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More Consumer, Corporate Bankruptcies Ahead This Year

Written by: Stephen Parezo

Article Overview: The Bankruptcy Abuse and Consumer Protection Act of 2005 was designed to change existing bankruptcy law to make it more difficult for both businesses and individuals to qualify for bankruptcy protection. The bill, which was pushed by the credit card, auto and retail industries, was intended to end abuse of the bankruptcy system yet U.S. consumer and corporate bankruptcies are expected to increase by 20% and 17%, respectively, in 2007.

More Consumer, Corporate Bankruptcies Ahead This Year

The Bankruptcy Abuse and Consumer Protection Act of 2005 was designed to change existing bankruptcy law to make it more difficult for both businesses and individuals to qualify for bankruptcy protection. The bill, which was pushed by the credit card, auto and retail industries, was intended to end abuse of the bankruptcy system yet U.S. consumer and corporate bankruptcies are expected to increase by 20% and 17%, respectively, in 2007.

Some industry experts argue that the law has gone beyond its original purpose and hurt those it was intended to help.

“Most of our members view the law’s provisions as too harsh and misdirected for what problems consumer bankruptcy abuses there really were,” said Sam Gerdano, executive director of the Alexandria, VA-based American Bankruptcy Institute (ABI), the largest multi-disciplinary, non-partisan organization dedicated to research and education on matters related to insolvency.

Just as Congress intended to reduce sharply the number of bankruptcies filed, Gerdano says those parties having financial problems panicked and filed for bankruptcy before the law hit the books “because they thought it was less viable and less affordable.” This diverted the fiscally troubled parties to alternatives such as credit counseling and debt management plans.

Since then, the bankruptcy pace has settled down to a much lower boil in terms of filings. In a typical month now there are about 50,000 cases which translates to roughly 650,000 cases annually.

Filings to be ‘more firmly felt’

Lexington, MA-based Global Insight which touts itself as being recognized as the most consistently accurate forecasting company in the world, anticipates an uptick in corporate bankruptcies this year.

Matt Killion, an analyst who covers bankruptcy issues for Global Insight, cited the deterioration of credit quality, a slowdown in economic growth and interest rates higher than in previous years as reasons why the full impact of the filings “will be more firmly felt.”

Another element figuring into the bankruptcy picture is the housing market which, Killion says, has taken a decided downturn, affecting construction, real estate and part of the mortgage industry.

Seemingly gone are the days when companies and individuals viewed filing for bankruptcy as a social stigma which was to be avoided if at all possible.

“There are fewer small business cases of bankruptcy than individual ones because of today’s modern financing mechanisms where start-ups can get cash advances, use credit cards and even finance it out of their back pockets,” ABI’s Gerdano said. “It often shows up as an individual filing since they are taking out the credit in their own name.”

An accepted part of U.S. commerce

Global Insight’s Killion observed that there are now alternatives available due to financial innovations that weren’t there 10 or 20 years ago. These include leverage and private kinds of financing which will have more of an impact on small and medium companies.

Bankruptcy has come to be an accepted part of U.S. commerce and has always been available, dating back to such entrepreneurs as Henry Ford who failed in several businesses before finally hitting it big.

“You want to have bankruptcy be available to encourage that kind of risk taking,” ABI’s Gerdano said. “That goes almost hand-in-glove with the small business environment because you can’t get traditional financing [from banks].”

Killion remarked that bankruptcy provides filers with a lot of flexibility “to try and fail and try again.”

For entrepreneurs, it’s vital that they have a business plan and alternative means of financing for their venture rather than using high interest rate advances where they are the most vulnerable to any short-term hit.

Still seen as a last resort

Since traditional bank loans have been harder to come by, some business owners have sought venture capital funds and hedge funds where others are willing to finance a short-term project with equity interest. Hedge funds have become such a major player in bankruptcies that the new Congress has signaled that they view these unregulated hedge funds as too risky.

Gerdano explained that if Congress attempts to rein in hedge funds, it may produce some newfound scarcity for hedge fund participation and will lead to a retraction in the amount of liquidity available.

For many businesses and individuals, however, filing for bankruptcy is still seen as a last resort. The most likely candidates to go this route are those that are in trouble with the Internal Revenue Service, according to Dale Ellery, district manager of Fiducial’s Detroit, MI, region.

“It’s time to file for bankruptcy when they get so far behind with the IRS and they may have other things happening like vendors or suppliers that refuse to ship unless they pay on delivery,” said Ellery.

He counsels clients unable to meet their tax liabilities that if they wait too long to take care of it, “it’s hard to recover.”

No plans to eliminate it

To avoid bankruptcy, Ellery advises small business owners to have an accountant that really knows their business, prepares their taxes and files them on time.

Over the years, Ellery has come across employers who withhold taxes and Social Security deductions from employees but instead of remitting them to the IRS, decide to use the money for other purposes.

“They always think they’re going to catch up,” he said. “Even if you went bankrupt you’re still not going to escape withholding taxes. These are ‘trust taxes’ and the IRS looks at that as a fiduciary responsibility that you’ve taken on for the government. You are supposed to remit them to the IRS because the government is crediting the employees with those deductions. The IRS looks at that as a double-whammy.”

Nonetheless, insolvency specialists maintain that the majority of small businesses fail whether they’ve filed for bankruptcy or closed their doors.

“That has been the standard and is not likely to change,” ABI’s Gerdano added. “Bankruptcy has always been available to the honest but overextended debtor to get a fresh economic start. I don’t think that Congress has any plans to eliminate it.”

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