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Pandemic fallout is about to overwhelm the bankruptcy system—and hit small businesses hardest

November 24, 2020, 6:16 PM UTC

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If you think bankruptcies have been a scourge in the pandemic so far, brace yourself—they’re set to rise dramatically.

The business busts will strike small firms disproportionately, which is bad news for more than just the business owners. It’s bad for the whole economy, because the surge of financial pain may overwhelm the bankruptcy system. As a result, the process could become chaotic, with viable businesses killed and doomed ones kept artificially alive. A major part of the problem: There are not enough bankruptcy judges.

That worrisome outlook emerges from new research by Robin Greenwood of the Harvard Business School, Benjamin Iverson of Brigham Young University’s Marriott School of Business, and David Thesmar of the MIT Sloan School of Management.

Their findings are full of surprises, starting with the reality of bankruptcies in the pandemic so far. Despite a parade of high-profile Chapter 11 filings, especially in retail—J.C. Penney, Neiman Marcus, J. Crew, Brooks Brothers—overall bankruptcies through August were “actually 1% lower than in the same timeframe in 2019,” the authors report. It’s no illusion that big companies were more likely to file during the first eight months of 2020, but small businesses were much less likely to file. Maybe that’s because they still had some Paycheck Protection Program funds. Or maybe, as a Jeffries note to clients hypothesized, it’s because many small businesses were so strapped they couldn’t afford to hire a bankruptcy lawyer.

In any case, the researchers argue that the numbers have to rocket. “We expect overall bankruptcies to increase by as much as 140% in the current year,” they write. “By all metrics, corporate financial distress is set to increase.”

Economists don’t see bankruptcies as necessarily bad. When tough times strike, some businesses inevitably will struggle; the bankruptcy process helps sort out which should be given a second chance and which should be liquidated. The resulting reallocation of capital and labor, painful as it may be, helps to rebuild the economy.

The danger in the pandemic crisis is that the process may not work as it should. That’s partly because “the balance sheets of small firms are hit the hardest by the current recession,” the researchers find, which is a problem because “small firms restructure very rarely.” Instead of working things out with their creditors, they mostly just fail. They’re less likely to get a second chance because some of their most valuable assets, such as the entrepreneur’s know-how, can’t be pledged to investors.

Making matters worse, judges and lawyers in the bankruptcy field may be “overwhelmed by the large wave of financial distress,” the researchers find. “We predict that the coming surge of bankruptcies could increase the judge caseload by 158% from 2019 levels, well beyond the caseloads seen in 2009-2010.” When the system is stressed, resources get misallocated. For example, when Circuit City filed for bankruptcy during the 2008-2009 financial crisis, the court authorized the company to borrow $1.1 billion in order to keep it alive. But it was a zombie; two months later, Circuit City announced it would liquidate. More broadly, judges and lawyers make more mistakes when courts are overwhelmed, cases take longer, and smaller businesses are more likely to be dismissed, “leaving many of them to liquidate without court protection.”

Many policy prescriptions have been advanced to fix these problems, though whether any fixes could be adopted in time to improve the fate of small businesses is far from clear. Other researchers estimate that just bringing back 50 to 250 former bankruptcy judges would be a significant help.

The larger point is that even as new vaccines promise to end the pandemic eventually, thousands or millions of small businesses have to get from here to there. The authors of the new research show that the fewer small businesses that make it, the more long-lasting “economic scarring” we’ll suffer. Their strongest conclusion serves as a message to the incoming Biden administration: “Policy should focus on smaller firms.”