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Office of Chief Counsel for Advocacy
U.S. Small Business Administration
Washington, D.C. 20416

April 22, 1998

Honorable Jerrold Nadler
U.S. House of Representatives
Committee on the Judiciary
Subcommittee on Commercial and
Administrative Law
Washington, DC 20515-6216

Dear Congressman Nadler:

This letter is in response to your letter of April 9, 1998, requesting my comments on the Bankruptcy Reform Act of 1998, (HR 3150), which is currently before the Subcommittee on Commercial and Administrative Law of the House Committee on the Judiciary.

The Office of Advocacy of the U.S. Small Business Administration was created by Congress to be the independent voice for small businesses within the Federal government and to represent the views of small business before Congress and Federal regulatory agencies.¹

Entrepreneurism is the foundation of this nation's economy and small businesses. As debtors and creditors, entrepreneurs need a bankruptcy system that is fair, equitable and flexible enough to accommodate the individual needs of different industries and the regional economies around the country.

I believe that the proposed Bankruptcy Reform Act of 1998 would make fundamental, expansive and potentially detrimental changes to entrepreneurship by altering bankruptcy protections for small businesses seeking to reorganize under Chapter 11 of the U.S. Bankruptcy Code.

The 1994 amendments to the U.S. Bankruptcy Code recognized that a "one-size-fits-all"² Chapter 11 is not in the best interests of small business and I believe the proposed mandatory "one-size-fits-all" definition for small business and the proposed stringent procedural requirements come dangerously close to undermining the intent of the 1994 amendments. In 1994, I commented on this exact issue. Attached please find a copy of my letter to Jack Brooks, Chairman, House Committee on the Judiciary, dated September 7, 1994.

As discussed in some of the testimony before the Subcommittee, several bankruptcy courts around the country have already implemented successful small business bankruptcy reorganization systems without any changes to the U.S. Bankruptcy Code. Since the courts have addressed the issue adequately, I strongly recommend that Congress defer consideration of any proposed bills to fundamentally change the bankruptcy laws for small business debtors and creditors until the implications of the proposals have been more fully researched and discussed.

Overview of the Importance of Small Business in the United States Economy

The United States has a strong and vital economy envied by the world. We encourage entrepreneurship and the creation of businesses in order to drive our free market system. Currently, there are 23.3 million small businesses in the United States. Our small business community continues to maintain and sustain our economy. For example, small firms created virtually all of the net new jobs between 1992 and 1996 (see attached chart). While the Fortune 500's share of U.S. employment has declined steadily since 1968, small business entrepreneurs have filled the gap (see attached chart). It is estimated that the fastest growing segment of the small business community, called the "gazelles" by many analysts, are numbered at 300,000 businesses.

In addition, our country is experiencing a major "information revolution" similar to the earlier industrial revolution. Our service-based industries are booming, with the information and technology sectors growing at an accelerated rate.

Every year, our economy experiences dynamic changes through the births and terminations of businesses. Last year a record 884,609 firms with employees were created. In contrast, 54,027 business-related bankruptcies were filed -- the majority of which were liquidations.³ A high rate of business formation and dissolution is characteristic of a dynamic economy. Our nation's economy depends on this flexibility and the special role of small business entrepreneurs to sustain growth.

Experience and our research have shown that many entrepreneurs do indeed fail at their first attempts at business, but it is through their experience of failure that they find the right formula for success.⁴ Unlike some European countries where business failure is a stigma for those who do not succeed on the first try, the United States has built its free market on competitive principles and on entrepreneurs' ability to try again. Failure should not be a hindrance to future success.

Of the 1.4 million bankruptcy filings in 1997, only 9,694 of the Chapter 11 filings (0.69 percent) and 11,095 filings of the Chapter 13 filings (0.79 percent) were business-related.⁵ Overall, small business bankruptcies declined 33.9 percent from 1987 to 1997. During that same time period new business formations increased by 18.2 percent.

The entrepreneurial spirit is fueling our nation's economy and permits entrepreneurs to take a challenge and face risks in order to succeed. The U.S. Bankruptcy Code, while not perfect, has allowed small businesses the flexibility to reorganize and has permitted local bankruptcy courts to adopt initiatives conducive to their local industries and diverse economies.

