions cushion them against the consequences of busi-
ness failure. Another hypothesis is that small busi-
ness lenders are more likely to deny applications for
credit from small businesses that are located in high
exemption states, because entrepreneurs in those
states are more likely to file for bankruptcy and less
likely to repay.
To test these hypotheses, I and two co-authors ex-
amined entrepreneurship patterns and markets for
business credit across states with different exemp-
tion levels. We used the home-
stead exemption as the basis for
comparison, because it is both the
largest exemption in nearly all
U.S. states and the most variable.
We took account of the fact that
renters cannot make use of home-
stead exemptions and, therefore,
they cannot shelter as many assets
when they file for bankruptcy.
Bankruptcy thus provides a much
more generous “insurance policy”
for homeowners who go into busi-
ness than for renters.
Effects on entrepreneurship 
Wei Fan and I used the Survey of Income and Pro-
gram Participation, a large panel dataset of U.S.
households, to examine how variations in bankrupt-
cy exemptions across states affect individuals’ deci-
sions to choose self-employment versus working as
an employee. Our data cover the years 1993-98. We
estimated a model explaining whether households
contain one or more workers who are self-employed
as a function of the bankruptcy exemption level in
the household’s state of residence plus control vari-
ables.The homestead exemption was represented as
a series of dummy variables representing quartiles of
the exemption distribution, plus an additional dum-
my variable for unlimited homestead exemptions.
To allow the effect of higher exemption levels to dif-
fer for homeowners versus renters, we interacted all
the homestead exemption variables with a dummy
for owners versus renters.
For households that are homeowners, we found that
the probability of owning a business increased from
0.101 in the lowest quartile of the exemption distrib-
ution to 0.135 in unlimited exemption states – or an
increase of 35 percent over the entire range. For
renters, the increase over the same range was from
0.083 to 0.107 – or 29 percent.Both increases are sta-
tistically significant. These results imply that both
homeowners and renters respond strongly to in-
creases in the homestead exemption in making their
decisions to be self-employed.For renters,the strong
response probably reflects the fact that most renters
expect to become homeowners in the future.
The average business owned by a self-employed per-
son is small.We therefore re-estimated the model for
large businesses, defined as having net business in-
3 Other features of U.S. bankruptcy law are uniform all over the
U.S. For a more detailed discussion of bankruptcy law and eco-
nomics and additional references, see White (2005).
Chapter 7 U.S. Bankruptcy Code:
Protection for failedsmall business owners 
Exemptions from creditor’s access to the debtor’s
Wealth
Future earnings Owner occupied housing
(“Homestead exemption“) Other
100% exemptionin all
U.S. states (allowing a 
“fresh start“) 
Note: This provision was
changedin the 2005 
reform. See text.
• Exemption unlimited in
6 U.S. states (e.g. Florida,
Texas)
• Exemptionup to $500,000 
e.g. in Massachusetts and
Minnesota
• Exemptions up to $10,000 in
13 U.S. states
• No exemption in two U.S. 
states
Most U.S.states
exempt goods of
daily necessity
and some types
of insurance and 
retirement
accounts.
  Source: Author.come greater than $2,000 per month. We found that
the probability of homeowners owning big businesses
was 28 percent higher in states with unlimited home-
stead exemptions as compared to states with exemp-
tions in the lowest quartile.This increase was statisti-
cally significant. For renters, the relationship was also
positive, but it was not statistically significant.
We also examined whether entrepreneurs behave dif-
ferently depending on whether their businesses are
incorporated or not. We predicted that owners of
non-corporate businesses would respond more strong-
ly to changes in homestead exemption levels than
owners of corporate businesses, because owners of
corporate businesses are less likely to be personally
responsible for their businesses’ debts.They therefore
are less likely to be affected by whether the exemp-
tion levels in their states are high or low.
For homeowners, we found that the probability of
owning a non-corporate business was 37 percent high-
er in states with unlimited exemptions than in states
with exemptions in the lowest quartile, while home-
owners’ probability of owning a corporate business
was 14 percent higher. Both increases were statistical-
ly significant. Finally, we examined whether home-
owners are more likely to start (as opposed to own)
businesses if they live in states with high homestead
exemptions.We found that their probability of starting
