Capitalisn’t: Should Luigi’s Pizza file for bankruptcy?

Jul 01, 2020

Sections Economics

Collections COVID-19 Crisis

The coronavirus has taken a heavy toll on most businesses, but it has been especially hard on small businesses. But should those businesses file for bankruptcy, and what will happen to them if they do? On this episode of the Capitalisn’t podcast, hosts Kate Waldock and Luigi Zingales explain how bankruptcy works—or doesn’t work—for small businesses and how the system needs to change.

Kate: Luigi, how’s it going? Have you been out to restaurants yet?

Luigi: No. You know I’m a chicken. I try to stay away as much as I can. But restaurants in Chicago are reopening. Speaking of, what’s happening with our bet?

Kate: Oh, right.

Luigi: I think it was a particular restaurant in Brooklyn that you like. The way I remember it is if we could have dinner last weekend at that restaurant. If we could, I win. Otherwise, you win.

Kate: I did contact that restaurant. They said that they are currently figuring out their plans. They don’t have space for outdoor seating. When I called them, they said they’re trying to figure out how they’re going to reopen, but they haven’t been accepting diners yet.

Luigi: OK. I guess you won. But you won not by much, not by much.

Kate: For once.

Luigi: And the economy is slowly restarting, but not all businesses are restarting. In particular, there are a lot of small businesses and restaurants that are struggling from a financial point of view.

Kate: One of the popular numbers that’s been thrown around in terms of how many businesses are already closed is 100,000. That doesn’t even count the ones that will close in the future.

Luigi: Today, we’re going to talk about Kate’s favorite topic, bankruptcy. 

Kate: Yay.

Luigi: When businesses cannot keep going the way they want, one possibility is to close. The other possibility is to actually go into bankruptcy.

Kate: From Georgetown University, this is Kate Waldock.

Luigi: And from the University of Chicago, this is Luigi Zingales.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: Most people perceive bankruptcy as death. This isn’t necessarily true. When a large company files for bankruptcy, it usually files for Chapter 11. Only about 13 percent end up being liquidated. Of that 13 percent, the ones that are liquidated, a quarter of them already knew that they had no chance of survival. They were like, “Yeah, we’re going to liquidate. We’re not even going to try to reorganize.”

The rest of these companies were either reorganized—they get to continue as they were before—or they’re acquired by other firms and operated under the management of those other firms.

Luigi: Kate loves the topic so much that she ends up loving bankruptcy. It makes it sound like this is a great thing. I have a more necessary-evil kind of a view of bankruptcy. It reminds me of a famous sentence that the late political economist Allan Meltzer used to use, which is, “Capitalism without bankruptcy is like religion without sin. It doesn’t work.” Actually, to be fair, sin, very often, is fun. And bankruptcy is not as much fun. But bankruptcy does play an essential role in a capitalist economy to maintain the process of creative destruction.

Kate: Right. And it’s also a necessary role if we want to have credit. We need for businesses to be able to borrow money, so that they can start up and they can invest and they can hire employees. And businesses wouldn’t be able to borrow any money if the lenders didn’t know what would happen if they weren’t paid back. There has to be some sort of system to work out what happens when a business defaults.

Now, you might think that the natural remedy, if a business defaults on money that it owes, is for the creditor to be able to come in and take everything. They take the assets of the business and then they sell them off and they try to get some financial recovery that way.

But what’s different about the system in the United States is that we actually allow businesses to survive, at least for a little while, because we believe that assets are worth more when they’re together, when they’re kept as a whole, at least in certain circumstances. So, we give businesses the opportunity to try to maximize the value of those assets as a whole before they’re liquidated.

Luigi: In fact, the role of bankruptcy is exactly the role of a filter, trying to figure out whether a firm is worth more alive than dead. If it is worth more than alive, how should we allocate the losses that exist in a way that is fair to those who invested the money but also makes the continuation of the business possible?

Kate: The fundamental point is that bankruptcy is a sorting mechanism to figure out which firms should be kept alive and which firms shouldn’t be kept alive.

Now, that seems kind of like a good thing to me, because at least there’s some chance of survival. But still, most businesses, even individuals, think of bankruptcy as this terrible state that they want to avoid.

Luigi: It’s a bit like a hospital. Unless you go to a hospital for a delivery of a baby, which is happy news, generally, when you go to a hospital, it’s not good news. You don’t see a hospital as a happy place. But hospitals are very necessary to help people recover or even, unfortunately, to help them in the process of dying.

