Velvet Bankruptcy

David Hahn


This Article discusses a triangle of forces that affect the activity of small-medium enterprises (SMEs). These forces are: limited liability, shareholder guarantees, and bankruptcy. Limited liability encourages entrepreneurship by reducing the personal risks shareholders are exposed to as a result of business failure. However, the limited liability shield creates the potential moral hazard of overinvestment. That is, the entrepreneur may involve the corporation in overly risky projects. To combat this risk, the lending practice requires entrepreneurs to sign a personal guarantee for corporate debt. The guarantee serves as a bonding device that forces the entrepreneur to internalize the costs of the corporate activity. This Article first argues that while personal guarantees can serve this economic goal, the lending industry demands them excessively and they are overused. The overuse of guarantees unnecessarily subjects good corporate borrowers as well as bad ones to this practice and causes underinvestment. The third force of the triangle, a discharge of the shareholder’s debts in bankruptcy, may balance this inefficiency. It potentially softens the effect of the guarantee and thus requires the lender to further gather borrowerspecific information at the lending stage. Unfortunately, personal bankruptcy is underused by individual debtors mainly because of the stigma it implies. To rebalance the triangle, this Article proposes to encourage the shareholder’s partial relief of the guarantee through an amicable procedure. I call this procedure Velvet Bankruptcy. Velvet Bankruptcy would first procedurally consolidate the private collection from the shareholder-guarantor with the pending corporate bankruptcy case, by authorizing the court to extend the automatic stay to protect the shareholder-guarantor. To the extent the court is convinced that the collection would render the shareholder insolvent, it could reduce the guarantor’s liability. This would effectively constitute discharge without officially declaring the shareholder bankrupt.

Full Text: