The B.E. Journal of Economic Analysis & Policy

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1 The B.E. Journal of Economic Analysis & Policy Advances Volume 10, Issue Article 82 Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Lars Lefgren Frank L. McIntyre Michelle Miller Brigham Young University, lars lefgren@byu.edu Brigham Young University, frank mcintyre@byu.edu Rutgers University, millerm@business.rutgers.edu Recommended Citation Lars Lefgren, Frank L. McIntyre, and Michelle Miller (2010) Chapter 7 or 13: Are Client or Lawyer Interests Paramount?, The B.E. Journal of Economic Analysis & Policy: Vol. 10: Iss. 1 (Advances), Article 82. Available at: Copyright c 2010 The Berkeley Electronic Press. All rights reserved.

2 Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Lars Lefgren, Frank L. McIntyre, and Michelle Miller Abstract Households often rely on professionals with specialized knowledge to make important financial decisions. In many cases, the professional s financial interests are at odds with those of the client. We explore this problem in the context of personal bankruptcy. OLS, fixed effects, and IV estimates all show that attorneys play a central role in determining whether households file under Chapter 7 or Chapter 13 of the bankruptcy code. We present evidence suggesting that some attorneys maximize profits by steering households into Chapter 13 bankruptcy even when the households objective financial benefits are low and the probability of case dismissal is high. An attorney-induced Chapter 13 filing increases household legal fees and reduces the probability of long-term debt relief. KEYWORDS: consumer bankruptcy, principal agent problems We thank Tina Lindsay and Jocelyn Rick for helpful discussions regarding institutional factors affecting personal bankruptcy. We thank Paul Weitzel, Amanda Boren, Laura Summers, Justin Hansen, Brad Hunter, Mirinda Martin, Henry Tappen, and Daniel Sullivan for excellent research assistance. We are grateful to David Sims, Joseph Price, Richard Butler, Brian Jacob, Mark Showalter, Brad Larsen, and seminar participants at Brigham Young University, the University of California, Berkeley, and the Wharton School of Business for their thoughtful comments.

3 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Introduction Individuals rely on informed professionals for many of their important financial decisions. A growing literature documents the extent to which professionals sacrifice their clients interests to increase profits. An early example of such work is Fuchs (1978) who presented evidence that the incidence and price of surgery increased with the supply of surgeons. More recently, Gruber and Owings (1996) provide evidence that doctors are more likely to perform expensive caesarian sections when there is relatively low demand for their services. Levitt and Syverson (2008) show that real estate agents price clients houses more cheaply than their own. Similarly, Harrington and Krynski (2002) discuss how funeral directors often induce households to bury their deceased loved ones in lieu of a less expensive cremation. Chevalier and Ellison (1997) demonstrate that mutual fund managers adjust the risk of their portfolio to maximize fund inflows instead of risk-adjusted returns. In addition, Bergstresser, Chalmers, and Tufano (2009) show that mutual fund brokers and financial advisors provide no discernible financial benefit to consumers. In this paper, we examine the principal-agent problem in the context of personal bankruptcy. When filing for bankruptcy, households can file under Chapter 7 or Chapter 13 of the Bankruptcy Code. 1 For most debtors, a Chapter 7 bankruptcy involves a quick discharge of most unsecured debts, while a Chapter 13 bankruptcy requires households to make payments for three to five years. As discussed in great detail below, the advantages and disadvantages of each chapter are complex--- indeed the optimal chapter for any debtor depends on very detailed aspects of his financial situation. Previous research, however, has suggested that the chapter under which households file is not purely a function of their financial situation. 2 1 During the time period in question, Chapter 7 and Chapter 13 relief was available to nearly every debtor. Prior to 2005, the bankruptcy trustee could ask the judge to dismiss a case because the debtor s income was so high that to permit the debtor to discharge his debts in Chapter 7 was a substantial abuse of the bankruptcy system. However, the attitudes of trustees and judges about abuse varied from district to district. Therefore, in 2005 the Bankruptcy Code was amended to include a means test which is intended to provide a more objective approach to the issue of a debtor s ability to pay. However, as discussed in more detail later in this paper, this income restriction rarely applies. It should be noted that relief under Chapter 11 was also available to individual debtors, but few debtors chose that option because of its significant cost. 2 For example, Lefgren and McIntyre (2009) report that the fraction of personal bankruptcies filed under Chapter 13 ranges from 0.03 in North Carolina to 0.62 in Georgia, suggesting legal culture plays an important role in chapter choice. Sullivan, Warren, and Westbrook (1998) emphasize that debt loads and repayment ability appear similar for Chapter 7 and Chapter 13 filers. Braucher (1993) presents qualitative evidence of the attorney s role in the chapter decision. Published by The Berkeley Electronic Press,

