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Bankruptcy For Growth? No More

March 21, 2001

Bankruptcy law used to be the part of our legal system that restored productivity after financial failure: the legal sun that melted the incapacitating ice of financial frost.

If Congress has its say, that will no longer be true.

Bankruptcy law is full of tricks for making people and assets productive again, after a financial calamity destroys productivity. The right to a speedy fresh start, reorganizations of businesses and numerous other provisions are tools that routinely contribute to the national product.

The fresh start means that honest but unlucky individuals who surrender their assets have their debts erased.

If John Doe is hit by an accident causing huge liabilities and has the prospect of creditors taking every single dollar he makes, his incentive to work is diluted. Bankruptcy law restores his failed productivity, albeit at his creditors' expense.

Creditors are also forced to serve productivity. They have an incentive to ensure they lend to the able, that they monitor their debtors' financial affairs and that they provide assistance to them when necessary.

That is the image of the banker we have from tradition and from the movies like "It's A Wonderful Life." Now that such bankers have disappeared, venture capitalists have profitably undertaken their former hands-on role.

The fresh start is nothing new. Ancient Rome may have given creditors extraordinary powers for persecuting their debtors, but with the empire's economic success came the realization that lenience pays.

From the times of Augustus (or, according to some, Caesar), debtors had available a fresh start under the process of cessio bonorum, by which the debtor erased his debts by ceding his goods to his creditors, very much along the lines of modern bankruptcy law.

After tortured transitions in the Middle Ages, when cessio bonorum took on the stigma of sin, England reinstated the discharge of debts as the carrot with which to reward honest debtors.

Reorganizations also arose to help creditors. At times of recessions, depressions and credit crunches that prevent the large-scale borrowing that is necessary for a new buyer to acquire a big business, there may be no buyers for a business that should stay in operation. Lenders to railroads experienced this and - certainly not for the first time - would buy the business in sham foreclosures using "credit bids," the money that the business owed them.

The passage of the Chandler Act of 1938 formalized reorganizations by creating processes inside bankruptcy for what had already been going on.

Reorganizations also save productivity. Recessionary environments with a dearth of buyers imply that some businesses may be liquidated that should not. In other words, the productive capacity of the business may be falsely destroyed.

Reorganization law takes away the threat of an immediate liquidation, saving the productivity that might have been destroyed and preventing a cascade of sales that lead to price drops, leading to foreclosures and more sales.

The bankruptcy reforms that the House and Senate have passed strike at the best and most valuable features of bankruptcy law. The reforms reduce the contribution to productivity restoration of both the fresh start and of the reorganization process.

The debtors who have the greatest productive abilities are those who society would benefit most by restoring to productivity as fast as possible by means of a speedy fresh start. The proposed bankruptcy reform would tie up those debtors with five-year "Chapter 13" processes for all debtors with incomes above each state's median income.

Small businesses are our traditional engine for growth. Bankruptcy reform fast-tracks the reorganization of small businesses. The increased hurry, of course, will only make it harder to find a buyer for the business and correspondingly increase the likelihood of the destruction of its productivity.

Not only does society lose the contribution of the falsely closed small businesses, but the reform also chills their creation. Starting a business becomes less attractive because small businesses are less recession-proof.

The campaign donations of financial giants are buying bankruptcy changes that seem good for credit card companies, but even those are good only during economic booms. The nation is paying a heavy price. Productivity revival is curtailed and the small business environment is chilled.

Nicholas Georgakopoulos is a professor of law at the University of Connecticut School of Law and a visiting professor at the Indiana School of Law in Indianapolis. His teaching and research focus on bankruptcy and corporate law, and the U.S. Supreme Court has cited his bankruptcy research.

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