Does Debtor Protection Really Protect Debtors? Evidence from the Small Business Credit Market

This paper analyzes how different levels of debtor protection across U.S. states affect small firms’ access to credit, as well as the price and non-price terms of their loans. We use a measure of debtor protection that has its maximum value when the borrower’s home equity is lower than the state homestead exemption (debtor is fully protected), and is decreasing in the difference between the home equity and the homestead exemption (the amount that the creditor can seize). We find that the unlimited liability small businesses (sole proprietorships and most partnerships) have lower access to credit in states with more debtor-friendly bankruptcy laws. In addition, these businesses face harsher loan terms – they are more likely to pledge business collateral, have shorter maturities, pay higher rates, and borrow smaller amounts. For small limited liability companies (corporations and limited liability partnerships), we find only an increase in the loan rate, and a consequent decrease in loan size. Our results suggest that the credit market strongly penalizes unlimited liability small businesses located in states with debtor-friendly personal bankruptcy laws.