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April 20, 2005
Financial risk and lack of an innovation policy
Recently, the question has arisen whether the US laws promote or discourage risk taking. There are a number of ways to approach this question and a number of laws that could be scrutinized. It is interesting to look at two areas that affect financial risk to see how the debate has approached the issue of innovation: one where innovation is at the forefront of concern and the other where innovation was almost completely ignored. Where innovation has been discussed is the issue of new corporate accounting rules under Sarbanes-Oxley. Where it has been almost ignored is the recently passed changes to the bankruptcy laws.
The contrast is striking and points to the lack of an innovation policy in this country. If we had a functioning innovation policy, we might be able to look at all these areas -- rather than the hit or miss approach where the issue is raise in one circumstance, but ignored in another.
The first issue is the growing concern about the new corporate accounting regulations under the Sarbanes-Oxley Act. There is a rising tide of rhetoric that the regulations are too burdensome, specifically Section 404 that requires companies to document and certify their internal financial reporting procedures and controls. Even before, there was concern about another section of the Act, Section 302 which required the CEO and CFO to sign a certification that the report was not untrue or misleading under penalty of criminal prosecution. This, we were told, was putting a chilling effect on innovation. An example of this argument is Peter Wallison of AEI, "Blame Sarbanes-Oxley":
An array of stimulus factors has failed to generate strong growth in the U.S. economy. That may largely be a consequence of the Sarbanes-Oxley Act and the stock exchange regulations it has spawned, which have altered the composition and dynamics of corporate boards in ways that discourage risk-taking.
The concern over innovation was acknowledged by SEC Chairman William Donaldson (in a 2003 speech) when he said:
I also hope that America's corporate leaders will not use Sarbanes-Oxley as an excuse for putting off innovation and investment.
Some argue that the concern over Sarbanes-Oxley is overblown. According to Ben Worthen, writing in CIO Magazine, A Funny Thing Happened on the Way to Compliance (It Got Easier):
Everyone thought the Sarbanes-Oxley financial disclosure act would require CIOs to perform heroic feats of integration, spend fortunes on software and invest enormous amounts of sweat equity. Now, with the law reinterpreted, only the last appears to be true.
Others argue that the requirements under Sarbanes-Oxley present an opportunity. As John Parkinson and Stewart Bloom writing in Optimize Magazine, "Surviving Sarbanes-Oxley"
From Enron to MCI, extreme accounting practices and poor management judgment have shattered investor confidence. That's why Congress passed the Sarbanes-Oxley Act of 2002, "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws." To survive, publicly traded companies now must re-establish investor confidence. And their CIOs have a new role to play in building and selling technology strategies to support that mandate.
Regardless of where you come down on the issue of Sarbanes-Oxley (and I personally believe that the negative impact is overstated), the issues of innovation and risk-taking are front and center.
The debate over the bankruptcy laws stands in stark contrast. As the The Economist puts it, the cure may be worse than the disease. They note that
while Europeans might be bemused at all the moral outrage in America over the latest reforms, they might also wonder why Americans are so eager to move their bankruptcy law closer to Europe's-especially since Europe is busily trying to emulate America. Until around 20 years ago, consumer bankruptcy didn’t even exist in many European countries, and corporate bankruptcy was a draconian process too dreadful for all but the most desperate managers to contemplate. Since then, these nations have relaxed their laws precisely because they see the economic benefits this has brought America.
The Economist goes on to look at the pros and cons of tighter bankruptcy laws:
Making bankruptcy harder tends to make borrowers more willing to lend, but consumers less willing to take on debt. The result is that interest rates-the price of credit-fall. At first blush, this would make it seem that Europe had the right idea in the first place; the vast majority of people and companies that never declare bankruptcy get better terms on their loans, while the few profligates are forced to watch their step.
But making bankruptcy more difficult has other, less attractive economic effects. Forced repayment plans can discourage people from working harder (or at all), since extra income simply goes to pay creditors. Making bankruptcy more unpleasant can also deter entrepreneurship; people starting businesses are often required to personally guarantee loans to their firm-and those without assets are often forced to rely on MasterCard and Visa for their seed capital (see article). Tougher corporate-bankruptcy rules seem to make companies more risk-averse. America's current permissive system does let many (possibly undeserving) managers keep their jobs, but it also saves workers and suppliers from a sudden loss of income.
The article they refer to cites recent academic work, including Wei Fan and Michelle J. White's Personal Bankruptcy and the Level of Entrepreneurial Activity. That study used the differences in state bankruptcy laws, specifically the "homestead exemption," to test the relationship between the bankruptcy laws and entrepreneurship. To the surprise of no-one who has studied entrepreneurship, they found that more tolerant laws promote entrepreneurship:
The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as consumers, because debts of non-corporate firms are personal liabilities of the firms' owners. If the firm fails, the owner has an incentive to file for bankruptcy, since both business debts and the owner's personal debts will be discharged. In bankruptcy, the owner must give up assets above a fixed exemption level. Because exemption levels are set by the states, they vary widely. We show that higher bankruptcy exemption levels benefit potential entrepreneurs who are risk averse by providing partial wealth insurance and therefore the probability of owning a business increases as the exemption level rises. We test this prediction and find that the probability of households owning businesses is 35% higher if they live in states with unlimited rather than low exemptions. We also find that the probability of starting a business and the probability of owning a corporate rather than non-corporate business are higher for households that live in high exemption states.
As I said, this finding comes as no surprise to those of us who have been following entrepreneurship. The international comparison study of entrepreneurship, the Global Entrepreneurship Monitor (GEMI) has routinely stated the same thing. In fact, their 2001 National Entrepreneurship Assessment of the Untied States raised the warning:
In early 2001, versions of the Bankruptcy Reform Bill passed through the House and Senate. The bill is designed to reduce the number of personal bankruptcy filings submitted each year in the United States by requiring the payment of some portion of debt determined under court supervision. Proponents feel reform will protect small businesses from debtors while opponents argue that large credit card companies will reap the benefits of such legislation.
The current movement to reform bankruptcy laws could seriously affect entrepreneurship in the United States. As one of our experts stated, "bankruptcy reform is sending entrepreneurship in the wrong direction" because it is discouraging risk.
I remember very clearly listening to a well-known entrepreneur explain to a luncheon of Congressional staff how he built his business my maxing out multiple credit cards. That was a few years ago - and apparently none of that staff is still working for Congress, because those issues were not at the forefront of the debate.
Now, not everyone agrees that these changes will be bad for entrepreneurship. For example, Professor Jeff Cornwall, Director of the Center for Entrepreneurship at Belmont University, is not all that concerned. As he writes, when he teaches entrepreneurship,
I want them a little afraid at their start-up. I want them a little nervous. I want them a little worried about what happens if they fail. Entrepreneurs who rush in blindly like marauding pirates have not learned the lessons we try to teach them in our classes.
. . .
If Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 causes folks to think twice about their business idea, that to me is a good thing. If one of their main exit strategies is a quick and easy bankruptcy, then I want them to either rethink their plan or start over. Or if they are one of my students, plan to take the class again next semester.
He may be right - I disagree.
But the fact is that these issues were not at the center of the debate. The House Judiciary Committee report on the bill (House Report 109-031 - Part 1) does not include the word "innovation" and only has one paragraph on entrepreneurship, in the minority (dissenting) report. This just shows how far we are from having a functioning innovation policy.
Posted by Ken Jarboe at April 20, 2005 11:51 AM
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