Kate: Yeah, this is absolutely true. Bankruptcy has a bad reputation. Most businesses, even individuals, think of bankruptcy as this terrible state that they want to avoid. I think that there’s several reasons for that.

Number one is that it’s a sign of failure. It’s a sign that somebody made some sort of wrong decision along the way, and you never want to be branded with that.

Another reason people don’t like it is because, in other countries, it’s often a lot less friendly than it is in the United States. In some countries, if you don’t pay a debt, then your business is automatically liquidated or handed over to a trustee who will liquidate it.

And then, finally, of course, there is the possibility that a firm will end up liquidated even if it’s good. It’s impossible for a court to be right a hundred percent of the time. So, invariably, there will be some mistakes made.

Luigi: And there can be two kinds of inefficiencies. You can either kill too many businesses that are worth more alive than dead, or you can let a lot of businesses that should die survive.

And, generally, noneconomists wonder, “What is the problem?” And the answer is you are wasting a lot of resources. Some of the money that is invested in this business would be burned, and that is reducing the size of the pie for everybody. So, I think it’s important to avoid both these two extremes.

This is very difficult, always, but it’s particularly difficult today, because it’s very easy for every business to say, “I am bankrupt not because I’m a bad business, but because of bad luck.” There are a lot of cases where COVID is just the last straw that breaks the camel’s back.

Kate: It’s a pretty big straw.

Luigi: It’s a huge straw. But I was reading the other day in the New York Times, think about bullfighting in Spain. OK? Now, Spanish people are asking for money to support the toreadors and the entire ecosystem of bullfighting, because, of course, they could not perform and they’re bankrupt.

A lot of people say, “Wait a minute, bullfighting was on the way out anyway, because there was so much resistance against the cruelty against the bulls, blah, blah, blah, this is a dying activity anyway, why do you want to subsidize a dying activity?”

So, some people see this as COVID is just an accelerator of a trend that was taking place. Some others say, “Oh, this is a terrible straw that hit me for no good reason.” And, of course, your views are very much influenced by what side of the fence you are on in these issues.

Kate: In the corporate context, there’s really two chapters of the bankruptcy code that matter. There’s Chapter 7, where the firm already knows that it’s going to shut down and liquidate and sell off all its parts. And there’s Chapter 11, where companies at least have a chance of survival.

Luigi: But my impression is that Chapter 11 doesn’t really work very well for small firms. Is that true?

Kate: Yeah, this is absolutely true. In fact, over a decade ago, the National Bankruptcy Conference put together a task force to look at this problem. They were trying to figure out why it is the case that so many small businesses, even though they file for Chapter 11, most of those cases either end up getting dismissed, and the company just disappears, or it ends up being switched into liquidation.

Some of the reasons they came up with were that it was too complicated. A company has to hire lawyers and they have to understand the complicated process, and small businesses just weren’t really equipped to do this.

Another reason is that secured creditors typically have too much influence over the process. Let’s say your bank. They could just be really annoying and basically force the company into liquidation by exerting too much control over the whole process.

The costs are just really high. The administrative costs of paying the court fees and paying trustee fees. These are just too high proportionally for small businesses.

And there’s just a lot of procedural obstacles that are in place that prevent small businesses from taking advantage of Chapter 11, including the absolute priority rule. There’s an ordering of who gets paid first in bankruptcy, and the equity holders, the people who own the business, aren’t supposed to get anything until all of the creditors are paid.

Now, usually for a small business, that’s not possible, which means that, historically, small businesses have just been forced straight into liquidation.

Luigi: But my understanding is, as a result of that committee, et cetera, a new law was passed that, by a lucky stroke, became law in February of this year. Kate, can you explain to me how this law is changing the game?

Kate: This is called the Small Business Reorganization Act. You’re absolutely right, it came into effect on February 19 of this year, which I think was just a couple of days before the first known US coronavirus death.

This just happened to coincide directly with the timing of the onset of coronavirus. Typically, in Chapter 11, there’s a plan of reorganization. Some plan that amends the debt, or maybe writes down some of the debt, so that the business can survive.

