The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 affects small businesses at both ends of the spectrum. For growing companies, it gives them more power to recover bad debts. At the same time, it makes bankruptcy a larger liability for entrepreneurs and their investors.
"Any change that makes it harder to get out of debt makes life better for small businesses," says Luis Salazar, a bankruptcy attorney for Greenberg Traurig. "If you have a financially sound company, you are worried about collecting from other people. This law keeps them out of bankruptcy and makes them pay."
According to Mr. Salazar, the consensus opinion among bankruptcy specialists is that this is "the best bankruptcy act money can buy." During debate in the Capitol, Representative Bill Delahunt, a Democrat from Massachusetts, said the "act was written by and for the credit card industry, and they spent north of $40 million to make sure that they got what they wanted."
Lobbyists for the act included the American Bankers Association, the U.S. Chamber of Commerce, and credit card issuer MBNA. Congressman F. James Sensenbrenner Jr., Republican from Wisconsin and the act's main sponsor in Congress, called it "truly a bipartisan effort," although only eight Democrats appear among his 88 co-sponsors. However, the final 302-126 vote in the House and 74-25 in the Senate demonstrate support from both parties.
Under the new law, debtors who make the average income in their state won't be able to walk away from their debts easily. Also, the law restricts the wealth a bankrupt person can hide from creditors in home equity (see box, "New Regulations"). Currently, most people file Chapter 7 bankruptcy, which provides for a court-appointed trustee to divide the available assets among creditors. Chapter 13 bankruptcy covers people who own a home and may restructure the debt to pay off creditors.
"The new law drives people into Chapter13," says Mr. Salazar. "The underlying theory is that bankruptcy is abused, so the idea is to push people above the median income into Chapter 13. The court will decide if they are able to pay."
In general, the law focuses on consumer bankruptcies, which officially account for 98 percent of all filings. For example, of the 1.6 million bankruptcies filed last year, only 34,317 were business bankruptcies, according to the Administrative Office of the U.S. Courts. But a study released in June from the Ewing Marion Kauffman Foundation estimates the true number of business bankruptcies at 260,000 to 315,000. The discrepancy comes from the fact that nearly all small businesses start as sole proprietorships, meaning the business and the owner's personal finances are legally the same.
Rene Diaz, a California-based financial consultant affiliated with Fiducial, has seen many small business clients go under, and in every case they filed for Chapter 7 as sole proprietors. "When they order supplies, they might use personal credit cards. The vehicles for the business are in their names. So when the business defaults, they're still liable," he says.
The line between personal and business obligations often blur at the point of home ownership. Many state laws protect a person's home from creditors, but filers often abuse this so-called "homestead exception." Mr. Salazar says that Florida and Texas have reputations as homestead states. In the past, people have moved to these states, purchased mansions, and declared bankruptcy while protecting their wealth in the form of home equity.
The new law cracks down on this practice, but legitimate businesses may get caught in the legal switch. Mr. Diaz says that when companies get in trouble, conventional financing often dries up. To keep the business afloat, the owner may tap his or her home equity. But in Mr. Diaz's experience, turnarounds never work for these firms, and both the house and the business debts become part of the bankruptcy.
The few business-specific sections of the new law deal with commercial real estate and international trade. "For small businesses with [commercial] real estate, the law will improve their control over recovering rent," Mr. Salazar says. In particular, the law sets time limits for a bankrupt tenant to decide on keeping a lease.
In international trade, the law brings the United States into alignment with a United Nations model for handling cross-border bankruptcies. Since Mexico was an early adopter of the U.N. model, this means "there will be certainty between the U.S. and Mexico in the resolution of disputes, because both nations have a similar statute," says Josefina Fernandez McEvoy, head of the Southern California bankruptcy and restructuring practice group at the law firm Squire, Sanders & Dempsey in Los Angeles. "I anticipate an influx of business and a lot of capital inflows to Mexico."
Operationally, "the new law changes the game because U.S. courts are authorized to cooperate and coordinate cross-border bankruptcies with foreign judges," which they could not do previously, according to Ms. McEvoy.
The new law makes it easier for small corporations to file under Chapter 11, the type of bankruptcy that allows firms to reorganize. "If you have debt below $2 million, you can do a small business Chapter 11 and it's easy," Mr. Salazar explains. He expects that the law will reduce the number of third-party lawsuits sur-rounding Chapter 11 bankruptcies, because the law requires these suits to be filed in the venue where the defendant exists rather than in Dela-ware, where most large companies incorporate.
While the new law gives businesses stronger collection rights, it might inadvertently discourage the formation of new businesses in the first place, according to the Kauffman study. "Our economic system needs to encourage entrepreneurs to make new investments. Sometimes these investments will fail through no fault of their owners, and when that happens, the owners need to be able to move to other businesses and create new jobs and investment opportunities," says Elizabeth Warren, co-author of the study and a professor at Harvard Law School.
"We need to appreciate the enormous risks that entrepreneurs take on, and the number of times many of them must try, fail, and try again until they hit the right idea at the right moment," explains Carl Schramm, CEO of the Kauffman Foundation. "Before taking final action, America's decision makers should be sure to assess the impact of proposed legislation on the thousands and thousands of entrepreneurs who create jobs and innovations, and who fuel our country's economic growth."
Despite the changes in bankruptcy code, one rule remains firm: You must pay your taxes, which Mr. Diaz says is often the largest single "debt" on the books. While individuals can escape with only paying three years of personal income taxes, businesses generally cannot avoid payroll and sales taxes. "I've seen cases with [unpaid] taxes over $1 million," he says. "You could have bills to pay for the rest
of your life."
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 contains these changes to current law:
RAISING THE BAR A new "means" test will determine if a debtor can afford to repay part of the debt. The test assumes people can repay if they make more than the median income in their state. (The national median household income equals $54,000 for a family of four.)
CREDIT EDUCATION To file for bankruptcy, a person must receive credit counseling within 60 days; to finalize the bankruptcy, the person must complete a financial literacy course. The idea is to help the debtor learn the U.S. financial system.
HOME EQUITY State laws protect from creditors some or all of the value of a primary residence, and debtors have taken advantage of this by buying big homes and then declaring bankruptcy. The new law restricts this "homestead exemption."
COMMERCIAL REAL ESTATE For commercial bankruptcies, the new law eliminates a $4-million cap on single-asset real estate cases, meaning that real estate holding companies or developers with large real estate holdings must put together a reorganization plan within 30 days or turn over properties to creditors.
TRUSTS Because debtors may use trusts to hide assets, the new law gives officials authority to void any transfer to a trust for up to 10 years prior to the bankruptcy filing.
Source: American Bankers Association
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