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Small Business or Consumer?

posted by Bob Lawless

Leslie Eaton of the N.Y. Times today reports on the state of small business in New Orleans, one year after Hurricane Katrina. It is a great article, exploring the relationship of small business both to the social fabric and economic health of a community. In the article are stories about the financial decisions small-business owners have made in recovering from Katrina's devastation. A restaurateur expresses hope that he has not made a "foolish decision" by using all of his savings to reopen his restaurant. To cover losses stemming from months when her store was closed and slow sales since reopening, a shopkeeper has "mortgaged her house to the hilt" and borrowed from in-laws.

Whether these are reasonable risks or foolish decisions, these stories illustrate that "consumer" credit policy presents subtle and highly textured issues. First, I highlight "consumer" because one wonders how to classify the financial decisions of these business owners. Are these consumer debts or business debts? If the restaurateur now begins to rack up credit card debts for his daily living expenses because his savings are sunk into the business, how do we count that? Is the shopkeeper's home mortgage a business debt? For a significant segment of the public, their financial affairs are in a gray area between consumer and business. About one out of every seven bankruptcies, for example, is someone that is or recently was self-employed. Most every small-business owner's personal and business affairs are intertwined and interdependent.

One might wonder why these small-business do not incorporate or form a limited liability company, to separate business and personal affairs. The answer is that they may have done do so, but why does it matter if they have put their personal credit at risk to finance the business? Even if they have not, that can be a rational decision. With the press of all the other demands of a small business, the time and expense it takes to incorporate may not seem worth it if you have put your personal credit on the line anyway. Regardless of the fiction of legal separateness, small-business owners cannot financially walk away from a failed business.

When we think about "consumer" credit policy, we are thinking about different groups, and small-business owners comprise one of these groups. Often, however, consumer credit policy thinks about consumers monolithically. The monolithic image that often results is the irresponsible, overspending, unsophisticated consumer, and we end up with rules that are unsuitable for large portions of the public. An example is the new bankruptcy requirement that all individual filers undergo consumer credit counseling. If the New Orleans business owners mentioned in the N.Y. Times article later end up in bankruptcy court, query what credit counseling would tell them. Don't take business risks? The credit counseling requirement is just one example. Last year, I taught a seminar where looked at a host rules that looked great for consumers or looked great for big businesses but did not work well for small business owners.

Credit and bankruptcy laws directed at consumers will sweep in small-business owners. At that point, another law may come into play--the law of unintended consequences.


Bob, I'm curious if you have recommended solutions to this. For example, in your latter remarks about the credit counseling, are you suggesting that you favor limiting the appication of the consumer credit counseling requirement to only those individuals with primarily consumer debts, like 707(b)? Does this mean you favor even more delineation in the rules of bankruptcy by type? Or is the problem that the rules of bankruptcy have become too particular based on the wrong model?

First, I was not thinking just about bankruptcy but about credit policy more broadly. On prebankruptcy credit counseling specifically, I think the whole endeavor is pointless, and it should be repealed generally. If we are going to keep consumer credit counseling--and realistically there is no chance it will be repealed--then it should be limited to persons with primarily consumer debts. But, even then, we run into definitional problems about what it means to be a person "with primarily consumer debts."

There are other parts of the Bankruptcy Code that deserve reconsideration for small-business owners. For example, the chapter 13 confirmation rules in their now rigid form are not well suited for a business owner with ups and downs in income. The chapter 11 process has become too cumbersome and expensive for small businesses, and the 2005 amendments introduced a host of new "gotchas"--small technical requirements--that become grounds for dismissal of a chapter 11.

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