The Office of Advocacy's Concerns with HR 3150

Currently, small business owners may file for bankruptcy protection to reorganize their businesses under Chapter 11 for commercial enterprises and under Chapter 13 of the U.S. Bankruptcy Code for sole proprietors. With the Bankruptcy Reform Act of 1994, small business owners were given the option of reorganizing their business in an expedited manner under Chapter 11.

In addition, the National Bankruptcy Reform Act of 1994 established the Bankruptcy Review Commission to evaluate the U.S. Bankruptcy Code and make recommendations for changes. In fall 1997, the Commission's final report was released. The proposals in HR 3150 are based on the Commission's recommendations. I will limit my comments to the proposed small business provisions in HR 3150 for Chapter 11 reorganizations.

Amending Chapter 11 of the U.S. Bankruptcy Code affects all small businesses, either as debtors or more likely as unsecured creditors. A delicate balance must be maintained in any amendments to ensure that each party receives fair and equitable treatment, while not undermining entrepreneurism. HR 3150 proposes substantial changes in the way small businesses reorganize under Chapter 11. The bill proposes to establish strict timelines for filings and submissions of plans, mandatory filing of monthly financial reports, and mandatory disclosure forms for those reports for small firms. In addition, the bill would create higher thresholds for extensions of deadlines and would establish entirely new and untested duties for the U.S. Trustees. Other provisions of the bill would expand the grounds for conversion and dismissal of business bankruptcies.

The most significant proposed change is that the voluntary election of the small business provisions permitted under Chapter 11 would be made mandatory for all businesses with aggregate liabilities of up to $5 million. According to the National Bankruptcy Review Commission's statistics, 85 percent of commercial bankruptcies under Chapter 11 would be forced to use the small business provisions. With the amendments in 1994, the small business provisions were created with full knowledge that all small businesses are not alike.⁶ Some businesses seeking reorganization may have less complicated reorganization plans and may opt to use the expedited provisions.

Unfortunately, HR 3150 would adopt a "one-size-fits-all" definition for small businesses regardless of the complexity of the bankruptcy, the industry of the small business, and/or any regional economic factors. One of the best aspects of Chapter 11 is that it was originally established to provide flexibility. Flexibility is needed not only with respect to the type of bankruptcy relief being sought but also based upon the different industries seeking bankruptcy protection and in the different ways businesses operate in various regions of the country.

In my experience with Federal regulatory agencies, blanket "one-size-fits-all" regulations typically do not target the specific problems that need to be addressed and usually have unforeseen consequences on small entities. In order to reduce the disproportional regulatory burden on small entities,⁷ Congress mandates that Federal agencies prepare regulatory flexibility analyses on the potential regulatory and economic impacts on small entities." I believe that the same principle applied here could quantify and identify the precise problems of small business bankruptcy reorganizations and the appropriate measures to make Chapter 11 work more efficiently and effectively.

As our country is growing away from our traditional manufacturing-based economy to service-based sectors (particularly information- and technology-based industries), flexibility in reorganizations of businesses is essential. In addition, many very small businesses have no prior experience with the bankruptcy system. Flexibility is needed to ensure that the debtors are properly educated about the process. Several bankruptcy courts around the country have found solutions to expedite the process while retaining flexibility. These local initiatives have been able to take into account the complexity of the bankruptcy, the nature of the industry of the debtor and any regional economic impacts. HR 3150 would eliminate vital judicial discretion now permitted by the U.S. Bankruptcy Code.

I believe that the changes proposed in the bill are of such immense proportion that further discussion is needed to address the full impact of the proposals on entrepreneurship, the small business community and our national economy. As the Bankruptcy Review Commission acknowledged in its Small Business Proposals, existing data on bankruptcies is poor. While research has been undertaken to show how quickly business bankruptcies go through the system and how they exit the system, no in-depth research has been done to understand how the bankruptcy system aids or impedes small business debtors and creditors.⁸ Even independent research done for the Office of Advocacy on small business bankruptcies has been significantly hampered by the lack of statistical data maintained by the courts.⁹ Before Congress fundamentally alters the way small businesses operate as debtors and as creditors, it should analyze whether the proposed changes will undermine the entrepreneurial spirit in this country.

