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Bankruptcy in Charter Cities

Within the charter cities space, there are many popular subjects of discussion, including industrial policy, urban planning, and corporate law. However, there is one critical legal subject that seems to be rarely discussed: bankruptcy.

Charter cities are an inherently entrepreneurial concept. Even the most conservative application of this concept applies proven institutional structures and ideas in new locations and often with new technology. Within the charter cities space, there are many popular subjects of discussion, including industrial policy, urban planning, and corporate law. However, there is one critical legal subject that seems to be rarely discussed: city bankruptcy.

The idea and discussion of city bankruptcy naturally gives many an uncomfortable feeling, but bankruptcy and bankruptcy law are critical elements in a thriving, entrepreneurial economy. When an entrepreneur is engaged in a failing enterprise, an entrepreneur-friendly bankruptcy code can provide the best means to avert a damaging loss of assets, ranging from funding and equipment to talent and time. Importantly, a sufficiently entrepreneur-friendly bankruptcy code can encourage entrepreneurs to engage in a new venture in the first place by ensuring that entrepreneurs know that they have a suitable worst-case scenario exit option.

Bankruptcy currently means the process by which firms or people who cannot repay their debts to their creditors are given some form of relief, usually through the discharge or reorganization of debt. However, the word “bankruptcy” developed from the brutal practice in Renaissance Italy where creditors would destroy the ability of merchants to do business if they became insolvent by breaking the bankrupt’s work bench, thereby preventing him from working again.

This is just one example of the many unpleasant outcomes that used to be associated with bankruptcy. In Ancient Greece, insolvent debtors were often forced into debt slavery. However, Christianity, Islam, and Judaism all have traditions which call for the forgiveness or reorganization of debt. What is widely considered to be the first bankruptcy legislation came about in England in 1542 in the form of the Statute of Bankrupts. This legislation treated those in insolvency as criminals and was mostly aimed at preventing the flight of the bankrupt. It was the advent of the joint stock company that helped to change attitudes regarding bankruptcy.

The passage of the United Kingdom’s Joint Stock Companies Act of 1856 merged previous corporate laws on joint stock companies and limited liability. With this merger, merchants could form a corporate entity with separate legal personhood from the shareholders, who in turn had limited liability, enabling entrepreneurs to more easily engage in risky ventures and raise capital. The limited liability shield kept the shareholders from being able to be sued by creditors in the event that the company became insolvent. The shield limited the amount to which the shareholders were liable to the company’s creditors to the amount of the shareholder’s investment in the company. With the evolution of bankruptcy law from codes meant to prevent debtors from absconding to codes that protected investors from loss greater than what they had put into an enterprise, modern bankruptcy law was born.

In general, there are two types of bankruptcy that a corporation can enter into under modern bankruptcy law: liquidation or reorganization. Liquidation is where a debtor company is dissolved, and its remaining assets are sold in order to repay the creditors. Reorganization is where the shareholders retain control of the company and the court facilitates debt restructuring negotiations between the debtor and creditors. Liquidation then, is an exit option and reorganization is an attempt to salvage a corporation.

For better or worse, while entrepreneurship can mean massive successes, it also means a high degree of failure. A reliable global comparative analysis of startup success rates has not yet been made, but using the United States and India as stand-ins for success rates around the world, one can see that 90% of American startups fail, and Indian startups don’t seem to fare any better. While not all of these failed enterprises will exit the market through bankruptcy, many of them will. Additionally, there has been an increasing trend in Silicon Valley to attempt to salvage investments or cut losses through Chapter 11 reorganization bankruptcy.

An entrepreneur-friendly bankruptcy code is especially important for developing economies. In such economies, like India and the Philippines, vendors can get trapped in cycles of debt from which they cannot easily escape. A bankruptcy code that is entrepreneur-friendly can provide a defense against falling into vicious cycles of debt. Though, it is important that a bankruptcy code properly balance the interests of creditors as well.

With the expectation that the majority of entrepreneurial ventures will fail, intermixed with the desire (indeed, necessity) to have an entrepreneurial economy, it is important to ensure that a charter city has a bankruptcy code that is entrepreneur-friendly. A study by researchers at the University of Texas (Dallas) business school — Mike Peng, Yasuhiro Yamakawa, and Seung-Hyun Lee — identified six elements that increase the entrepreneur-friendliness of a bankruptcy code.

First, the bankruptcy code should include a reorganization option, which allows for an entrepreneurial firm to eliminate some debt and reorganize so that it can compete more effectively in the market. Second, it should be quick and easy to follow procedures when in bankruptcy, especially liquidation bankruptcy, such that entrepreneurs can rapidly go back into the market and start a new company. Third, bankruptcy procedures should be low cost, which will make entrepreneurs more willing to consider bankruptcy as an option and preserve more assets for the creditors. Fourth, it is important that entrepreneurs are not personally liable for the debts of an enterprise after the company has completed bankruptcy. This means that entrepreneurs get a fresh start, as the creditors only have rights to the residual assets of the bankrupt firm and cannot seek repayment of corporate debt from the entrepreneur personally. Fifth, an automatic stay of assets should be included in the code. This means that once a firm has declared bankruptcy, its creditors can no longer continue debt collection efforts outside of bankruptcy court, thereby allowing for negotiations between the debtor and all of its creditors. Sixth, a bankruptcy code should ensure that entrepreneurs won’t be forced out of their enterprises in the event that they enter reorganization bankruptcy. This helps avoid situations where entrepreneurs are reluctant to enter reorganization when it would otherwise be prudent to do so, out of the fear that they will lose control of their business. A bankruptcy code that meets these six elements will help ensure an entrepreneur-friendly environment for what is likely the most unpleasant part of business: failure.

In order to be most effective at promoting entrepreneurship, the law in a charter city needs to be friendly to entrepreneurs in all stages of a business, from founding a new firm, through obtaining funding, engaging in commerce, and finally dealing with exit options. Statistics show that many, now-successful, entrepreneurs fail several times before attaining their success. Given this reality, a charter city intent on creating an entrepreneur-friendly business environment will create an entrepreneur-friendly bankruptcy code.

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