4 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 Personal bankruptcy is one of the most important mechanisms through which Americans are insured against adverse financial, health, and personal shocks. Nearly five out of every thousand persons in the United States filed for personal bankruptcy in 2009, more than quadruple the rate for And given the current economic crisis, the bankruptcy filing rate is likely to increase. According to the Administrative Office of the U.S. Courts, bankruptcy transferred over $206 billion dollars in more than state unemployment insurance programs and Temporary Assistance for Needy Families (TANF) combined (Lefgren and McIntyre, 2009). We find a strong correlation between the debtor s chapter decision and the chapter decisions of his attorney s other clients. Specifically, our household-level data from California, Texas, and Utah, shows that an attorney s fraction of other bankruptcies filed under Chapter 13 explains percent of the variation in chapter selection. This correlation could be due to households matching to attorneys based on the household s preferred bankruptcy chapter. However, we argue that this correlation is more likely caused by attorneys steering clients into the attorneys preferred bankruptcy option. In particular, the correlation persists even after we control for the household s financial situation and neighborhood fixed effects. Additionally, we find the same results when we employ an instrumental variables strategy in which we instrument attorney fraction 13 with a measure of the average attorney filing behavior in a debtor s neighborhood. This strategy takes advantage of the fact that a particular household is more likely to file under Chapter 13 if attorneys close to them specialize in this chapter. To address concerns that our instrumental variables specifications are biased by variation in neighborhood level attitudes towards default, we show that our results are robust to the inclusion of Census block fixed effects or Census tract*year fixed effects. Attorney specialization appears to be consistent with firm profit maximization. We show that large (high volume) firms and firms with a client mix better suited for Chapter 13 bankruptcies tend to specialize in Chapter 13. This supports a model in which firms that expect to file a large number of Chapter 13 bankruptcies engage in fixed investments to reduce the marginal costs of filing such cases. Thus, firms encourage Chapter 13 when the cost is low enough to rationalize (from a profit-maximization perspective) pursuing the higher courtregulated attorney fees available under this chapter. Firms specializing in Chapter 13 collect more for these bankruptcies, although less payment is required upfront. Yet these firms do not offer benefits in terms of lower dismissal rates or more manageable payment plans. Indeed, our IV estimates, which focus on households that chose attorneys based on geographic convenience, suggest that those who file under Chapter 13 with 2

5 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Chapter 13 specialists are often objectively poorly suited for this type of bankruptcy and have high dismissal rates. While it is plausible that some variation in attorney behavior may be driven by differing views regarding the advantages of each type of bankruptcy, attorney specialization is empirically consistent with debtor interests being subordinate to firm profits. Regardless of the cause of specialization, a typical lawyer-instigated decision to file under Chapter 13, as opposed to Chapter 7, leads to a substantial transfer of wealth from insolvent households to specialized attorneys with a reduced probability of long-term debt relief. Review of the Literature In addition to the empirical principal-agent literature cited in the introduction, our paper relates to a large existing literature on personal bankruptcy found in both the economics and legal disciplines. Most closely related to our analysis is a set of papers that explore factors driving a household s choice of bankruptcy chapters. Nelson (1999), Domowitz and Sartain (1999), Sullivan and Worden (1990), Li and Sarte (2002), and Sullivan et al. (1988) all find that financial incentives play a role in the household s choice of bankruptcy chapter. However, many economists note that legal culture and the choice of attorney also play important roles in the chapter decision. Specifically, Lefgren and McIntyre (2009) find that the propensity to file under Chapter 13 of the bankruptcy code varies greatly across localities. Because these differences are extremely persistent and exist across adjacent states with seemingly similar populations, they conclude that the differences in the proportion of Chapter 13 filings are likely due to legal culture. Sullivan et al. (1994) also argue that all of the variation across bankruptcy courts in chapter choice cannot be explained by state laws, by the behavior of particular individuals or by other non-legal factors. The authors develop a model in which the local legal culture is dominated by lawyers. According to this model, the lawyer, due to specialty, moral preference, or stereotype, influences the chapter choice. Braucher (1993), Neustadter (1986) and Sullivan et al. (1988) all provide important qualitative evidence that lawyers often steer households toward one particular bankruptcy alternative. Our paper is also closely related to the medical literature examining variation in treatment choice across providers and locations. Health economists have widely documented the variation in physician practice styles which cannot be explained by income, insurance, or patient preferences. Recent examples including Chandra and Staiger (2007), Epstein, Ketcham and Nicholson (2005), and Grytten and Sørensen (2003) show that choice of service provider plays an important role in the type of treatment patients receive. Chandra and Staiger Published by The Berkeley Electronic Press,