Now, in this new act for small businesses, only the managers of the small business can come up with this plan. They have to do it within 90 days to streamline the whole process. There’s a case trustee who’s appointed to help the small business throughout the process of coming up with this plan. And then, importantly, in order for the plan to be confirmed, the business doesn’t need votes from classes of creditors that are impaired. They’re not going to get paid a hundred percent of what they’re owed. That would typically be required in a regular Chapter 11 case.

So, the solicitation of votes isn’t necessarily needed, and the plan can be confirmed by the judge as long as it’s considered fair and equitable, even if it violates the absolute priority rule.

Even if the original small business owner can continue to own the business afterwards, and some creditors aren’t paid back in full, this is OK. This technically violates the fundamental rule that has existed in bankruptcy, which is that the equity holders can’t get anything if the creditors aren’t paid back. For the first time, we’re waiving that requirement.

Luigi: OK, let me get this straight. Suppose I run Luigi’s Pizza, and I don’t have a lot of clients, so I cannot pay my debts as they come due. I can file for this new kind of reorganization, and for 90 days, I can basically decide on my own what the plan is for restructuring without paying any of the existing debts.

If you are the debt holder, you cannot come and take away my oven, even if it was a secured loan, because that would disrupt my ability to produce pizza. So, I think that I have an automatic stay for 90 days. And for 90 days, I’m the only one that comes up with a proposal. I can come up with a proposal without a vote of the creditors? I can come up with a proposal and say, “Kate, I’m sorry. Out of the $100 of a loan, you’re going to see only $2, and tough luck. Let’s move on.”

Kate: OK. There’s a couple of modifications I would make to what you just described, the Luigi’s Pizza reorganization. Number one is that you’re not doing this by yourself. There’s a case trustee who’s an expert in this, who’s looking through your books, looking at how much you’ve made in the past, trying to get a sense of whether you’re actually a viable business.

Number two, all right, here’s where it gets a little bit complicated, but there’s a distinction between a secured creditor who has collateral—they technically have a right to seize this pizza oven, which is a physical asset—and unsecured creditors, let’s say, like your credit-card company.

Now, the secured creditors still have to be paid in full over the course of the plan. Let’s say you come up with a five-year plan for after you emerge. That five-year plan still needs to involve paying back those secured creditors who have the right to the pizza oven.

Luigi: OK. So, just to make sure, if in my plan, I propose something that says I pay you less than a hundred cents on the dollar, the plan is not viable?

Kate: For the secured creditors.

Luigi: For the secured . . . Yeah. You are a secured creditor. You own my oven.

Kate: OK. I’m a secured creditor. I’m the bank.

Luigi: You’re very secured. Yeah.

Kate: But what’s interesting and different is the unsecured creditors. Let’s say you had spent $10,000 on pizza dough using your Discover card, and you don’t want to pay that $10,000 back. In fact, over the course of the next five years, you think that you can only pay $1,000 back. So, they’re taking a 90 percent haircut, basically, on what they’ve lent you.

What’s new about this act is that you can still run the business. You can still control the firm and technically be the owner of the firm, even though Discover is only getting paid back 10 cents on the dollar.

Luigi: Sorry, but as an Italian, not only do I know how to make pizza, I also know how to play tricks. What prevents me from claiming disaster and not paying you back at all?

Kate: Well, I think the check on abuse is the monitoring that’s built in to this new act. This case trustee is really supposed to work very closely with the debtor. They’re supposed to understand how much cash they have saved up. They’re supposed to understand any personal guarantees that might have been made by you, Luigi, the owner of this business. They’re supposed to understand how much money the company is taking in.

They have a good picture of not only what debts are owed and what cash has been accumulated, but what things might look like going forward. They’re supposed to come up with a plan. They’re supposed to help you come up with a plan in a way that’s fair to all of those creditors.

Luigi: This guy is appointed by the court?

Kate: Yes. In fact, assuming that you can’t pay back some of your unsecured creditors, the only thing that you’re supposed to be able to take for yourself as the owner of the business over the course of the plan is really the bare necessities to survive.

So, basically, this plan is going to garnish your wages. They’re going to garnish as much as they possibly can, assuming you can still survive and pay for education of your kids and stuff. Anything beyond that goes to all of the creditors.

Luigi: Sorry if I’m so Italian in this, but what prevents me from writing a nice check to the trustee to make sure that he does what I want and not what the creditors want?

