Corporate bankruptcies* climbed new heights during the Great Recession of 2008–2009. Firms ranging from mighty ones such as Lehman Brothers and General Motors to tiny entrepreneurial outfits dropped out left and right around the world. In the COVID-19 crisis of 2020, a wave of new bankruptcies hit the world, thanks to lockdowns of entire economies. Since bankruptcies do not sound good or inspiring, is there anything that we—the government, financial institutions, consumers, taxpayers, or the society at large—can do to deal with widespread bankruptcies?

One perspective suggests that bankruptcies, which are undoubtedly painful to individual entrepreneurs and employees, may be good for society. Consequently, bankruptcy laws need to be reformed to become more entrepreneur-friendly by making it easier for entrepreneurs to declare bankruptcy and move on. Consequently, financial, human, and physical resources stuck with failed firms can be redeployed in a socially optimal way.

A leading debate is how to treat failed entrepreneurs who file for bankruptcy. Do we let them walk away from debt or punish them? Historically, entrepreneur friendliness and bankruptcy laws have been something of an oxymoron because bankruptcy laws are usually harsh and even cruel.

The very term bankruptcy is derived from a harsh practice: In medieval Italy, if bankrupt entrepreneurs did not pay their debt, debtors would destroy the trading bench (booth) of the bankrupt. The Italian word for broken bench, banca rotta, has evolved into the English word bankruptcy. The pound of flesh demanded by the creditor in Shakespeare’s The Merchant of Venice is only a slight exaggeration. The world’s first bankruptcy law, passed in England in 1542, considered a bankrupt individual a criminal. Penalties ranged from incarceration to death sentence.

However, recently, many governments have realized that entrepreneur-friendly bankruptcy laws not only can lower exit barriers but also lower entry barriers for entrepreneurs. Although many start-ups will end up in bankruptcy, it is impossible to predict up front which ones will go under. Therefore, from an institution-based view, if entrepreneurship is to be encouraged, there is a need to ease the pain associated with bankruptcy by means such as allowing entrepreneurs to walk away from debt, a legal right that bankrupt US entrepreneurs appreciate. In contrast, until recent bankruptcy law reforms, bankrupt German entrepreneurs might remain liable for unpaid debt for up to 30 years. Furthermore, German and Japanese managers of bankrupt firms can also be liable for criminal penalties, and numerous bankrupt Japanese entrepreneurs have committed suicide. It is not surprising that many failed entrepreneurs in Germany and Japan try to avoid business exit despite escalating losses, while societal and individual resources cannot be channeled to more productive uses.

In the United Arab Emirates (UAE), prior to bankruptcy law reforms in 2016, even a bounced check could land an entrepreneur in jail. In India, before the 2018 reforms, bankruptcy cases could drag on for four years. Overall, as rules of the “endgame,” harsh bankruptcy laws become grave exit barriers. They can also create significant entry barriers, as fewer would-be entrepreneurs may decide to launch their ventures.

At a societal level, if many would-be entrepreneurs, in fear of failure, abandon their ideas, there will not be a thriving entrepreneurial sector. Given the risks and uncertainties, it is not surprising that many entrepreneurs do not make it the first time. However, if they are given more chances, some of them will succeed. Approximately 50% of US entrepreneurs who filed bankruptcy resumed a new venture in four years. This high level of entrepreneurialism is, in part, driven by the relatively entrepreneur-friendly bankruptcy laws (such as the provision of Chapter 11 bankruptcy reorganization instead of straight liquidation). On the other hand, a society that severely punishes failed entrepreneurs (such as forcing financially insolvent firms to liquidate instead of offering a US Chapter 11-style reorganization option) is not likely to foster widespread entrepreneurship. Failed entrepreneurs have nevertheless accumulated a great deal of experience and lessons on how to avoid their mistakes. If they drop out of the entrepreneurial game (or, in the worst case, kill themselves), their wisdom will be permanently lost.

Recent bankruptcy law reforms in Germany, India, Japan, and the UAE all endeavor to change the incentive structure in order to promote more entrepreneurship.

Worldwide, an award-winning study conducted by your author and colleagues, which leverages evidence from 29 countries (involving both developed and emerging economies from five continents), has identified a strong linkage between entrepreneur-friendly bankruptcy laws and new firm entries.

In summary, one side of the debate asserts that at a societal level, entrepreneurial failures may be beneficial, since it is through a large number of entrepreneurial experimentations—although many will fail—that winning solutions will emerge and that economies will develop.

Thus, the boom in busts is not necessarily bad. However, President Donald Trump’s history of walking away from six corporate bankruptcies (although never personal bankruptcy) has energized the other side of the debate.

Trump praised himself in public for “playing with the bankruptcy laws.” Critics argue that people with lots of money such as Trump can easily avoid the consequences of big losses by cashing out at the first sign of trouble, because bankruptcy laws protect them. But workers have no such protection, are stuck with the mess, or are simply out of work. Is that fair?

Case Discussion Questions

1. What are the pros and cons for entrepreneur-friendly bankruptcy laws?
2. Why can bankruptcy laws become exit barriers for an entrepreneurial firm? Entry barriers?
3. ON ETHICS: Some argue that entrepreneur-friendly bankruptcy laws, which may allow entrepreneurs to walk away from their debt, are unethical because they increase the cost of financing for everybody. What do you think?