6 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 (2007) and Allgood and Bachmann (2006) highlight the health benefits that patients receive from physician specialization. The current study makes three contributions to the existing literature on chapter choice. First, we quantify the magnitude of the attorney s role in chapter choice. Second, we address concerns that the apparent role of lawyers is driven by the endogenous sorting of clients to attorneys. Third, we show that attorney Chapter 13 specialization is on average detrimental to clients and plausibly driven by profit maximization on the part of the attorney. Our paper also adds fresh evidence regarding the problems of principal-agent relationships when the principal (the insolvent household in our example) is unsophisticated. Institutional Background For insolvent households, personal bankruptcy is a primary instrument of debt relief. Federal authority for bankruptcy is found in Article 1, Section 8 of the United States Constitution. For this reason, many aspects of bankruptcy are uniform across states. When households file for bankruptcy, creditors must stop all collection measures; this means that creditors must cease all foreclosure proceedings and garnishments. In addition, creditors cannot send the debtor correspondence. 3 When they petition for bankruptcy, debtors must decide whether to file under Chapter 7 or Chapter 13 of the Bankruptcy Code. The complex differences between Chapter 7 and Chapter 13 are detailed in the subsection below. Under Chapter 7, often referred to as liquidation, households may only keep exempt assets. All other assets of value (if present) are liquidated by a trustee and distributed to creditors. 4 This process is fast and simple; Chapter 7 debtors are able to obtain a speedy discharge of most unsecured debts and remove some judicial liens. On the other hand, under Chapter 13, debtors keep all their property and instead agree to repay their debts using their future income. 5 Chapter 13 cases are comparatively complex and lengthy. From 1999 to 2001, 3 U.S.C (j) provides an exception for sending of correspondence for bills of the regular periodic payment on a home mortgage. 4 As detailed in the subsection below, in at least 95 percent of Chapter 7 cases, the debtor does not have any non-exempt assets to liquidate. 5 Before the Bankruptcy Code was amended in 2005, households could choose either a three or five-year repayment plan. If a debtor had a five-year repayment plan (as opposed to a three-year repayment plan), they typically paid less every month. Therefore, debtors typically repaid the same amount, regardless of the length of the plan. After the Bankruptcy Code was amended in 2005, household with income above the state median level were required to enter into a five-year repayment plan. Only debtors with income below the state median level could enter into a threeyear repayment plan. 4

7 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Lefgren and McIntyre (2009) report that 70.5 percent of all personal bankruptcies were filed under Chapter 7. Institutional Procedure: The Difference between Chapter 7 and Chapter 13 A Chapter 7 case begins when the debtor s attorney files a petition with the bankruptcy court. 6 In addition to the petition, the debtor must detail his assets, liabilities, monthly income, and average monthly expenses. After the petition is filed, a Chapter 7 bankruptcy trustee holds a meeting of creditors, during which the trustee and creditors may ask the debtor questions regarding these documents. According to conversations with bankruptcy attorneys, creditors typically do not even attend these meetings. Following the meeting of the creditors, the trustee will gather and sell some of the debtor s assets. The Bankruptcy Code, allows the debtor to keep certain exempt property. Specifically, debtors may keep assets with a value below the personal and homestead exemption levels. These exemption levels vary dramatically across states. For example, Florida has an unlimited homestead exemption while Delaware has none. The large majority of Chapter 7 cases involve no non-exempt assets that are profitable for the trustee to sell. According to the 1997 National Bankruptcy Review Commission Report, less than 5 percent of Chapter 7 consumer bankruptcies were denominated as asset cases. After the debtor s assets are liquidated, the proceeds are used to repay creditors and the debtor is discharged (released from liability) of any remaining debts. In other words, all remaining debts are then forgiven. Because the typical Chapter 7 bankruptcy does not involve contested filings or the liquidation of assets, it is quick and simple for both the attorney and the client. Furthermore, only a small fraction of such bankruptcies are dismissed. In our sample of Chapter 7 filings, only 3 percent were listed as being dismissed. Not all households, however, can file for Chapter 7 bankruptcy. Households who already filed for Chapter 7 bankruptcy within the past six years are ineligible. 7 Additionally, United States trustees, who represent creditor interests, may attempt to force individuals to file under Chapter 13 if it is clear that the debtors possess the ability to pay a substantial fraction of their debts percent of Chapter 7 and 4.1 percent of Chapter 13 cases are filed without an attorney. We ignore such cases in our analysis. 7 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) extended the time households must wait between consecutive Chapter 7 cases to eight years. 8 Indeed, while courts have long had the discretion to mandate that high-income households file under Chapter 13, the BAPCPA required that households earning income above the state median level file under a Chapter 13. Households are allowed to deduct certain expenses from their income, however. Most economists argue that this income restriction rarely applies. In a sample of 1,938 cases filed nationwide between November 1998 and August 1999, Flynn and Bermant (2000) only found two petitions which were filed under Chapter 7 but failed the means test. Published by The Berkeley Electronic Press,

