How to Fail in Business : Many Find Road to Bankruptcy Is Paved With Credit Cards

Marilyn August believed in the entrepreneurial dream--that anyone with enough guts and perseverance could cut the cord to corporate America and start up a business.

She found out the hard way, though, that you can’t put the American dream on your American Express. Seven years ago, after quitting her training job with a La Palma computer company to start a cosmetics distributorship, excessive credit card debt forced her into bankruptcy.

August is not alone. Easy credit, a legacy of the debt-happy 1980s, spawned a generation of hopeful start-up businesses. Now many of them are in bankruptcy court, victims of too much credit card use. The cards they used as bootstraps for their businesses have become cement shoes.

There are abundant social messages to encourage people to charge freely on their credit cards, said August, now a financial counselor in Huntington Beach. “It’s a national problem, but it’s not getting national attention.”

Ten or 20 years ago, it was nearly impossible to finance a business on credit cards, said Ed Flynn, a management analyst for the bankruptcy division of the federal court system’s administrative offices in Washington. Credit cards weren’t that easy to get.

Not anymore. Now an estimated one in five entrepreneurs uses cards to get started, said Gerri Detweiler, director of Bankcard Holders of America, a consumer education group in Herndon, Va.

Indeed, a 1991 poll of 2,000 companies conducted by the Kessler Exchange in Northridge, an information clearinghouse and consulting firm for small business, showed that 30% were relying more often on personal credit cards because they couldn’t get bank lines of credit or other loans.

“It is still very easy to get access to credit cards, with no application or approval necessary,” said Detweiler. “An average consumer could acquire between $50,000 and $90,000 worth of credit if he wanted to.”

But it comes with a price.

“In the last year or so, the rate of bankruptcies has skyrocketed,” said Christian Keena, a Tustin attorney who has handled bankruptcies for 10 years. “And it used to be mainly blue-collar workers filing. Now it’s a cross section--it’s doctors, psychologists, even lawyers.”

But a large number of those who file are would-be entrepreneurs of all kinds who tried to bankroll their nascent companies on bank credit cards only to see their efforts fail.

“There’s a lot of gray area between a business and a personal filing,” Keena said. Many of these people would not have had to file bankruptcy, he said, except they were trying to start a business.

“About 20% of all bankruptcies are business failures, and 80% are personal,” said Paul Richard of the National Center for Financial Education, a nonprofit consumer education group in San Diego. “But of that 80%, about 40% are the result of people trying to start their own businesses, usually using personal credit cards.

“Credit card spending is such a part of the American culture that people don’t think about their real costs,” Richard said. “Some people luck out and it pays off.”

Most don’t. “It’s a killer right there to begin with,” he said. “The debt is so short-term, and so very, very expensive.”

August knows firsthand the consequences of overcharging. After she filed bankruptcy, she vowed to help others avoid the spending patterns that got her into her predicament. Today she teaches courses in entrepreneurship as well as what she calls “money dynamics,” exposing the myths about money that influence people’s spending habits. “I deal in reality checks,” she said.

AN EPIDEMIC OF DEBT

But August and other financial counselors are far from having conquered the problem.

Bankruptcies are on the rise throughout the nation and Orange County--historically a breeding ground for small businesses--has been especially hard hit.

Every weekday, in a packed fifth-floor hearing room across the street from the federal courthouse in Santa Ana, people are flooding into creditor hearings to declare publicly that they are broke.

The U.S. trustee’s office now processes 40 or 50 creditor hearings an hour, as many as it used to do in a day, Keena said. “The load is almost paralyzing. It’s standing room only, you would think they were giving prizes away.”

In a sense, they are. Only the prize is a fresh start. In exchange for filing a Chapter 7 or Chapter 13 bankruptcy, most petitioners are discharged from their debts--a transaction that can legally stay on their credit histories for up to 10 years.

Last year, 14,320 Orange County residents filed for protection under the Federal Bankruptcy Act, a 16% increase over the previous year and an 84% increase over the amount five years ago.

And the high rate of bankruptcy appears to be continuing into 1993. In this year’s first quarter, 3,365 Orange County residents filed for bankruptcy, only a slight decrease from the 3,498 who filed during 1992’s first quarter.

Among the different forms of bankruptcy, the greatest increase has been in Chapter 7 filings, said Wendy Webster, a spokeswoman for the U.S. Bankruptcy Court for the Central District of California. Under Chapter 7 of the Federal Bankruptcy Code, individuals agree to sell all their assets to be relieved of all debts. Most who are forced to file personal bankruptcy after a small business failure file Chapter 7.

Last year, 12,066 Orange County residents filed for Chapter 7 bankruptcy-- more than double the 5,980 who made similar filings in 1987. Nationally, Chapter 7 filings grew 71% to 679,662 during the same five-year period.

