New bankruptcy law: many changes, few benefits for small businesses

Joseph Anthony is a tax professional in Portland, Ore., who writes about finance and tax issues affecting small businesses. Send Joseph an e-mail.

By Joseph Anthony

The most sweeping change in U.S. bankruptcy rules in a quarter-century takes effect in October 2005.

Here are the Cliffs Notes on what to make of it:.

In short, life becomes harder for debtors under the new federal law, which was passed by Congress and signed by President Bush in April 2005.

Here's a more detailed look at what small-business owners should know about the new bankruptcy law.

From Chapter 7 to Chapter 13

Any business owner owed money by someone who has filed for bankruptcy — and gotten all his or her debts erased — has to be pleased about the new law. That's because it makes it harder for individuals to wipe out all of their debts in a bankruptcy.

Previously, debtors filing for Chapter 7 bankruptcy protection could their financial slate wiped clean and emerge from bankruptcy with a fresh start. That made Chapter 7 the preferred filing path for most people who need bankruptcy protection.

The new law, however, requires debtors seeking bankruptcy protection to file under Chapter 13. That requires them to pay back part of their debts, if they have an income higher than the median income for their state. In time, there will be a means test to determine how much those consumers are able to pay.

Jeffrey Wong, a bankruptcy attorney with Greene & Markley, P.C., in Portland, Ore., says under the old law, more than 90% of people filing for bankruptcy were able to get all of their debts discharged with no installment payments. "In that respect, the new bankruptcy code probably enhances a business's prospect of some recovery," Wong says, "because it is anticipated that a significant number of people who could get a discharge of all their debts under Chapter 7 are going to be forced into Chapter 13 and will have to make some payments."

Yet little relief seen for business creditors

However, just because there is a prospect of fewer Chapter 7 filings doesn't mean that small businesses will see any significant benefit if someone owing them money files for bankruptcy protection, many legal experts say.

Greg Jordan, an attorney and senior partner at Dykema Gossett PLCC in Chicago, says the new rules will have no effect on most businesses that are owed money by customers or clients who go bankrupt.

"Most businesses do not sell to consumers on credit, and even if they do, they are unlikely to have a personal guarantee from the customer. So at best they would be unsecured creditors, just as they are now," Jordan says.

"You can have a claim against a debtor, but whether the debtor files a Chapter 7 or a Chapter 11 or a Chapter 13, they have to pay their secured creditors before they pay you," he adds. "That has not changed under the new law. You and other average business people are not going to see any more money from debtors who go into bankruptcy under the new law than you did under the old."

There also is unlikely to be much relief for small businesses owed money by larger entities that go belly-up.

"The changes in the new code are all about consumer debt, not business debt," says Wong. "This [law] is pounding small America, not big America. The vast majority of the changes are targeted at wage earners and at small-business owners with large personal debts. Big businesses with unsecured debts will still be able to file for bankruptcy protection and small businesses who are owed money still won't be able to do much about it."

Fewer risk takers; fewer startups?

Jordan says the new means test could discourage some debtors from filing for protection at all. "The whole basis of bankruptcy is to allow a fresh start, and if people are discouraged from filing and thus discouraged from getting a fresh start, they are still going to operate but they'll go underground financially and find different ways of financing their lives," he says.

Jordan also contends the new law will eventually discourage entrepreneurs from trying to start a new venture if they've had a previous failure.

"To be entrepreneurial is to be a risk taker, and risk takers sometimes run into problems," he says. "If a risk-taker can start again, he still has a chance to build something valuable for himself and for society as a whole. The new bankruptcy law won't give him that chance to get back to the starting line."

Some old rules still apply

The legal world is still sorting out the new rules and figuring out how they will be applied. For now, if you're worried about the credit-worthiness of someone with whom you do business, some of the old rules still apply: