I once received a pink flyer from a major bank that said in bold letters “Turn your stucco into sand,” while the inside of the flyer advertised home equity loans for purposes of taking beach vacations. This was supposed to be an enticement, but with this stucco-into-sand imagery, it seemed more like a warning about the consequences of using home equity, leaving people to make their own choices. I’m starting to wonder whether the bankruptcy system needs a similar warning. First, studies by Cheryl Long and Aparna Mathur suggest that there generally are longer-term home-owning consequences to filing for bankruptcy. Second, some homeowners file for bankruptcy primarily to save their homes from foreclosure — presumably because their lenders/servicers will not agree to a workout with a borrower they believe cannot or will not sustain the mortgage, but possibly for other reasons. These filers use chapter 13 bankruptcy, which not only stops a foreclosure but allows them to cure a default over time over the objection of the lender/servicer. The administrative costs alone of chapter 13 to the homeowner probably add up to at least one or two mortgage payments, or, if homeownership is not to be, then a few months of rent in a new home. But I’ve seen no evidence that chapter 13 turns out to save homes in the long term, or that it is any more successful than other anti-foreclosure interventions. We’ll get help figuring this out once real estate finance experts recognize chapter 13 for what it is – a federal mortgagor protection device, albeit of unknown efficacy, that overrides many of the state real estate laws they have spent considerable time analyzing.
Author: Melissa Jacoby
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Chapter 11 as Federal Tax Collection?
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Debtor-creditor types tend to focus on private creditors in the business of extending credit or loaning money. Of course, debtor-creditor relationships vary considerably and accordingly have rather different dynamics. The findings in several empirical studies of chapter 11 should keep us mindful about the significant role of the Internal Revenue Service as a creditor in bankruptcy and how tax obligations affect the bankruptcy initiation decision for small businesses. In the recent working paper Dynamics of Large and Small Chapter 11 Cases: An Empirical Study, Douglas Baird, Arturo Bris, and Ning Zhu analyze chapter 11 cases in the Southern District of New York and the District of Arizona between 1995 and 2001. Baird and co-authors find vastly different patterns of general unsecured creditor payout between the big cases and the small cases (short version: general unsecured creditors get paid very little in the small cases). Although perhaps not their main result, they also report that “The need to resolve tax obligations is the engine that drives the typical small chapter 11 case.” (pp. 19-20). In in-depth research on chapter 11 cases in the Northern District of Illinois, Baird and Ed Morrison similarly have found the IRS in a prominent role. In their 2005 Columbia Law Review article Serial Entrepreneurship and Small Business Bankruptcy, Baird and Morrison suggest that the IRS essentially encourages entrepreneurs to put their struggling businesses into chapter 11, where it will renegotiate the entrepreneur’s personal liability. So notwithstanding the special collection entitlements the government gives itself, it seems that the IRS prefers to encourage the initiation of a costly bankruptcy process, with other parties footing the bill.
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Following the Money in Large Chapter 11 Cases
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In the new working paper "Rise of the Financial Advisors: An Empirical Study of the Division of Professional Fees in Large Bankruptcies," Lynn LoPucki and Joseph Doherty of UCLA report findings distinguishing patterns of compensation of lawyers and financial advisors using data from the extremely valuable Bankruptcy Research Database. According to this paper, approved financial advisor fees rose at a much faster rate (25% per year!) than lawyers’ fees in the big cases during the study period (plans confirmed between 1998 and 2003). Although the paper’s other findings are independently interesting as well, they are especially intruiging when considered in connection with LoPucki’s other recent work. In the book Courting Failure, LoPucki hypothesized that chapter 11 outcomes (including a repeat filing rate of nearly half among the largest cases) are in part a function of court practices — including the handling of fee applications — designed to attract repeat players (many from New York) who help decide where the cases should be filed. LoPucki characterized the Delaware and New York courts as the major case competitors racing to the bottom. Those looking for a more detailed summary and critiques of these aspects of Courting Failure should check out the Buffalo Law Review symposium on Courting Failure that was organized by Bill Whitford of the University of Wisconsin and should be on Westlaw and elsewhere imminently.
In Rise of the Financial Advisors, LoPucki and Doherty fill in a few more pieces of the puzzle regarding the New York and Delaware courts. According to the working paper, debtor-in-possession (DIP) attorneys fees awarded by New York and Delaware courts were not statistically different from those awarded by other courts (p. 13). And fees awarded to New York DIP attorneys were not significantly higher than those awarded to non-New York DIP attorneys. But approved financial advisors’ fees were generally higher in the Delaware court than in other courts (p. 19), and the New York court was "more likely than other courts to award fees to investment banks at very high hourly rates" (p. 29). The paper indicates that the raw data will be posted here so that other researchers can independently evaluate. Among other things, these findings could lead to a refinement or adjustment of LoPucki’s theory regarding the pathways through which court practices may affect reorganization outcomes.