Kate: I think that’s a great question, Luigi. I’m not sure that those safeguards are in place. I think that this sort of corruption is less endemic in the United States, but it still remains to be seen whether this will be a problem.

Luigi: This is a fantastic topic for you to study in the future.

As Kate said, it was a lucky coincidence that this procedure just got passed before COVID. It was relatively easy for Congress, under the CARES Act that was approved at the end of March, to increase the threshold to file for this kind of bankruptcy to $7.5 million in debt.

While it is an untested procedure, it is better to have this available than not to have it in a moment where a lot of businesses have to go through this filter. Because one point that most people don’t fully appreciate is bankruptcy, as you taught me, Kate, is a federal thing in the United States.

There are only 350 bankruptcy judges. So, you cannot rely too heavily on the judges, because if you have hundreds of thousands, if not millions, of businesses filing for bankruptcy, and you have 350 people doing it, then clearly this is a clog in the system.

My understanding, and tell me if I’m wrong, Kate, but my understanding is we did not immediately see a jump in bankruptcies. We don’t know exactly why that’s the case. It could be because, simply, bankruptcy courts were closed, so you couldn’t file. Or because the CARES Act actually did provide some relief. Or because people waited to see whether conditions will improve. But now, we slowly are seeing a large number of companies going through bankruptcy.

Then the question is, what is this going to do to the economy in general? Actually, one point that I should know, but I’m sure you know, is what is the treatment of workers in bankruptcy? So, if Ramsay’s an employee of my Luigi’s Pizza, and I go bankrupt and I owe him a month of wages, what’s happening? He’s an unsecure creditor in the plan.

Kate: Yeah. Where he is in the unsecured spectrum depends on how old the past-due wages are. If they were relatively recent, within the past couple of months, then he’s at the top of the unsecured priority spectrum. But if they were really old, let’s say, from six months ago, then he’ll be at the bottom.

Then, in terms of his wages going forward, most businesses, in fact, submit these motions to the court that say we have to continue paying our employees, we have to continue paying our expenses, in order to keep operating. So, once the bankruptcy starts, if the judge gives permission to continue operating as normal, then his wages will continue to be paid.

Luigi: Yeah. So, if I delay filing for bankruptcy, if Luigi’s Pizza delays filing for bankruptcy, the employees are worse off?

Kate: Yeah. If an employee is not paid, and then the company waits several months to file for bankruptcy, then, yes, that could push them into a lower priority in the claim structure of bankruptcy.

It’s complicated because, A, the CARES Act tried to take care of workers. The name of the funding that was set aside for small businesses was the Paycheck Protection Program. It wasn’t just money for you to continue operating, because what Congress cares most about is employees and workers.

A fraction of that money is supposed to be dedicated to making sure your workers are taken care of. So, I’m doubtful that there’s a whole lot of past-due wage claims because of the emphasis that’s attached to the financing from the CARES Act on paying your employees.

The other thing is that there are also inefficiencies that still exist in the bankruptcy code for small businesses. Even though it was lucky that the timing kicked in right before coronavirus, the Small Business Reorganization Act was not written with coronavirus in mind.

In terms of accumulated leases and treatment of that rent in bankruptcy, there’s a lot that might still push companies into liquidation. I’m not sure the right answer is that we should encourage small businesses to file.

I want to avoid on this episode giving recommendations to workers, because it depends highly on what sort of position you’re in. For many workers, it might be the case that it’s better for them to be unemployed, so that they can collect unemployment benefits while they still last and for businesses to stay out of bankruptcy as long as possible, because landlords will be very aggressive in bankruptcy and they can use their leverage to basically make sure that they’re paid first.

So, I think it’s actually better for small businesses to stay out of bankruptcy for the time being. It’s really the landlords that are the problem.

Luigi: OK. Now, I’m very curious about that, because I actually thought the opposite, that the landlord was screwed in bankruptcy. But you’re saying, no, the landlord has a lot of power. Is that true?

Kate: They can be screwed in bankruptcy if you have a large company with, let’s say, a thousand retail storefronts. In that case, let’s pretend half of those storefronts are not profitable and the other half are. In that sort of situation, the large bankrupt company would have the ability to reject all the unprofitable leases. Companies have a lot of power to do that in bankruptcy. In that sort of situation, landlords might end up getting screwed in the sense that they don’t get paid as much as they were expecting under the terms of their lease.