8 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 Rarely are the income restriction or trustee objections an obstacle for households considering bankruptcy. Indeed, in our sample, only 47 cases were converted from a Chapter 7 to a Chapter 13. As an alternative to Chapter 7, households may file for bankruptcy under Chapter 13 of the Bankruptcy Code. As in a Chapter 7, a Chapter 13 case begins when the debtor s attorney files a petition with the bankruptcy court. Again, the debtor must detail their assets, debts, monthly income, and average monthly expenses. In addition to the bankruptcy petition, when a debtor files under Chapter 13 of the Bankruptcy Code, their attorney must create a Chapter 13 repayment plan. This plan specifies the amount debtors will pay to the trustee every month; debtors pay their projected monthly disposable income, generally calculated as the difference between their monthly income and monthly budgeted living expenses, into the Chapter 13 payment plan. 9 Thus, to create this plan, attorneys must collect and investigate their client s receipts and bank statements, and generate a comprehensive itemized budget for their clients to follow over a three- to five-year period. The paperwork, planning, and organization required to complete this task is substantial. Therefore, filing under Chapter 13 of the Bankruptcy Code involves substantially more time and paperwork than a Chapter 7. After the repayment plan is submitted, as in a Chapter 7, the bankruptcy trustee holds a meeting of creditors, during which the trustee and creditors may ask the debtor questions regarding these documents. After the meeting with the creditors, the Chapter 13 repayment plan must be confirmed by the court. This process can also be fairly difficult and time Similarly, Culhane and White (1999) estimated that only 3.6 percent of debtors would be barred from Chapter 7 when a means test was enacted. True to speculation, within the first year of its enactment, the Acting Director of the Executive Office of the U.S. Trustees testified that approximately 0.5 percent of Chapter 7 filers were being affected by the means test (Tabb and McClelland 2007). White (2007) also finds that only a relatively small minority of filers were affected by the means test. 9 Before the BAPCPA of 2005, households used their projected monthly income and actual monthly expenses to determine the monthly amount paid into a Chapter 13 plan. After 2005, households use the means test to determine the monthly amount paid into a Chapter 13 plan. Instead of using their projected monthly income, households use their average monthly income over the past six months. If the household s average income over the past six months was below the state median income level, the household deducts actual monthly expenses--- the difference between its average monthly income and its actual monthly expenses is the amount the household will pay into a Chapter 13 plan each month. If the household s average income over the past six months was above the state median income level, the household subtracts standard deductions for expenditures---the difference between its average monthly income and standard expenditure deductions is the amount the household will pay into a Chapter 13 plan each month. A recent Supreme Court decision, however, stated that if a household s circumstances changed over the past six months, and its average monthly income over the past six months differs from its projected monthly income, the household must use its projected monthly income to calculate the amount paid into the Chapter 13 plan. 6

9 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? consuming. On average the Chapter 13 confirmation process takes four months to complete. 10 At the confirmation hearing, the Chapter 13 repayment plan can be dismissed, converted, or confirmed. Dismissal can occur if the repayment plan is not in the best interest of the creditors, if the plan was not proposed in good faith, if the plan is infeasible, or if the debtor does not cooperate in providing sufficient documentation. If the case is dismissed, the debtor does not receive a discharge, and thus, does not receive any long-term debt relief. If the case is converted to a Chapter 7, the debtor only receives long term debt relief if they are able to receive a Chapter 7 discharge. If the Chapter 13 repayment plan is confirmed, the Chapter 13 trustee will begin to distribute funds to creditors. 11 Only upon completion of the plan, which, as mentioned, takes three to five years, are the household s remaining debts discharged. 12 If the debtor is unable to complete their repayment plan, the case will either be converted or dismissed. If the case is ultimately dismissed the household is once again liable for any remaining debts; thus, they do not receive any long term debt relief. It should be noted that debtors can file under Chapter 13 as frequently as every six months. 13 Figure 1 contains a diagram outlining the legal procedures discussed above. The Advantages and Disadvantages of Chapter 13 Relative to Chapter 7, Chapter 13 is advantageous for some households but is detrimental to many debtors. One of the main benefits of a Chapter 13 is that debtors may keep all of their assets. However, in order to discharge its debts under Chapter 13, a household must complete its repayment plan. Thus, Chapter 13 is designed for households with a continuing ability to earn income and minimize future expenditures. As mentioned, if a debtor is unable to follow through on a long-term plan, his case will be dismissed, and he will be liable for all his original debts as well as additional court and lawyer fees. According to 10 By comparison, a Chapter 7 bankruptcy may never appear in court. Unless there is a problem, a Chapter 7 bankruptcy sails through the administrative process without appearing before a bankruptcy judge. 11 The funds are first disbursed to the debtor s lawyer, then to creditors with priority claims, and finally, any remaining funds are used to repay creditors with unsecured claims. 12 The Chapter 13 discharge is often referred to as the super-discharge; in addition to the debts discharged under Chapter 7, Chapter 13 debtors can discharge debts from property settlements following a divorce, debts for willful and malicious injury, child support payments, and debts incurred to pay non-dischargeable tax obligations. Before the BAPCPA, debtors filing under a Chapter 13 could also discharge debts from embezzlement, larceny and fraud. 13 The BAPCPA extended this time period; households must now wait two years between Chapter 13 cases. Published by The Berkeley Electronic Press,

10 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 Lefgren and McIntyre (2009), while 29.5 percent of bankruptcies are filed under Chapter 13 of the bankruptcy code, the majority of these bankruptcies (60 percent) are dismissed largely due to nonpayment on the debtor s part. 14 Another 12 percent of the Chapter 13 filings are ultimately converted to Chapter 7 for the same reason. Thus, Chapter 13 bankruptcies only represent 10 percent of bankruptcy discharges. For these reasons, the majority of households filing under Chapter 13 do not receive one of the long-term benefits of bankruptcy, the discharge of unsecured debts. Figure 1: Institutional Procedures 14 Others have found even higher failure rates of Chapter 13 bankruptcies. See for example, Norberg and Velkey (2006). Norberg and Velkey (2006) also discuss how many households file repeat Chapter 13 bankruptcies in response to these high dismissal rates. 8

