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Personal Bankruptcy Law and Entrepreneurship

posted by John Armour

An issue that's been at the forefront of recent personal (i.e. non-corporate) bankruptcy reforms in Europe has been the notion that an unforgiving bankruptcy regime may act as a deterrent to starting a business. There's a strong perception in European policy circles that US bankruptcy law is more forgiving of overindebtedness, and that this in turn is linked to a more entrepreneurial business culture. Thinking of this sort (see, e.g., the Insolvency Service' Consultation Paper) underpinned the UK's recent relaxation of its personal bankruptcy laws (effective 1 April 2004), to permit individual bankrupts to obtain a discharge from prebankrupty indebtedness after only one year, as opposed to the three years it previously took. Similar policy initiatives, encouraged by the European Commission, have also been taking place in other European countries. There's a certain irony, however, that at the very time this has been going on in Europe, in the US-- the country offering the inspiration for reform-- access to a fresh start for individual debtors has been made more difficult. One of the important questions this raises is whether there really is a link between bankruptcy law and entrepreneurship.

In the US, Michelle White has looked at this issue using state-level data. She found that larger bankruptcy exemptions (in particular, the homestead exemption, which varies from state to state) were associated with greater willingness to run one's own business, as measured by self-employment statistics. The intuition is the same as the UK government's: a more forgiving bankruptcy regime is associated with greater willingness to run one's own business, as opposed to working for someone else. (To be sure, incorporating one's business will reduce that risk considerably, but as long as creditors can and do take personal guarantees, it is personal bankruptcy law that will provide the bottom line for downside risk).

From an international perspective, however, less is known about the links between differences in bankruptcy laws and entrepreneurship. When one compares across countries the bankruptcy regimes applicable to individuals who are running a business, the most striking difference, to my mind at least, is whether a fresh start is permitted at all for individuals (at least, without some form of composition with creditors), and if so, the length of time it takes before a debtor is permitted to obtain it.  For example, there was no fresh start available at all in Germany until 1999, and now it takes 6 years before a debtor receives a discharge. Similarly, in Belgium, there was no fresh start available until 1998; since then it has been possible for a debtor to receive an immediate discharge with the permission of the court.

Other differences between the treatment of individual bankrupts include the degree of disabilities to which persons who are 'in bankruptcy' (i.e., have not yet been discharged) are subjected-- in many jurisdictions there are restrictions on access to credit and involvement in running a business, but in some they are more severe. For example, in Italy, until 2006, a bankrupt debtor's ability to travel was restricted by seizure of his or her passport. There are of course also differences in the level of exemptions, although the US (or rather, some states in the US) seems to be something of an outlier in the generosity of exemptions.

In a recent empirical paper, Douglas Cumming and I seek to address the question whether these legal differences are associated with differences in entrepreneurship. We gathered information on 13 European and North American countries' personal bankruptcy laws over the period 1990-2005 (which was a huge undertaking-- if I'd had any idea at the start how much work this was going to be, I might not have set out on this project!) and constructed a series of indices along which the laws varied-including availability of, and time to, discharge; level of exemptions; disabilities imposed on bankrupts; level of creditor consent necessary to agree a composition; and minimum capital required to incorporate a business (we expected a high minimum capital to compound any deterrent effect of a tough bankruptcy law). We then looked for correlations between these indices and a number of different measures of self-employment (an imprefect proxy for entrepreneurship, but more sophisticated measures such as the GEM dataset are not available for the time period we are studying).

Our results (you can see the paper on SSRN here) are in the expected direction - a tougher personal bankruptcy law is associated with less entrepreneurship. Of course, we show only correlation, rather than causation, but we do test using lagged data on self-employment-- that is, we find a link between changes in bankruptcy law in year 1 and changes in self-employment in a year 2-- and we think it is more realistic to explain this by reference to a change in the law affecting subsequent self-employment, rather than vice versa.

Of course, a whole host of other things affect self-employment across countries, meaning that the correlation might be downto some unobserved variable not captured in our model. To minimise the chance of this, we used a country fixed effects specification, which controls for all national differences that don't change over time. We also control explicitly for some variables that do change over time and may be expected to impact business start-up rates-- GDP, stock market indices and patent creation data. Whilst it's still possible that other time-variant factors may be affecting the results, we think that our findings go a good way to establishing the link that European policy makers intuitively believe to exist.


This is the kind of scholarship that Congress should take into account when evaluating BAPCPA. It offers a solid factual basis for public policy, rather than the usual hand-wringing,chest-thumping and crocodile tears.

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