Small businesses vital to economic recovery go bankrupt

— -- Entrepreneurship and new small businesses are supposed to lead us out of the recession, just as they have in prior downturns, right?

Sure. Your neighbor's grand idea will persuade a bank to lend her start-up money; she'll open for business in six weeks; and money will immediately flow from customers to her to her employees. Taxes will be paid, and the national economic engine will hum effortlessly in no time.

If only.

Today shows a different reality: Commercial bankruptcies are surging. Fewer people are starting small businesses, and firms already open are struggling under changing consumer habits, a lack of funding options and tougher bankruptcy laws. If a nationwide trend seen since January holds true, more than 300 businesses will file for bankruptcy — today alone.

Cafe Boulevard, for 12 years a popular European-style restaurant in Dayton, Ohio, hasn't been able to endure the downturn.

Rising gas and food prices, increased competition and an ill-timed expansion cut profits. Local unemployment made matters worse, because the regulars no longer showed up. In April, the restaurant's owner, Eva Christian, was one of 8,149 U.S. business owners who filed for bankruptcy-court protection.

She didn't close the cafe. Instead, Christian is trying to retain her employees while she works with creditors.

"When I decided to file for Chapter 11 bankruptcy, I felt crushed," Christian says. "But my attorney said that Donald Trump did it, and GM did it, and Delta did it. It gives people the opportunity to bounce back."

The first five months of this year have shown a 52% increase in the total number of commercial bankruptcy filings (36,106) compared with the same period last year (23,829), according to the Automated Access to Court Electronic Records. On average thus far in 2009, some 350 commercial enterprises file for bankruptcy daily — an increase of 240% from 2006, the first year after the bankruptcy law was changed.

Small companies hardest hit

Major corporate failures, like GM and Chrysler, flash across front pages and websites. But the vast majority of commercial bankruptcies, which are not separated by size of firm by data keepers, are filed by entrepreneurs and small-business owners, says Robert Lawless, professor of law at University of Illinois.

Troubling for the economy, say Lawless and Todd McCracken, president of the National Small Business Association, is the double-whammy of fewer start-ups and increasing bankruptcies.

"There is always this dynamism in the small-business community: Businesses are always dying, and new businesses are always getting started," McCracken says. "Usually more start than fail, but my sense is that now it has flip-flopped. And it's alarming."

Lawless agrees.

"In the past, small-business formation increased in a recession because people had self-employment thrust upon them," he says. "One avenue out of economic hard times — self-employment — has become less attractive, because the bankruptcy law is less forgiving" and there are fewer options for those entrepreneurs to get bank loans or to find funding elsewhere.

Trickle-down effect hurts

Small business is considered the backbone of the economy. In the past, new businesses led economic recoveries, McCracken says. Small businesses — those with fewer than 500 employees — make up half of the gross domestic product and account for most job growth.

Problems from the devastated housing market, overall recession and suffering major industries all funnel down to small businesses, especially those that supply the troubled corporations.

"When you have the GMs of the world filing for bankruptcy, they are canceling contracts and discharging debts that they owe to their suppliers," says B. William Ginsler, a bankruptcy lawyer in Portland, Ore. "And those are small businesses that are less solvent than larger corporations."

The transportation industry, which includes the auto and airline businesses, has sparked the biggest run-up in small-business bankruptcy filings, according to new data from an Equifax bankruptcy study. After transportation, the construction, manufacturing and retail industries are the major causes, the study says.

While not always the case, the line from one faltering company to another can be direct.

Just before the economic slump, Cafe Boulevard's Christian opened a second restaurant in Dayton called Cena. Cena's outlook is bleak, because a nearby General Motors assembly plant is closing, and NCR is moving its headquarters from Dayton to Georgia.

"It was bad timing to expand into a second restaurant," Christian says.

Household spending cutbacks reach far, too. Dual-income families who are now single-income may no longer need or be able to afford child care, so many of those services are going out of business, says Lester Thompson, a bankruptcy lawyer in Dayton. Sporting goods stores and lawn-mowing services also have struggled.

Small-business bankruptcy filings jumped the most in the Los Angeles and Chicago metro areas, according to Equifax. But even smaller areas of the country are experiencing a big increase.

David Hicks, a bankruptcy lawyer in Omaha, says he has seen an increase in business struggles related to the auto industry and the mortgage crisis. Among them are owners of used car lots and housing contractors.

In South Carolina, bankruptcy attorney Jane Downey has worked with dry cleaners and gourmet sandwich shops.

Robert Chernicoff, a bankruptcy lawyer in Harrisburg, Pa., says one client who recently filed for Chapter 11 bankruptcy is the owner of a new small strip mall, Shoppes at Silver Spring. Mall owners counted on about eight tenants. It's in a good location, Chernicoff says, but the economic downturn caused some tenants to back out, and it has taken longer to find new ones.

Chapter 7 vs. 11 vs. 13

Many small businesses owe so much money to creditors that there is no future. Such owners often file for Chapter 7 bankruptcy and shut their businesses for good. Chapter 7 allows sole proprietors to discharge their debt and for corporations to have an orderly liquidation.

Those who want to reorganize a business or sell it as a going concern may file for Chapter 11. Chapter 13 is a similar but less costly and time-consuming option that is limited to individuals who have a certain amount of debt.

Last month, Randy Wicker filed for Chapter 11 bankruptcy because his 15-year-old business, Earth Structures, had hit a significant rough spot after previously earning up to $8 million annually. His corporation, based in Spartanburg, S.C., primarily builds retaining walls for highway projects.

Earth Structures has worked on Department of Transportation projects, but those have nearly disappeared. Wicker and other contractors are now competing in the commercial market.

"More contractors are vying for less jobs," Wicker says.

"Maybe President Obama's effort to restore the highways with a stimulus plan will lead to more work for him," says Downey, his lawyer.

Lack of loans worsens problem

The credit crunch is a major contributor to the rise in filings.

Loan dollar volume from the U.S. Small Business Administration has increased 35% since the American Recovery and Reinvestment Act was passed on Feb. 17, according to the SBA. Even so, a National Federation of Independent Business trend report states that in May the percentage of business owners reporting that loans are harder to get rose to 16%, the highest reading since the 1980-82 recession.

Businesses can't easily rely on credit cards these days, either.

"What's happening now is that a lot of banks are retrenching and cutting back on lines of credit and credit card limits," McCracken says.

With that reality, and loath to dip into their retirement savings, struggling small-business owners have few options other than bankruptcy. When the bankruptcy law changed in 2005 it was mostly aimed at curbing abuse of personal bankruptcy filing. But it also singled out small businesses for harsher treatment, and those changes did not apply to larger corporations, Lawless says.

Small businesses that file for bankruptcy have a shorter time frame to reorganize, Hicks says. "And before, a judge could pull the plug on a small-business owner that was playing the system, or he could give a break to somebody who was legitimately trying to reorganize," he says. "Most of the discretion is now gone."

But the data show the change hasn't deterred small businesses from filing for bankruptcy.

"You can change the bankruptcy law all you want, but if we have a recession, lots of business are going to file," says John Pottow, professor of law at the University of Michigan Law School. "The increase is yet another sobering economic milestone."

Bankruptcy is still the only option for many small-business owners who are hanging by a thread.

"The failure of a small business doesn't have to be a lifetime sentence for the owner," says U.S. Bankruptcy Court Judge Lewis Killian, in Tallahassee. "Bankruptcy gives them the ability to go forward, to start up again and be successful."