11 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Another benefit of filing under Chapter 13 is that debtors may save secured property (such as a home) by curing an arrearage (the value of missed payments) this benefit is discussed in more detail below. 15 Again, it is unlikely that this benefit will be realized if the case is either dismissed or converted to a Chapter Therefore, as this secondary benefit is primarily received upon completion of the plan (when a discharge is received) it stands to hold that the majority of households filing under Chapter 13 do not receive the long-term benefits that bankruptcy can provide. Finally, under Chapter 13 bankruptcy, the household retains the right to file under Chapter 7 should future economic shocks occur. Attorney Fees Both the timing of the attorney fees and the amount collected vary by chapter. Chapter 7 attorney fees are unregulated by the courts and households typically pay the entire fee upfront. 17 With Chapter 13, households usually pay some fees upfront; however, the majority of the fees are collected as part of the household s repayment plan. This can represent a substantial benefit to the clients as they are often hard pressed to assemble the legal and filing fees up front. 18,19 Individual bankruptcy courts set standard no look fees for Chapter 13 compensation--- only fees above a customary limit are subject to special scrutiny. Thus, attorney 15 Collateral retention may also be possible under Chapter 7. Before the BAPCPA, five circuit courts of appeal recognized the ride-through as part of the Bankruptcy Code. This ridethrough allowed bankrupt households to keep their property during and after bankruptcy by remaining current on their payments; it prevented creditors from imposing harsher terms on debtors during the bankruptcy process. The BAPCPA modified the Bankruptcy Code sections relating to the ride-through. While the ride-through was not eliminated, the BAPCPA also did not endorse its expansion. As a result, the courts are still split over the ride-through (Hogan 2008). 16 If the Chapter 13 repayment plan is breached, the creditor is no longer bound by the plan and the debtor is once again liable for all debts in addition to any accrued late fees. In cases where the arrearages are cured, the debtors may still be able to retain secured assets even if the plan fails. 17 In the Texas sample for which we have some repayment information, 60% of Chapter 7 lawyer fees are completely paid up front. For the other 40% it is not clear from our available data when the remainder was paid. For Chapter 13 filings virtually none are paid up front, with the vast majority of clients having paid less than 25% up front. 18 See Mann and Porter (2010) for a discussion of the difficulty households face in saving for bankruptcy. 19 In some cases, an attorney will convert an unsuccessful Chapter 13 case to a Chapter 7 without additional charge if adequate fees have been paid through the repayment plan. Published by The Berkeley Electronic Press,

12 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 fees are tightly clustered around this informal limit. 20 Courts also retain the right to review Chapter 7 fees for reasonableness. As we document above, Chapter 13 bankruptcies are substantially more difficult to file than Chapter 7 bankruptcies. Perhaps for this reason, the customary Chapter 13 fee is typically much higher than the equilibrium Chapter 7 fee set by the market. A 2008 U.S. Government Accountability Office (GAO) report found that before the BAPCPA, the median attorney fees for a Chapter bankruptcy was $2,400 compared to $712 for a Chapter 7 bankruptcy. Attorneys are able to collect higher fees from a Chapter 13 bankruptcy even if the case is unsuccessful (i.e., even if the household is unable to discharge its unsecured debts). Households begin making payments into the Chapter 13 repayment plan within one month of submitting the plan. Thus, even if the plan has not been confirmed, households must begin making payments into the Chapter 13 repayment plan. In the Chapter 13 repayment plan, attorney and trustee fees are given priority status relative to other creditors; their fees may displace payments to other creditors. Thus, even if the plan fails, attorneys collect the majority of their payment. 22 As an example of this, we drew a random sample of 54 dismissed (unsuccessful) Chapter 13 bankruptcies filed in Texas in For these 54 cases, the average lawyer fee was $2,055. The final trustee reports show that the average dismissed case lasted 13 months. Despite the rapid dismissal of the majority of these cases, lawyers still received $1,376 on average 66 percent of the nominal fee. In discharged cases (which we did not sample), we know the lawyer is fully paid; thus a lawyer s unconditional expected payment from a Chapter 13 filing was 80 percent of their fee. 23 The average unsecured debt in these dismissed cases was $19,803; households repaid $302 on average. Secured debt averaged $21,546 with $2,280 in principal repaid and $598 in interest. Thus, for this small Texan sample, even when a case was dismissed, the attorney received substantial compensation though a very small fraction of the other debts was repaid. In 22 out of 54 dismissals, the lawyer was paid more than all other creditors combined. 20 See Braucher (1993). Note that these fee limits increased in the aftermath of the 2005 law change. The averages we report here are from February 1, When we look at fees as an outcome variable, we restrict our sample to pre A discussion of how the BAPCPA altered attorney fees can be found below. 22 Braucher (1993) finds that in some jurisdictions, the price differential between Chapter 13 and Chapter 7 bankruptcies is much smaller. In these jurisdictions, lawyers only rarely file bankruptcies under Chapter percent of 2003 Chapter 13 cases in Texas were dismissed..4*1 +.6*.66 =

