Creditor Rights and Entrepreneurship: Evidence from Fraudulent Transfer Law

In this paper, we document a slowdown of entrepreneurial activity following the adoption of fraudulent transfer laws in the United States.

Fraudulent transfers are viewed legally in two ways: actual fraud or constructive fraud. Actual fraud refers to actions taken by the debtor with the intent to diminish the claims of its creditors. Constructive fraud refers to actions taken by the debtor that, as a result of the economic circumstances surrounding the transaction, ended up diminishing the claims of its creditors. In a state with fraudulent transfer laws based on actual fraud, the burden of proof is on the creditor to clearly demonstrate the fraudulent intent of the debtor. In a state with fraudulent transfer laws based on constructive fraud, however, all that is necessary is that debtor’s business operations are sufficiently poor. A shift to a constructive-fraud based system therefore improves creditor rights, particularly those of unsecured creditors.

While the adoption of a constructive view of fraud is likely to expand the supply of credit via a reduction in debt enforcement costs, the effects on credit demand, however, are less clear. Transfers may be an important component of asset protection for certain businesses and therefore serve an insurance function by limiting the owner’s downside risk. Such a change in the law might then cause risk-averse owners to reduce the equilibrium level of credit.

We argue that the impact of fraudulent transfer law is likely to be larger for entrepreneurial firms. It is common in large bankruptcies for unsecured creditors to pursue adversary proceedings, or suits that are separate from, but related to, the bankruptcy case, based on the avoidance of transfers. In contrast, the impact of constructive fraud laws, to the extent that they hinder business growth, should be stronger for start-ups because, first, entrepreneurs are more likely to have personal assets co-mingled with those of the business, and, second, large businesses are more likely to reorganize or have control over matters of jurisdiction in insolvency.

To investigate this hypothesis, we study the real impact of an increase in unsecured creditors' rights by employing a difference-in-differences methodology that exploits the staggered adoption of constructive fraud statutes by states that formerly had lax fraudulent transfer policies. Drawing on establishment-level data from the US Census Bureau, we find that states experience a significant decline in entrepreneurial activity in the years following the adoption of constructive fraud laws.

We observe substantial declines in both start-up entry and closure rates after the passage of constructive fraud laws. The decrease in entry rates occurs both among the smallest businesses that succeed and fail within three years of starting up, suggesting creditors are not able to screen out the riskier borrowers. We find similar negative effects when we compare start-up entry and exit with intensive margin adjustments made by incumbent, multi-unit firms that are unlikely to capture entrepreneurial activity. We further examine heterogeneity of the average treatment effect and find that the effects are present only among the smallest single-unit firms with between one and five employees. In addition, we find that effects are present only for firms in industries with low levels of start-up capital, where owners’ financing using personal assets as collateral is more likely to be feasible.

Taken together, our results indicate that expanding laws which allow unsecured creditors to reclaim a higher fraction of assets upon business failure discourage start-up creation and extend the survival of old ventures. This suggests a potentially negative spillover from adopting a constructive definition of fraud: entrepreneurs may become constrained in their ability to redeploy assets into new and potentially more productive uses.