Better than Bankruptcy?

US bankruptcy, according to many, is failing small businesses. Federal bankruptcy law, it has been thought, provides the exclusive legal mechanism to reorganize a financially distressed business; experts have expressed concerns that the US Bankruptcy Code is simply a poor fit for small businesses. 

It is very expensive to reorganize under chapter 11 of the Bankruptcy code, generally. For many businesses, the small-business-specific bankruptcy laws raise the costs of bankruptcy and limit its effectiveness. Small businesses face higher reporting requirements, and they enjoy less flexibility in the plan confirmation process. In addition, the bankruptcy confirmation requirements (especially the “absolute priority rule” which permits creditors to insist on payment in full before owners retain any equity interest in the business) may impose a particularly high cost on owner-operators. 

Without an effective bankruptcy law for small businesses, there have been reports of small businesses turning to state debtor-creditor laws – whether state receivership or assignments for the benefit of creditors (ABCs). The conventional wisdom has been that such state laws provide only limited relief: federal bankruptcy law alone can impose a reorganization plan, and so state laws may serve as a mechanism only to liquidate a business. 

My research, reported in a forthcoming article Better than Bankruptcy?, challenges this conventional wisdom. Although there has been path breaking research examining the availability and popularity of ABCs as a liquidation device (see Mann and Morrison), this study is the first to report empirical data regarding the outcomes of such state procedures. Based on data gathered on every ABC filed in the Miami-Fort Lauderdale-Palm Beach metropolitan area over a three year period from 2012-2014, this study reports that many debtors use ABCs to reorganize, not liquidate.  Roughly forty percent of the businesses in this study used the ABC process to sell substantially all assets in a “free and clear sale.” The majority of these sales, in turn, were made to the old owners (or insiders of the old owners). Thus, business owners were able to discharge debts and retain ownership of their firms – a sort of relief generally thought to be available only under federal bankruptcy laws.

These findings raise important legal, systemic, and policy questions about the interaction of state debtor-creditor laws and the federal Bankruptcy Code. Understanding ABCs as reorganization alternatives, there may be serious federal preemption challenges, given that the ABCs are operating within the federal government’s power to enact “uniform laws on the subject of bankruptcies.” While I do not evaluate the merits of such claims in this article, I do suggest that such challenges – even if potentially successful – are unlikely to be raised, since the ABC process typically has the blessing of the secured creditor(s).

 These findings might also shed light on the failure rate of small business bankruptcies. Small businesses are less likely to confirm a plan of reorganization than are large businesses. While this may reflect problems with the US Bankruptcy Code as applied to small businesses, it may also reflect a selection effect: small businesses that file for bankruptcy may be ones that had attempted, but failed, to resolve their financial distress through the less expensive state law alternative. This data cannot support or refute that theory; rather, it simply points to this as a possible and as-yet-unexplored explanation for the failure rate of small business bankruptcy cases.

Finally, policy-wise, there may be serious concerns about these state law proceedings. On the one hand, to the extent that there should be some legal tool to preserve going concern value, these state law alternatives may serve a valuable role. When federal bankruptcy fails, state law alternatives (however imperfect they may be) are better than having no corporate reorganization option at all. On the other hand, these state law procedures may be less costly to debtors because they shift costs on to other creditors – in particularly on to unsecured creditors. This suggests the need for a deeper cost-benefit analysis of business bankruptcy law reforms: too much protection for creditors in bankruptcy may end up pushing such debtors into the de-federalized arena of state bankruptcy laws. 

Andrew Dawson is an Associate Professor at the University of Miami School of Law.