13 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Lawyer Specialization Lawyers vary significantly in the fraction of bankruptcies they file under Chapter 13. Figure 2 shows the distribution of lawyers in California, Texas, and Utah by the fraction of bankruptcies they file under Chapter 13. This histogram demonstrates the large variation in lawyer behavior. 42 percent of lawyers file fewer than 10 percent of their cases under Chapter 13 of the Bankruptcy Code. On the other hand, 20 percent of lawyers file more than 40 percent of bankruptcies under Chapter 13. If bankruptcy clients shop for lawyers who meet their specific financial situations, specialization may not indicate that lawyers play a significant role in determining chapter choice. On the other hand, if filing households are relatively unsophisticated when selecting a lawyer, the high degree of lawyer specialization suggests that the attorney is crucial in a household s choice of bankruptcy chapter. Prior research suggests that attorneys play a strong role in guiding households in their bankruptcy decisions. Braucher (1993) notes that consumer bankruptcy clients are not typically repeat clients. 24 First time bankruptcy clients typically have little information regarding the costs 24 Over time it has consistently been shown that repeat filers represent a small fraction of debtors. Sullivan, Warren, and Westbrook (1989) estimated the only 3 percent of their sample represented repeat filers. Similarly, the 1997 National Bankruptcy Review Commission estimated that only 8 percent of debtors were repeat filers. And in a sample of debtors who filed after the BAPCPA, Miller and Miller (2008) found that only 5 percent of debtors were repeat filers. Published by The Berkeley Electronic Press,

14 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 and benefits of each type of bankruptcy. Additionally, it is likely that the social stigma associated with personal bankruptcy reduces information about peoples bankruptcy experiences. Braucher (1993) effectively documents the role that attorneys play in guiding typically unsophisticated clients towards one type of bankruptcy. Some attorneys influence clients to file under Chapter 13 by emphasizing the benefits of retaining secured assets, the morality of repaying creditors, and access to future credit. 25 Other attorneys shift households towards Chapter 7 bankruptcy by highlighting the difficulty of maintaining the payment plan, the moral obligations to provide financially for their families, and the predatory nature of some creditors. 26 Braucher finds that clients' guilt and loss of self-esteem makes them highly vulnerable to lawyers' influence, whether exercised unwittingly or deliberately. She concludes that attorney practices have more effect on chapter choices than features of the law conventionally thought to be important. Similarly, Sullivan et al. (1988) find that among other factors, attorneys greatly influence the choice of chapter. Using data collected during surveys, the authors find that nearly 32 percent of debtors consulted attorneys specializing in bankruptcy while the remaining debtors sought counsel from more general practitioners. The authors discover a positive, moderate unconditional correlation (r = 0.27) between seeing a bankruptcy specialist and filing under Chapter 13 of the Bankruptcy Code. This suggests that attorneys may exert an important influence over whether debtors file Chapter 7 or Chapter 13. The heterogeneity in attorney behavior can be rationalized by a model in which firms engage in investments to lower the marginal cost of filing Chapter 13 bankruptcies. 27 The formal model is available upon request from the authors. As discussed above, attorneys collect higher fees from a Chapter 13 bankruptcy. Thus, while Chapter 13 bankruptcies are more difficult to file than Chapter 7 bankruptcies, they generate more revenue. However, firms can engage in investments to lower the marginal cost of filing Chapter 13 bankruptcies Though a Chapter 13 bankruptcy remains on a credit report for less time, in some cases Chapter 7 is a better choice for households seeking access to credit. Lenders are aware that households who file under Chapter 7 have fewer competing debt obligations than Chapter 13 filers. Also filing for Chapter 7 bankruptcy removes the option of doing so again in the near future. 26 The difficulty of assessing the relative costs and benefits of each chapter may also allow attorneys to rationalize either chapter choice decision. 27 Many others have considered the principal agent problem from a theoretical standpoint. Yet none have considered the problem in the context of personal bankruptcy. However, Carlin and Gervais (2008) and Inderst and Ottaviani (2010) are recent examples of theoretical papers considering principal agent problems in the context of retail financial markets. 28 Compared to Chapter 13 bankruptcies, Chapter 7 bankruptcies are relatively simple to file (at times they are even filed without the help of an attorney) which is why we do not consider the possibility that attorneys could engage in investments to reduce the cost of filing Chapter 7 bankruptcies. 12