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21st Century Debt Collection Techniques
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Several years ago, Lucette Lagnado wrote a series of Wall Street Journal articles on the use of formal debt collection techniques for debts owed to hospitals by patients. That series probably helped set off a chain reaction of Congressional hearings, state legislative initiatives, lawsuits, and self-regulation measures by the hospital industry. As Bob Lawless has reported, the Boston Globe is nearly done with a set of investigative reports that broaden and deepen the inquiry regarding debt collection practices in Massachusetts, framing each article so far on a major institution or actor that shapes the debt collection process (e.g., debt collection companies, small claims court, and — perhaps the most intriguing — the constable). Like the Wall Street Journal series, the Globe investigation apparently has been a wake-up call of sorts, this time to the Massachusetts court system.
The Globe investigation comes at a time of reawakened interest among debtor-creditor scholars in the use of formal collection procedures for consumer debts (including some important systematic in-the-trenches studies being conducted now by Rich Hynes at William and Mary and separately by Sidney Watson and colleagues at Saint Louis University). In the past several decades, many scholars have assumed that the formal judgment collection process was too expensive and cumbersome for relatively small consumer debts, and largely have focused their research energies elsewhere (e.g., federal bankruptcy, or laws that regulate informal collection techniques such as phone calls or letters). With technology that facilitates spreading default risk and encouraging debtor repayment through other means, one might have expected even less use of the arcane formal process by repeat player claim holders today than a decade or two ago. The Globe investigation does not study changes over time, but it does invite the question of whether technological developments and innovation in the credit and collection industries actually have increased, rather than decreased, the use and cost-effectiveness of arcane state collection procedures.
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Bankruptcy Filings and Consumer Behavior
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When it comes to the bankruptcy filing rate, fiscal year 2006 (10/1/2005 onward) is turning out to be a very odd period. First, filings surged to historic heights in early October. Then, in the second quarter, filings dropped to the lowest rate since the mid-1980s. An intervening event was the mid-October effective date of an omnibus bankruptcy reform bill, the most extensive changes to the formal bankruptcy law in a generation. Most bankruptcy filers are individuals rather than business entities, so it appears that individuals became sensitive to changes to the Bankruptcy Code and may have altered their plans accordingly. Does this mean that individuals also can be expected to alter their borrowing behavior because of the bankruptcy law changes? Not so fast, say Professors Susan Block-Lieb and Ted Janger in an article just published in volume 84 of the Texas Law Review.
Block-Lieb and Janger apply insights from behavioral decision research suggesting that individuals’ cognitive limitations, and not strategic behavior, provide an explanation of consumer overextension that is more consistent with consumer credit data. They also consider the possibility that lenders capitalize on these cognitive limitations. Whatever happens with the official bankruptcy filing rate reported by the government, Block-Lieb and Janger warn in their Texas article that “overleverage is here to stay.”
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Hospital Bad Debt and Medical Credit Cards
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A leveraged buyout is in the works for the Hospital Corporation of America, a giant for-profit hospital operator. The stated reasons for HCA’s disappointing stock performance in recent years depend on the news story, but at least one national news report has highlighted uncollected patient bills as a major culprit. Surely this is too simplistic an explanation, but the existence of significant bad debt owed by patients to for-profit hospitals makes one wonder why medical providers haven’t been more successful in encouraging patients to use third-party credit (e.g., credit cards) to finance the self-pay portion of their care. Apparently, various credit providers and accounts receivable management businesses have had similar thoughts. As can be seen here and here and here, credit products now are being marketed specifically for medical expenses to both patients and providers. The real growth in medical credit will flow from the rise of health savings accounts that offer credit components. These medical credit products aren’t likely to transform the for-profit hospital industry, but, depending on their terms, could have a significant effect on household finances.
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Credit Slips from Getting Sick?
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Everyone is talking about household medical debt this week. American Enterprise Institute Research Fellow Aparna Mathur has just issued a report finding that “nearly 27% of bankruptcy filings are a consequence of primarily medical debt” based on an analysis of data from the Panel Study of Income Dynamics. Meanwhile, over at the Center for American Progress, we can find the results of a poll in which 44% reported being worried about falling deeply into debt because of medical expenses – more than were worried about being hurt or killed in a terrorist attack or losing a home in a natural disaster.
Medical debt deserves a prominent place on the public’s radar screen and on the research agenda of scholars from a variety of disciplines. Still, a slight reframing of the problem is in order. Incurrence of catastrophic medical expenses is a serious policy issue but a rather rare event. Flowing far more commonly from medical problems is the incurrence of non-catastrophic (but still substantial) out-of-pocket health and incidental expenses coupled with income loss, various opportunity costs, and the price of credit used to smooth consumption when household savings are not up to the task. It is this more subtle and complex combination that is heightening financial risk for many American households.