a business was 23 percent higher in states with unlim-
ited exemptions than in states with low exemptions.
These figures, taken together, indicate that bank-
ruptcy law has a strong effect on whether workers
choose self-employment.
Effects on small business credit
In the second study, Jeremy Berkowitz and I exam-
ined how bankruptcy exemptions affect small busi-
ness credit markets. We used data from the 1993
National Survey of Small Business Finance, which is
produced by the Federal Reserve Board of Gover-
nors and the U.S.Small Business Administration.The
survey covers businesses with up to 500 employees.It
asks managers whether they applied for credit during
the previous three years and,if so,whether they were
turned down. It also asks managers whether they
were discouraged from applying for loans during the
previous three years because they anticipated being
turned down. We defined small businesses as credit
rationed if they were either turned down for credit or
discouraged from applying.We ran a regression mod-
el that explains whether small businesses are credit
rationed as a function of the homestead exemption
level in the firm’s state and control variables.We al-
so included measures of whether the firm or its own-
er previously experienced financial distress or filed
for bankruptcy.We ran separate regressions for non-
corporate versus corporate firms.
One problem with these regressions is that higher
exemptions affect both supply of and demand for
business credit. Demand for business loans rises in
high-exemption states because entrepreneurs are
more willing to borrow and invest when they have
additional wealth insurance. However the supply of
business loans falls in these states, because entrepre-
neurs are more likely to default and file for bank-
ruptcy and this makes lending less profitable. The
overall effect of higher exemptions on the extent of
credit rationing depends on whether lenders reduce
the supply of credit by more or less than entrepre-
neurs increase demand.
Holding other factors constant, our results show that
the probability of a non-corporate firm being turned
down for credit rises from 0.122 at the 25th percentile
of the exemption distribution to 0.196 at the 75th per-
centile – an increase of 32 percent. We also find that
the probability of a corporate firm being turned down
for credit rises from 0.196 at the 25th percentile to
0.255 in unlimited exemption states – an increase of
30 percent. Both increases are statistically significant.
These results imply that both types of firms are more
likely to be credit-rationed if they are located in
states with high rather than low exemptions.The re-
sults also imply that, holding other factors constant,
corporate firms are more likely to be credit-rationed
than non-corporate firms at all exemption levels.
This makes sense because non-corporate firms have
both the firm’s and the owner’s assets to back up
their loans, while corporate firms have only the
firm’s assets. Finally we found that small businesses
are three times as likely to be credit rationed if they
or their owners have previously filed for bankruptcy
and twice as likely to be credit rationed if they or
their owners have previously experienced financial
distress. Thus past financial difficulties are a heavy
burden when small businesses attempt to obtain
credit.The effect is similar for corporate versus non-
corporate firms.
We also examined how high exemption levels affect
the interest rates that firms paid on their most recent
CESifo DICE Report 1/2006 24
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loan. Here higher exemption levels are unambigu-
ously predicted to cause interest rates to rise, since
both the demand increase and the supply decrease
point in the same direction.For non-corporate firms,
we found that interest rates rise by more than 2 per-
centage points when firms are located in states with
unlimited homestead exemptions rather than in
states with exemptions at the 25th percentile of the
distribution. For corporate firms, interest rates rise
by 0.83 percentage points when firms are located in
states with exemptions at the 75th percentile versus
the 25th percentile.Since some corporations are cred-
it-worthy enough to be able to borrow on their own,
it is not surprising that interest rates paid by non-
corporate firms are more sensitive to changes in ex-
emption levels than interest rates paid by corporate
firms. We also found that a past bankruptcy filing is
associated with interest rates that are 5.4 percentage
points higher for non-corporate firms and 2.1 per-
centage points higher for corporate firms.
A final result is that both corporate and non-corpo-
rate firms receive smaller loans if they are located in
states with higher homestead exemptions. For both
types of firms, loan size is $70,000 to $80,000 smaller
if firms are located in states with homestead exemp-
tions at the 75th percentile rather than the 25th per-