A CREDIT EXPLOSION

Not coincidentally, the number of credit cards in use nationally has also risen. The explosion of credit card use began in the 1980s, the result of card companies increasing their marketing efforts and easing credit restrictions to make cards available to a wider range of consumers.

In 1981, about 62 million Americans carried 116 million MasterCard, Visa or Discover cards. Ten years later, card use had peaked with 97 million Americans holding 263 million cards. The number of people with cards and the total number of cards in circulation fell in 1992 as the recession and lower interest rates caused people to close accounts and consolidate their debt on lower-cost cards. Last year, 87 million people held 235 million cards.

Despite overall lower rates for most loans, interest rates on credit cards still average between 16% and 18%, according to the American Bankers Assn. Credit Card Industry Report.

“Using credit cards, with interest rates so high and monthly payments that barely cover more than financing fees, it’s very easy to get overextended,” said Detweiler of Bankcard Holders of America. “Finally, the whole house of cards comes down.”

Outstanding credit balances also continue to grow. According to Bankcard Holders of America, nearly half of all card holders paid their balances off each month five years ago; now, fewer than a third of them do.

Visa and MasterCard issuers wrote off more than $8 billion of delinquent balances on more than 3.7 million accounts in 1991, a 45% increase over the previous year, according to the American Bankers Assn. in Washington. (Figures for 1992 are not yet available.)

An increase in card debt doesn’t surprise bankruptcy attorney Elizabeth Swank of Laguna Hills. In the late 1980s, the average number of cards held by her clients who filed bankruptcy was between 10 and 15, she said. Today it’s between 15 and 20.

The balances on those cards have ballooned as well. “It used to be four or five years ago, the average credit card debt of someone filing bankruptcy was about $12,000,” she said. Today it is $20,000 or more. “We’re seeing a lot of biggies now,” Swank said.

Bill, who asked not to be identified by his last name, was one of those biggies.

“There was a time in my life when I had between six and 10 bank accounts in four or five different states and over 40 credit cards,” said Bill, who now participates in Business Owners Debtors Anonymous, a 12-step recovery group similar to Alcoholics Anonymous, which helps people control their urge to spend. The group is affiliated with Southern California Debtors Anonymous in Los Angeles.

A certified public accountant, Bill used the cards to build his accounting practice, entertain clients and to buy lavish gifts. “But I couldn’t tell you the difference between my personal and business finances,” he said. “I made everything a business expense.

“I used what I call CRAP--Creative Reporting and Accounting Principles,” he said. “Eventually, American Express caught up to me and said: ‘Leave home without us.’ ”

In 1985, the Laguna Hills resident declared bankruptcy owing $300,000, which included $125,000 in credit card debt. He owed American Express $27,000 alone.

“My whole life was (built on) credit,” he said. “I spent one whole day a month juggling credit bills, using one card to pay another. I knew I was in over my head but I always figured something would bail me out.”

Like another credit card. Bill said he once lied on credit applications. And because he was in a six-figure income bracket, the cards kept coming in.

Bill joined the Debtors Anonymous chapter in Laguna Hills two years ago when he caught himself sliding back into old habits. Bill said he is now debt-free and that his business has doubled. He lives strictly on cash.

“I just took my family on a 17-day vacation and paid cash for it,” he said. “I had budgeted $2,637 for our trip, but we only spent $1,732. I came back with $900 to put back in savings.”

Despite his bankruptcy, he continues to get pre-approved credit card offers in the mail. “Now I throw them in the trash.”

Bill’s experience is not all that unusual, said financial counselors. And you don’t have to be a big spender to get into trouble.

Neil, another member of Business Owners Debtors Anonymous, operates a modest landscape business near Laguna Hills. He also didn’t think he was getting in debt trouble until it was nearly too late.

“I got into that situation where I was getting mailed a lot of credit cards,” he said. “It seemed like free money to me.”

So he used the cards to buy tools and equipment. “It’s a big temptation to have that automatic money,” Neil said. “Each time I figured maybe this will make (the business) more successful.”

But the free ride didn’t last long. With 10 credit cards and $40,000 in charges that he couldn’t pay, Neil was nearly evicted from the small, one-bedroom Laguna Niguel duplex he rented and his truck was about to be repossessed. He considered filing bankruptcy, but joined Debtors Anonymous instead.

Now Neil said he keeps track of every penny he spends and is working with his creditors on an extended repayment schedule. His landscaping business hasn’t recovered yet, but Neil said he is optimistic that it will improve as he gets out of debt.

A FINANCING ALTERNATIVE

The irony of stories such as Neil’s and Bill’s is that numerous business advisers touted credit cards in the late 1980s as a legitimate alternative source of financing--something to take advantage of.