However, in the case of a small business, a lot of these small businesses only have one retail space. If they want to continue operating, presumably it’s pretty important for them to stay in that one space.

Now, for companies that want to assume their leases, which is to say that they want to continue operating in the same physical retail space, they’re supposed to pay back any unpaid rent and then also continue paying rent during the bankruptcy, subject to a grace period of two months. But the point is that a lot of small businesses won’t be able to do that.

Luigi: You are supposed to pay the back rent based on what? Because they’re not secured creditors.

Kate: Yeah. This is a tricky part of the bankruptcy code. You’re right in the sense that landlords aren’t considered creditors in the bankruptcy, but they do have a contract with a bankrupt company. And contractual obligations are treated a little differently than debt obligations in bankruptcy, but that doesn’t mean that they have no rights.

If a company wants to continue their lease contract, which is to say that they want to stay in the same space, they have to cure defaults under that lease, which is basically to say that they have to pay back their back rent. Not only that, but they’re supposed to do it promptly.

This used to make sense in normal times, because if you want to use somebody’s property going forward, then it makes sense that you should pay them back for having used that property in the past.

But times are a little bit different now because of coronavirus. It’s not really clear what counts as using this property or what the definition of a prompt payment is. Some judges are revising these interpretations on their own. But, at least according to the historical standards, that back rent is supposed to be paid if you want to continue using that space.

Luigi: So, if I decided to downsize my Luigi’s Pizza because I don’t have a lot of people coming in and I only do home delivery, so I don’t want to stay in the same place, I can go through bankruptcy, get rid of my lease, not cure the existing lease and get a lease in a smaller place.

Kate: That’s true. And you raised a good point, which is that I think what the bankruptcy code encourages now is for people to switch, for small businesses to basically be like, “Oh, Luigi’s Pizza’s over there and Kate’s Pizza’s over here.” It’s actually beneficial for us to just switch spaces, which is not efficient from a societal perspective. It’s more efficient for companies to just stay where they are. This treatment of leases, I think, is something that needs to change given the current environment.

Luigi: But this is one of the most important issues, in my view, because, besides workers, the biggest costs for a lot of small businesses are the leases they pay. Clearly, having missed two or three months of revenues, even if they go back to a previous equilibrium, they find themselves incapable of paying all the past leases.

It could be that the landlord voluntarily renounces some of that. That would be nice, but in practice, it would be, I think, impossible for most small businesses that really live on the threshold of financial difficulties any time of the day to have the liquidity to pay back three or four months of leases without the revenues.

And, remember, the Payroll Protection Act was not really giving them money to do that. So, either we find a way to have a general kind of partial forgiveness, or a lot of businesses will play the game of swapping leases and going through bankruptcy.

Kate: Yeah, I totally agree. According to PayScale, the average small business owner pays him- or herself about $70,000 a year. The way that small business bankruptcy now is supposed to work is that you reduce that $70,000 to an amount that’s considered the bare necessity to survive.

I don’t know how much that’s going to end up being. It’s up to the case trustees and the judges to determine that, but let’s say it’s like $40,000 a year, $50,000 a year, which I think already is quite low.

That just means that there’s not a whole lot left over to then go to reimburse all of the unpaid debts and the unpaid credit cards and the unpaid leases for three to six months. Who knows? I just don’t think that extra amount for a lot of small businesses is going to be enough to pay back all of their old leases.

So, you’re absolutely right. I think that the real reform that needs to take place on top of the Small Business Reorganization Act is a treatment of leases during the coronavirus pandemic to say there are modifications that could be made to those contracts that allow small businesses to waive some of their lease requirements during the period of shutdown or the stay-at-home orders.

Luigi: This is particularly true for large commercial landowners. They got, as a benefit, basically zero interest rates. The Fed policy was such that the cost of capital went down tremendously. Many of those are leveraged 75 percent, 80 percent.

So, most of the cost of capital is given by the borrowing cost. And this borrowing cost is approaching zero. They get a huge benefit on the one side, so I think it would be reasonable that they make some concession on the revenue side.

Kate: I think the difficult component of what you’re saying here is, how much of their cost of capital is really going down? Are commercial landowners borrowing a lot more, according to the Main Street facilities? Are they having their loans purchased? And, if so, does that really help their cost of capital if they’re not able to tap credit markets now? Or is it the case that there’s something going on in the background? Which is, the Fed has advised the banks to allow for loan modifications and forbearance, in which case those commercial real-estate owners don’t actually have to pay any debts right now.