centile.
Overall, these results suggest that small businesses
face more difficulty in raising capital if they are lo-
cated in states with high exemption levels, but – de-
spite this barrier – more individuals in these states
choose to be self-employed.
Small business under the 2005 U.S. bankruptcy 
reform 
The most significant change made to U.S. personal
bankruptcy procedures under the 2005 reform is that
debtors no longer have an automatic right to file for
bankruptcy under Chapter 7. Instead they must un-
dergo a new “means test,” which compares their in-
come to the median income level in their states. If
debtors’ income per month is more than $100 above
the monthly median income in their states, then they
may be forced to file under another personal bank-
ruptcy procedure, Chapter 13, which has no “fresh
start.” Debtors in Chapter 13 must use part of their
post-bankruptcy earnings for five years to repay their
debt. The repayment requirement is based on a for-
mula developed by the Internal Revenue Service for
delinquent taxpayers. It sets a fixed dollar repayment
requirement per month that in some cases could be
more than the debtor actually earns.4 However the
new means test applies only to debtors who have “pri-
marily consumer debts”, so that small business own-
ers are allowed to bypass it and file under Chapter 7
as long as most of their debt is business debt.For own-
ers of failed businesses who file under Chapter 7, the
bankruptcy reform also makes it more difficult to
shelter financial assets using states’ homestead ex-
emptions, since it includes new restrictions on con-
verting non-exempt assets into exempt home equity
and on moving to Texas or Florida to take advantage
of their unlimited homestead exemptions before fil-
ing. Finally the new law substantially increases the
costs of filing for bankruptcy and imposes new paper-
work and nuisance requirements.5
The research discussed here suggests that potential
entrepreneurs are very responsive to the terms of
the “bankruptcy insurance” policy. The new law re-
duces the amount of insurance that bankruptcy pro-
vides by requiring entrepreneurs to repay more from
wealth or future earnings when their businesses fail.
It therefore forces entrepreneurs to bear greater risk
and provides a much harder landing for those whose
businesses fail.As a result, many potential entrepre-
neurs will find it less appealing to go into business
and fewer new firms are likely to be started each
year in this U.S. This change will have both positive
and negative effects. On the positive side, some en-
trepreneurial activity in the United States is essen-
tially disguised unemployment and wiping it out will
have little adverse effect. Also, business owners are
likely to find it easier to obtain credit, because
lenders will be more willing to extend business loans.
But on the negative side,some of the businesses that
never get started will inevitably involve innovative
new ideas that would have generated jobs and eco-
nomic growth. The result may be higher unemploy-
ment and lower economic growth in the U.S.
References 
Berkowitz, Jeremy and Michelle J. White (2004), “Bankruptcy and
Small Firms’ Access to Credit”, RAND J. of Economics, vol. 35:1,
pp. 69–84.
Fan, Wei and Michelle J. White (2003), “Personal Bankruptcy and
the Level of Entrepreneurial Activity”, Journal of Law & Econo-
mics, vol. 46:2, pp. 543–568.
4 This differs from the pre-reform Chapter 13 bankruptcy proce-
dure, which was voluntary rather than mandatory and allowed
debtors to propose how much they would repay.These plans often
involved only token repayment amounts.
5 See White (2006) for discussion of the 2005 U.S. bankruptcy re-
form.Lawless, Robert M. and Elizabeth Warren (2005),“The Myth of the
Disappearing Business Bankruptcy”, California Law Review, vol.
93, p. 743.
White, Michelle J. (2005), “Economic Analysis of Corporate and
Personal Bankruptcy Law”, NBER working paper 11536. To be
published as “Bankruptcy Law”, in Handbook of Law and Econo-
mics, edited by A.M. Polinsky and Steven Shavell. Elsevier.
White, Michelle J. (2006), “Abuse or Protection? Bankruptcy Re-
form under ‘BAPCPA’”, Working paper, available at www.econ.
ucsd.edu/~miwhite.
CESifo DICE Report 1/2006 26
Forum

Abuse or Protection? Bankruptcy Reform under ‘BAPCPA’”, Working paper, available at www.econ.

Bankruptcy and Small Firms’ Access to Credit”,

Economic Analysis of Corporate and Personal Bankruptcy Law”, NBER working paper 11536. To be published as “Bankruptcy Law”,

for discussion of the 2005 U.S. bankruptcy reform.Lawless, Robert M. and Elizabeth Warren

Personal Bankruptcy and the Level of Entrepreneurial Activity”,

Bankruptcy and small business - lessons from the US and recent reforms

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Bankruptcy and small business - lessons from the US and recent reforms

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