As traditional business financing from banks became increasingly difficult to get, popular business literature urged entrepreneurs to cash in on those pre-approved credit cards flooding their mailboxes.

Regulatory scrutiny of banks is much more stringent following hundreds of bank and thrift failures in the past decade and bankers are taking fewer lending risks, said Geoffrey Kessler, president of the Kessler Exchange.

Businesses with high asset-to-loan ratios, such as real estate and manufacturing, find it easier to get bank loans despite general troubles in both industries. But small service companies, which typically have few assets but may have better likelihood of success, often can’t get loans.

Traditional bank “credit has been cut way back,” Kessler said. “More and more small businesses are looking to alternative sources.”

But credit cards with high interest rates are a particularly hazardous method of financing a start-up company with its uncertain cash flow.

“The trend I see, is people don’t know how to tell if they’re making any money in their businesses,” said Elise Edgell, a bankruptcy attorney in Orange. “They see fairly large amounts of money coming in, and it’s very hard for them to realize most of that money is spoken for with taxes and bills. They don’t know how to figure out what the demands are on their income.

“When you use a credit card to finance things--you lose the perspective that it’s money,” she said.

The growing number of small-business bankruptcies is, in a sense, a microcosm of what happened in several Fortune 500 companies in the go-go ‘80s.

A feeding frenzy, with junk bonds as the bait, helped fuel an unprecedented wave of mergers and acquisitions in corporate America. Before long, corporations that took on huge debt to acquire other companies were forced to restructure themselves, purging tens of thousands of workers and whole layers of middle management in the process.

Since 1980, an estimated 4.4 million workers have lost their jobs in this wave of what is now euphemistically known as “downsizing.” Educated and experienced, many of those displaced workers became consultants or decided to begin their own small service companies. An unknown number of them used credit cards for start-up capital.

“This was heaven for consultants down here” in Orange County, Keena said. The nature of the leading industries in Orange County--real estate, high-tech, medical and banking--lent themselves to using consultants to avoid increasing permanent payroll costs.

But when the recession forced companies into a second or third round of cutbacks, consultants were among the first to go. “Unfortunately, the consultants became the fat,” Keena said.

Consequently, numerous consultants--and thousands of other entrepreneurs--who found themselves cash poor and laden with credit card debt turned to bankruptcy attorneys for help.

Bankruptcies on the Rise O.C. BANKRUPTCIES 1ST QTR. 1993

Chapter 7 Chapter 11 Chapter 13 Total Jan. 792 21 137 950 Feb. 901 18 136 1,055 March 1,165 30 156 1,351

NATIONAL BANKRUPTCY BY DECADES

Total Filings per 1,000 Decade filings U.S. population 1900-1909 173,298 1.88 1910-1919 215,296 2.03 1920-1929 410,475 3.33 1930-1939 614,938 4.65 1940-1949 296,021 1.96 1950-1959 584,272 3.26 1960-1969 1,695,416 8.34 1970-1979 2,086,189 9.21 1980-1989 4,583,391 18.12

Sources: Administrative Office of the U.S. Courts, Bankruptcy Division; U.S. Bankruptcy Court, Central District of California; Researched by CAROL SMITH and JANICE L. JONES /Los Angeles Times

PROFILE OF O.C. BANKRUPTCIES An era of easy credit was followed by a deep economic slowdown, so local bankruptcy courts are full these days. Among those in the packed courtrooms are many who attempted to begin a small business with credit-card financing. Credit Cards: a Losing Hand For Some It used to be that the average credit-card holder had just one or two cards. Easy credit in the 1980s upped that number to three. How the number of MasterCard, Visa and Discover cards in circulation, and their holders, have increased over the decade:* Bankruptcies: a Glossary * Chapter 7: Allows businesses and individuals to keep some personal property and in some instances, their home and automobile. But they must sell the rest to pay off at least part of what is owed. * Chapter 11: Provides businesses protection from creditors while reorganizing operations and establishing a payment plan. * Chapter 13: Allows individuals protection from creditors and allows payments to be extended up to five years. Orange County Bankruptcies Bankruptcy declarations nearly doubled in Orange County from 1987 to 1992. Chapter 7 1992: 12,066 Chapter 11 1992: 416 Chapter 13 1992: 1,838 Total 1992: 14,320 National Bankruptcies Chapter 7 1992: 679,662 Chapter 11 1992: 24,029 Chapter 13 1992: 267,121 Total 1992: 970,812 Sources: Bankcard Holders of America; administrative office of the U.S. Courts, Bankruptcy Division; U.S. Bankruptcy Court, Central District of California; Researched by CAROL SMITH and JANICE L. JONES / Los Angeles Times