Rehabilitation or Liquidation: Consumers' Choices in Bankruptcy

Rehabilitation or Liquidation: Consumers' Choices in Bankruptcy The purpose of the Bankruptcy Code is to establish procedures by which debtors may resolve, in an orderly and equitable fashion, problems associated with insolvency or their inability to repay debts out of income. A major revision in the Bankruptcy Code enacted in 1979 and subsequent amendments significantly changed administrative procedures associated with chapters of the code pertaining to nonbusiness debtors. The purpose of this paper is to identify the legal, environmental, and economic factors that influence the relative benefits and costs of rehabilitation versus straight bankruptcy. A model of the determinants of nonbusiness debtors' choices is empirically estimated based on the cross-state variation in the probability that debtors in bankruptcy filed petitions under Chapter 13 of the code. The change in the availability of Chapter 13 provided by the Bankruptcy Reform Act of 1978 had a noticeable positive influence on the average probability that a petitioner would choose that route to debt relief. But the changes in procedures for Chapter 13 provided by the Bankruptcy Amendments and Federal Judgeship Act of 1984 had an offsetting negative effect on the general probability that a petitioner would choose Chapter 13. Before the Bankruptcy Reform Act was enacted, about 25 percent of nonbusiness petitions for bankruptcy were filed under Chapter 13. Between 1980 and 1983, the proportion of petitions filed under Chapter 13 climbed from 25 percent to 31 percent. By 1988, the proportion had declined, and approximately 27 percent of nonbusiness petitions were filed under Chapter 13. In addition to the above observation that the overall average proportion of nonbusiness bankruptcy petitions filed under Chapter 13 appears logically correlated with changes in the Federal bankruptcy law in the last ten years, considerable cross-state variation exists in the statistic. In the 12 month period ending June 1986, the proportion of total nonbusiness petitions filed under Chapter 13 varied from 3 percent to 69 percent across the fifty states and the District of Columbia. Recent studies have analyzed the causes, costs, benefits, and processes of bankruptcy (American Bankruptcy Institute 1987; Johnson et al. 1982; Sullivan 1982) and the effects of changes in the law on overall trends in bankruptcy (Shephard 1984a; Shephard 1984b; Shiers and Williamson 1984; White 1987-1988). There has been some analysis of the economic circumstances of debtors who choose Chapter 7 versus those who choose Chapter 13 (Sullivan and Drecnik 1984), and there is ongoing debate concerning the optimal bankruptcy legislation. Interest in the determinants of debtors' choices in bankruptcy is based on the need to understand further the economic incentives associated with nonbusiness bankruptcy. There is evidence that unsecured creditors recover a higher percentage of claims in a Chapter 13 procedure relative to Chapter 7. (1) However, current law does not require debtors to choose that avenue to debt relief that produces the lowest loss for lenders and, therefore, the lowest social cost. (2) With greater knowledge of the multitude of factors that influence debtors' choices, policy makers will be in a better position to draft laws to produce the desired social outcome and to evaluate the social consequences of the continuously evolving institution of bankruptcy. DEBTORS' CHOICES FOR DEBT RELIEF Debtors are assumed to repay debt according to the terms of their contracts as long as the net benefit associated with repayment exceeds that of default. The debtor seeking relief from existing credit contracts has several possible courses of action. These include restructuring debts, either privately with creditors or by enlisting the services of a credit counselor; petitioning for rehabilitation or liquidation under the Bankruptcy Code; or outright default. …