15 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Suppose that firms can undertake investments in technology, personnel, or human capital to lower the marginal costs of filing bankruptcies under Chapter Firms that expect to file enough Chapter 13 bankruptcies would find it optimal to undertake such investments. Investments made to lower the cost of filing bankruptcies under Chapter 13 lead to law firm specialization. More specifically, investing firms find it optimal to steer a higher fraction of households into Chapter 13 than non-investing firms, even holding client mix constant. There are two testable implications of this model. First, larger (high volume) firms will file a higher fraction of bankruptcies under Chapter 13 than smaller firms. The second implication is that firms with a client mix better suited for Chapter 13 will be more likely to file any given bankruptcy under Chapter 13. Similar implications can be obtained from a learning-by-doing model in which attorneys become better at filing Chapter 13 bankruptcies with practice. Our theoretical framework suggests that attorneys will steer households towards the bankruptcy option that maximizes profits, even, in some cases, at the 30,31 expense of their clients financial interests. Of course, Chapter 13 specialization may also lead to lower costs or improved bankruptcy outcomes. We examine these possibilities empirically and find little evidence that insolvent households benefit from employing a Chapter 13 specialist. Description of Data Our bankruptcy data come from Public Access to Court Electronic Records (PACER), the bankruptcy courts centralized registration and billing website. 32 Our dataset is limited to the three bankruptcy courts which gave us access to their 29 Specialized software programs automate much of the bankruptcy filing process. According to attorneys, this software is more helpful for the filing of Chapter 13 bankruptcies than the filing of Chapter 7 bankruptcies. 30 Specialization likely also reflects different attorney beliefs regarding the relative benefits of Chapter 7 and Chapter 13 bankruptcy. Lawyers may also vary in how seriously they take their obligation to look after their clients best financial interests and ethical views. These hypotheses cannot be tested, however, with available data. 31 One might believe that market competition among attorneys would limit the ability of attorneys to steer their clients in a direction contrary to their best interests. However, there is strong reason to believe that attorneys have substantial market power. In particular, households are much more likely to go to attorneys located close to their homes than to more distant attorneys. This is manifest by the strong first stage power of our instrument, which we discuss later. Consequently, we believe that attorneys have a great deal of influence over their clients choices. Additionally, the disciplining power of reputation is limited by clients sense of embarrassment in discussing bankruptcy. 32 Each court operates its own database with case information. Launched in 1997, courts slowly began to use PACER s electronic database system. The last court adopted the PACER system in Published by The Berkeley Electronic Press,

16 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 electronic records: Utah, Texas Northern, and California Northern from the period 2000 to The Utah sample is a census of bankruptcies from early 2000 to late 2004; after cleaning the data, our Utah sample includes 68,123 cases. On the other hand, the Texas and California data are samples from 2003 to 2006; these samples include 29,188 of the 113,412 and 24,105 of the 78,263 cases filed in the Northern Districts of Texas and California, respectively, during these four years. 36 percent of the bankruptcies in our sample were filed under Chapter 13 relative to just under 30 percent in the U.S. prior to the 2005 bankruptcy reform and just over 20 percent in The filing rates for the states in our sample are also somewhat higher than the filing rate for the nation as a whole. 33 For each petition in our sample, we have information on the bankruptcy chapter, the filer s address, the lawyer s identity, and the lawyer s address. In addition, we observe whether the case was dismissed or received a discharge of debts. Because we know the lawyer used in each case, we can calculate the fraction of bankruptcies (excluding the reference individual) filed under Chapter 13 for each attorney. We do this separately by year to allow for changes in attorney behavior over time, though the results are robust to calculating this fraction for the entire sample period. Filer address information was used to merge in 2000 Census block group level data. 34 Census block groups typically contain 600 to 3,000 residents, with 1,500 being the target size. The Census data provide information on demographics, income, and housing values of the filer s neighborhood. Table 1 shows sample means of the filing information and block group level demographics. The Census data suggest that nearly two-thirds of the population is married and another 11 percent is divorced. While the large majority at the block group level has completed high school, about one fifth of the population has obtained an undergraduate degree. The average median income across Census block groups is $50,122, the average unemployment rate is 3.5 percent, and about 61 percent of households are homeowners. Finally, almost the entire sample, 93 percent, resides in an urban Census block. For a subset of 33 The national average was 15 filings per 1,000 households in For approximately the same time period, California s filing rate was 16, while Utah s filing rate was 28, and Texas s filing rate was 8. In terms of demographics, per capita income in 2006 was $25,287 in the entire United States, $21,016 in Utah, $26,974 in California, and $22,501 in Texas. The foreign born percentage was 13 percent in the United States, 8 percent in Utah, 27 percent in California, and 16 percent in Texas. The black percentage was 12 percent in the United States, 1 percent in Utah, 6 percent in California, and 12 percent in Texas. Median age was 36 in the United States, 28 in Utah, 34 in California, and 33 in Texas. We control for observable demographic differences in the regressions. 34 From 158,218 fillings, we were able to match 139,839 to latitude and longitudes, which enabled us to assign them to Census block groups. Of those, we drop another 10,254 because they filed with a lawyer who filed fewer than 10 filings in the year (and so we cannot precisely estimate their lawyer s filing propensity. We also exclude those who live more than 10km from the centroid of the nearest census block group, leaving a final sample of 121,

17 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? Variable Census Block Sample Texas Detailed Sample Table 1: Sample Means Variable Census Block Sample Texas Detailed Sample Filed Median Household Income $50,122 $47,743 Lawyer Fraction HH Income Under $10, Urban HH Income $10-$20, Married HH Income $20-$30, Divorced HH Income $30-$40, Household of HH Income $40-$50, Household of HH Income $50-$60, Household of HH Income $60-$75, Household of HH Income $75-$100, Household of Fraction Homeowners Household over th Percentile of Log Housing Value Finished High School th Percentile of Log Housing Value Finished college Monthly Income 3,131 Black Fraction with no Income Hispanic Land Assets 76,239 Other Race Fraction with no Land Assets Age Below Personal Assets 30,990 Age 6 to Fraction with no Personal Assets Age 19 to Secured Debts 82,216 Age 25 to Fraction with no Secured Debts Age 30 to Unsecured Debts 47,036 Age 40 to Fraction with no Unsecured Debts Age 50 to Unemployed Observations 121,416 15,293 Self-Employed Published by The Berkeley Electronic Press,

