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.
This clear preference in the paper for Chapter 7 bankruptcies appears based on the oft repeated statement that “[f]or 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.” This is a myopic view of bankruptcy, however. In most Chapter 13 cases, the household is only paying its mortgage, car payments and taxes (if any) during the three to five years of the plan, with little or nothing being paid to unsecured creditors. Similarly, in most Chapter 7 cases, the household also continues paying its mortgage, car payments and taxes (if any). The difference being that the Chapter 7 Debtor gets a discharge quickly and is then left to fend for himself with the mortgage, car and taxes. The Chapter 13 Debtor does not get a discharge for three to five years, but is protected from all creditors during that time.
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