Luigi: But my impression is that there still are pretty active debt markets, and many companies have refinanced their debt at much lower rates. Remember, part of the CARES Act is what I call the Mnuchin hedge fund, where the Fed can leverage the $450 billion that the Treasury gives it into loans for up to $4 trillion.

So, the Fed has plenty of ability to finance businesses. The question is, should they make, as a condition of good financing, the fact that they might forgive or partially forgive some of the leases?

Kate: It’s an interesting idea that if the Fed helps out commercial landlords by providing them subsidized credit, then they can insert as one of the conditions for that borrowing that those commercial landlords should then pass on some of that subsidy to their small business tenants in the form of some lease forgiveness or rent forbearance.

As of right now, I think, though I might be wrong, that commercial landlords don’t actually have access to that Mnuchin hedge-fund facility. I think you’re referring to the Main Street Lending Program.

It’s up in the air as to whether the real-estate industry in general is allowed to access that facility. And, even if they were, they might not meet some of the leverage requirements in order to be eligible for that sort of lending.

I think the more important thing is that they’ve basically removed all requirements for banks. If a bank modifies the loan, they no longer need to report that. If a company undergoes a troubled-debt restructuring, that no longer needs to be reported. We have no idea what’s going on in our economy in terms of how these loans are being changed. I think that can be good for commercial real-estate lenders, because all the interest that they owe right now, they’re pushing back and capitalizing it and adding it to the end of the loan. But that’s going to come back and hit us in a few years.

Luigi: But, sorry, what was the logic to allow no reporting?

Kate: I think the government doesn’t want transparency on this right now, because it might set off a crisis.

Luigi: So, this is like President Trump saying we should not test too much for COVID, so that we don’t find out there are COVID cases?

Kate: Absolutely. Our banking sector may or may not have a huge disease. And we don’t know.

Luigi: So, Kate, what’s going to happen to all of us with all this bankruptcy coming online?

Kate: I think that’s a little bit like asking me to be able to read a crystal ball.

Luigi: I feel that this is what we economists do all the time, no?

Kate: Just because I do research in bankruptcy does not make me any better equipped to forecast the future state of the world than you, Luigi.

Luigi: But I think that, on the one hand, as we said at the beginning of the episode, people fear bankruptcy too much. We need some bankruptcies of small businesses to clear the system. We are betting a lot on the efficiency of this new procedure. If this new procedure is efficient, we can get a lot of firms through the system without killing, hopefully, many of the viable ones.

And my take would be, why don’t we extend some unemployment-insurance assistance to shield workers from the pain of the process? Because, if I’m a worker, and my firm goes through bankruptcy, I’m not responsible for that, unless I’m the manager that brought it to bankruptcy.

Kate: I think that these are good recommendations. And, look, I think what’s important to keep in mind is that we haven’t seen a huge wave of bankruptcies yet. There have been some notable, high-profile cases in the past few weeks of large corporations going bankrupt, Hertz being one of them.

But in terms of small businesses, we just haven’t seen the big flood that we were expecting. A lot of that is because we solved the problem from the other direction. We just tried to give them a lot of money and we tried to create a lot of unemployment protection. I think that that was the right solution.

But as to whether this will continue, I mean, that’s the big open question. The Heroes Act was supposed to issue another round of checks to people. It was supposed to free up a lot more money for states and municipalities, and that hasn’t been passed yet because it’s been stuck in the Senate. So, is that going to be confirmed? If it isn’t, that means that we might see a big round of bankruptcies.

Luigi: But I question, actually, the validity of extending not the unemployment insurance, because I think it should be extended, but all the other subsidies for much longer. I think the situation is very different than it was in March. In March, we had the perception that this was a temporary issue and then pretty quickly we were going to go back to normal. Unfortunately, now we see that this is not the case, and probably we’re going to live with this for another year.

So, certain businesses will change dramatically. The number of restaurants, services, that people will demand is going to be reduced significantly for a long period of time. It’s painful, but some restaurants, my Luigi’s Pizza, need to go.

The sooner we realize that, the better. We don’t want to leave the workers at Luigi’s Pizza without a salary. That’s why the unemployment insurance is important. But I don’t see the benefit of sustaining Luigi’s Pizza forever when it has no future, in the sense that at the end of the day, you don’t want to throw bad money after good money.