Two consequences of the potential legislation are evident. For small business debtors, the proposed changes would require such substantial additional costs (in terms of document preparation and legal counseling) for the reorganization process that many small businesses may forego reorganization and immediately file for liquidation proceedings under Chapter 7 of the U.S. Bankruptcy Code or, in the alternative, just close their doors leaving all creditors without recourse.

In addition, this legislation could have serious detrimental effects on federal loan and investment programs. Small businesses that opt for liquidation proceedings rather than attempt to reorganize may cause the default rate on federal government loan and investment programs to significantly increase in the near future. The impact on these programs must be analyzed completely before major policy changes in the bankruptcy system.

Overall, I believe that sufficient research and dialogue has not occurred on small business bankruptcy issues or on the small business recommendations of the National Bankruptcy Review Commission. It is obvious from the statistics that small business reorganizations have not presented a crisis in the bankruptcy system. Only 0.69 percent of all bankruptcy filings in 1997 were business-related reorganizations under Chapter 11. In addition, business-related bankruptcies declined by 33.9 percent between 1987 and 1997. We need to quantify the problem. The opportunity is ripe for developing better statistical data and more comprehensive research on how the bankruptcy system for reorganizations has been beneficial and/or detrimental to small business debtors and creditors. HR 3150 has several provisions that address the need for more statistical data on bankruptcies.

In light of the significant changes that will arise if HR 3150 is adopted, I strongly recommend that you defer consideration of any bankruptcy legislation affecting small businesses until we are able to fully assess the impact of the proposed changes on the small business community, federal loan and investment programs and our nation's economy. Any amendments to the U.S. Bankruptcy Code without full comprehension of the consequences could irreparably damage the entrepreneurial spirit that has made our economy as strong as it is today.

Sincerely,

Jere W. Glover
Chief Counsel for Advocacy

Enclosures

cc: Honorable George W. Gekas, Chairman
Subcommittee on Commercial and
Administrative Law

Honorable James Talent, Chairman
Committee on Small Business

Honorable Nydia Velazquez
Committee on Small Business

¹ The Office of Advocacy, established by Public Law 94-305, is an independent office charged with representing the views and interests of small businesses before the Federal government. By law, the Chief Counsel is appointed by the President from the private sector and confirmed by the Senate. The Chief Counsel's comments and views are his own and do not necessarily reflect the views of the Administration or the U.S. Small Business Administration. Return to Text

² Public Law 103-394, Title II, Section 217. Return to Text

³ Administrative Office of the U.S. Courts. Return to Text

⁴ See Richard F. Fullenbaum and Marianna A. McNeill, The Function of Failure, prepared by M & R Associates, for the U.S. Small Business Administration, Office of Advocacy (Springfield, Va.: National Technical Information Service, 1994). See attached copy of the research summary. Return to Text

⁵ Administrative Office of the U.S. Courts. Return to Text

⁶ Letter to Jack Brooks, Chairman, House Committee on the Judiciary, dated September 7, 1994. Return to Text

⁷ The Regulatory Flexibility Act, Public Law 96-354. The Office of Advocacy of the U.S. Small Business Administration is charged with monitoring Federal regulatory agencies" compliance with the Regulatory Flexibility Act. Return to Text

⁸ Specifically, research should include but not be limited to the following questions: what are the causes of bankruptcy (i.e., economic conditions, loss of production facilities, loss of federal government contracts, international affairs, etc.), what are the specific size classifications of small businesses that use Chapter 11 effectively, are there specific industries that have problems reorganizing under Chapter 11 (i.e., do service sector businesses or businesses relying on intellectual property rights need more time to file reorganization plans), what is the success rate of businesses five and ten years after completing a reorganization, and are there specific small business remedies that do not require wholesale changes for all business reorganizations. Return to Text

⁹ Fullenbaum and McNeill, The Function of Failure. Return to Text