18 The B.E. Journal of Economic Analysis & Policy, Vol. 10 [2010], Iss. 1 (Advances), Art. 82 households in our dataset, we were able to collect more detailed information. Specifically, for a sample of 15,293 Texas filings, the court provided additional machine readable documents. For households in this subsample, we could collect data on income, debt, asset, and household composition. 35 Summary statistics for this sample are also provided in Table 1. The means of the Census block variables are generally similar to those of our baseline sample. The additional financial information shows that households in this subsample earn about $3,100 in gross income per month, have secured debt levels of about $82,000 and unsecured debt levels around $47,000. Empirical Specification One of our goals is to document the role attorneys play in the chapter decision; in this section we outline our methodology. We later use analogous methods to examine the consequences of filing with a particular attorney on other bankruptcy outcomes including the dismissal rate, appropriateness of Chapter 13, and legal fees. Note that our sample consists of households that actually filed for bankruptcy; our empirical model will be misspecified if a client s decision to file for bankruptcy (regardless of type) depends on his lawyer s behavior. It seems plausible, however, that most households are in such dire financial straits that the decision to file for bankruptcy is insensitive to attorney behavior. Braucher (1993) reports that By the time [debtors] consult a lawyer, they may have been living on credit card advances for six months or a year after losing a job or undergoing a divorce. We therefore assume that clients inelastically file for bankruptcy and simply choose between Chapter 7 and Chapter We wish to estimate the extent to which a lawyer s propensity to file a certain chapter steers the household to file under that chapter. Thus our baseline empirical specification is the following linear probability model: 35 From this sample we exclude households with over $500,000 of unsecured debt. There were fewer than 20 of these outliers which were, in many cases, obviously erroneous. This cleaning did not substantially affect our conclusions, although in a couple cases it had a large impact on reported means. For example, one filing reported debts in excess of seven billion dollars for an unsecured lease. 36 The impact of lawyer behavior on the probability that a household files for bankruptcy cannot be measured using our data. However, it seems implausible that this would be an important concern, as nearly all lawyers file some bankruptcies of each chapter. To the extent that it is more profitable to file a client under the non-preferred chapter than to not file them at all, a lawyer has a strong incentive to provide the type of services that keeps the client from leaving his office. Additionally, a household that is pushed in a direction contrary to its best financial interest retains the option to consult a different attorney. Finally, to the extent that pushing households towards Chapter 13 bankruptcy, which typically yields the fewest financial benefits, causes them not to file for bankruptcy at all, our estimates will be biased downwards. 16

19 Lefgren et al.: Chapter 7 or 13: Are Client or Lawyer Interests Paramount? (1) chapter13 ij = X i β + α frac13 ji + ε ij where chapter13 ij is a binary variable equal to one if individual i filing with attorney j files under Chapter 13 of the Bankruptcy Code and zero otherwise. X i is a vector of household-level characteristics correlated with the decision to file under Chapter 13, and frac13 ji is the fraction of an attorney s clients who file under Chapter 13, excluding the reference household, i. Going forward, we will refer to this term as fraction 13. We use frac13 ji as a proxy for the lawyer s latent propensity to file households under Chapter 13. Due to potential nonrandom matching between firms and households, estimates of α may not reflect the causal effect of lawyer behavior on household filing behavior. Suppose, for example, that lawyers are chosen by filers to maximize an objective function that takes as inputs the lawyer price, p j, distance to travel to the lawyer, d ij, lawyer quality, q j, and, potentially, the lawyer s propensity to file a Chapter 13 bankruptcy, θ j. Filers may vary in terms of their preferences (or suitability) for Chapter 13 bankruptcy, which is indexed by ψ i. Thus, for each lawyer the agent computes U(p j, d ij, q j, θ j ψ i ), and picks the lawyer who maximizes this function. The OLS specification in equation (1) is inconsistent if ψ i, the agent s preference for Chapter 13 bankruptcy, is causing them to match to attorneys with a high θ j. In this case, the estimated α reflects variation in both ψ i and θ j. 37 Alternatively, distance to a particular lawyer, d ij, may be correlated with consumer preferences, ψ i, if attitudes toward Chapter 13 bankruptcy vary across neighborhoods. In this case, our estimate may reflect the preferences of the lawyer s clientele rather than a lawyer effect. One method to control for these unobserved preferences is to assume that ψ i = ψ k, where k is the neighborhood of household i. Then we can control for this unobserved preference using neighborhood fixed effects: (2) chapter13 ij = ψ k + X i β + α frac13 ji + ε ij where ψ k is estimated using Census block group fixed effects. Alternatively, we can define the neighborhood more broadly at the tract level, but include year interactions so that preferences are allowed to vary arbitrarily over time. This 37 A brief perusal of the yellow pages in Utah found plenty of advertisements for bankruptcy attorneys, but nothing that suggested lawyers seek to match on the basis of chapter filing preferences of the lawyer or client. One attorney, though, did mention their flat fee for Chapter 7 a possible signal of Chapter 7 preference. Braucher (1993) provides more systematic evidence that attorneys do little to signal specialization. Published by The Berkeley Electronic Press,