Kate: I think that you raised a good point. At the heart of all of this is this extreme uncertainty as to what the new normal is going to look like. Is it going to be that we end up going out to restaurants 90 percent as often as we used to? Or is it going to be 60 percent as often as we used to?

For a company that’s barely hanging on prior to the crisis, that can make a really big difference in terms of whether it’s viable or not viable.

I’ve been working with a group of bankruptcy professors to try to think about these issues for small businesses in particular. We’re still puzzling over what’s going on. To be honest, we’d like to see a little bit of what’s going to happen before we really make concrete recommendations about how to change the bankruptcy code.

But the two things that we have been able to say have been, number one, we need more judges and trustees, because, like you said, there’s approximately 350 judges in the whole country. That’s not enough if we see a big wave of filings.

Number two, we would like a little bit more time. Under the act right now, it’s really meant to be streamlined. The manager of a small business is supposed to have 90 days to file a plan. It’s just not clear to me how much of that uncertainty is going to be resolved within 90 days or even 120 days.

We’ve proposed that we just push back some of these deadlines by about six months, so that companies can know a year from now whether they’re viable or not. We don’t want a bunch of reorganizations of firms thinking that they might be viable because we’re overly optimistic, only to have them end up liquidated down the road, because they can’t meet the terms of their plans. We also don’t want a bunch of liquidations if it turns out that the economy ends up rebounding in a year.

Luigi: But can’t you differentiate a bit between different kinds of companies? Because, with all due respect for pizza places, it’s not that the organizational capital of Luigi’s Pizza is so great, in the sense that there is an oven, there’s a client list. If I were to shut down Luigi’s Pizza for six months, and then we restart, the client list is probably still good. I can rent another oven. And I don’t think that the oven has depreciated very much.

The important point here is that we want to save businesses that are worth more as going concerns than debt. Those businesses are businesses where there’s a lot of organizational capital. There is a lot of unique, dedicated capital that once we destroy the business, we can’t reconstruct overnight. Many small businesses, in my view, don’t fit that bill.

Kate: I think this is what makes it so hard to think about a small business. Because, from an economic standpoint, just in terms of comparing a small business to Facebook as a startup, it seems like a pizza restaurant really isn’t that valuable.

But if you think about small businesses as a whole, every single one in the country, I think that there is a great deal of positive externality there. It makes it nicer to live in a community that has a bunch of businesses open. If you shut down a bunch of businesses, that can lead to problems.

When we talk about the economic value of a small business, I don’t think that we really take into account those positive externalities. That makes it really hard to think about when we talk about efficient reallocation.

Luigi: I agree that in some cases you have positive externalities. First of all, this might be true for retail, physical brick-and-mortar retail businesses. When you go to online businesses, it’s less clear that’s the case. But if that’s the case, that can be very easily addressed by the municipality that can reduce taxes on those buildings. In a sense, if I want to preserve a vibrant downtown center, I reduce or even eliminate property taxes for businesses that have some of those characteristics. End of story. We don’t need to use the bankruptcy system to achieve those goals.

Kate: I totally agree. I don’t think we should be using the bankruptcy system to achieve those goals. I think that the bankruptcy system should be an absolute backstop. But one of the problems with what you proposed is that states and municipalities are also really hurting right now. And it’s not obvious that they’re going to be able to afford to cut back on those taxes, because the alternative is that they’re going to have to fire 100,000 teachers. So, everyone’s in a bind right now.

Luigi: Yeah, I think we discussed this in a previous podcast, but there is definitely room for some fiscal transfer from the federal government to the local government to avoid a downward spiral in the local economy. I think that there’s clearly some reason.

And, as we said, maybe this should be part of a bigger package in which some states might be allowed to go bankrupt because of their past mistakes. And this is the lesson of bankruptcy, we need to divide the past mistakes from the future viability. Your financial situation is a combination of the two. In fact, your financial situation reflects your past mistakes more than your future viability. What bankruptcy should help you do is separate the two.

Bankruptcy itself is capitalism, I think we said at the beginning.

Kate: OK. Yeah.

Luigi: Whether this particular reform is the best we could have, only time will tell, but let’s face it. We are lucky to have this versus what we had a year ago.

Kate: I will tell because I’m writing a paper on the efficiency of the new system.