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Severed Ties

Bankruptcy reforms threaten to cut entrepreneurs off from protective measures.

New legislation aimed at reforming the bankruptcy system will eliminate a much-needed safety net for America's small businesses, casting a pall over not only aspiring entrepreneurs but established businesses as well, experts say.

"It will chill the formation of startup businesses," predicts Robert Lawless, a law professor at the William S. Boyd School of Law at the University of Nevada, Las Vegas. "It would have the same effect on businesses taking on new investment risk. It's going to dampen the enthusiasm both to start new businesses and expand existing ones."

Lawless co-authored a recent study that examines the impact of bankruptcy reform on small business. Chief among its findings: The U.S. government has grossly underestimated the number of entrepreneurs affected by the bankruptcy reforms. According to the study, which was funded by the Ewing Marion Kauffman Foundation in Kansas City, Missouri, small-business owners file an estimated 260,000 to 315,000 bankruptcies annually, which is nine times higher than the government's official tally.

What's more, the study found, government statistics report that business bankruptcies have declined steadily since the mid-1980s--when businesses comprised about 18 percent of all bankruptcy filings--to their present-day total of only 2 percent. That is in stark contrast to annual statistics compiled by D&B and the SBA, which reveal a significant increase in small-business failures during the same period.

The government's statistics, the study maintains, reflect efforts in the mid-1980s to simplify the bankruptcy reporting process as well as the use of new computer software, which changed the way attorneys completed forms used to compile the government statistics. Consequently, many entrepreneurs who declare bankruptcy are now classified as consumers cases rather than business cases.

Entrepreneurship advocate Bob Litan, vice president of research and policy at the Ewing Marion Kauffman Foundation, is concerned about the long-term effect of bankruptcy reforms on business development in the United States. Litan notes there is evidence that
in countries with weak bankruptcy protections, entrepreneurial activity is adversely affected: "It's something that's in the back of people's minds: If you take away the system, you [can] lose everything--your house, your car, your furniture."

By the same token, some existing business owners will likely pass up growth opportunities in an effort to minimize financial risk. "I think that as it dawns on people already in business that it's going to be tougher to get bankruptcy protection, they may be more risk-averse," Litan explains. While entrepreneurs--and aspiring entrepreneurs--should carefully evaluate risks before making business decisions, "[taking risks] is the only way some businesses can grow."

Standing Your Ground
In June, the Supreme Court upheld cities' right to use eminent domain, or condemnation, to give land to large businesses to bolster economic development. (In the past, eminent domain was typically reserved for public uses, such as building roads.) Since bigger companies can deliver more tax revenue to cities, the ruling will make it more difficult for small landholders to fight eminent domain in state courts.

Still, entrepreneurs have some recourse. The Senate and the House of Representatives are considering limiting the use of eminent domain to benefit big business; state legislatures have taken up the issue; and small landholders, via an organization called the Castle Coalition, have organized protests denouncing the ruling. Eminent domain opponents are even getting creative: One group is trying to condemn Supreme Court Justice David Souter's property.

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This article was originally published in the October 2005 print edition of Entrepreneur with the headline: Severed Ties.

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