Justifying Debt Forgiveness: Information Asymmetry and Risk Allocation

In my last guest blogs before quitting, I want to briefly discuss, and hopefully get a discussion going, about two topics related at the Illinois Debt Symposium. This was a fabulous interdisciplinary event, about which Mechele Dickerson has blogged extensively already.  But a couple of the topics are still stuck in my craw.

Ever since Heidi Hurd’s talk at the Illinois Debt Conference, about why we grant a bankruptcy discharge in our society, I have been unable to stop thinking about it. She attempted to justify debt forgiveness because it is the right things for a just, moral, wealthy society to do. The most interesting thing about topic is that it implicitly challenges what many of us take as a given. Is it necessary to forgive debts for people cannot pay them? On what basis? Many readers of this blog cannot imagine a world without a bankruptcy discharge, but numerous others in our society (and other societies) completely disagree. Professor Hurd (and her coauthor Professor Brubaker) ask us to justify the forgiveness of debts, something we should be able to do.

Still, the idea that we do this because it is the right and moral thing to do is foreign. I prefer commercial/ economic justifications for commercial/economic laws, to justify forgiving debts because it is good for the economy, for capitalism, for fueling commerce. I always have believed that we forgive debts because it is efficient, utilitarian, and promotes more spending and more commerce. I also prefer to avoid discussing debt in moral terms because what is deemed moral changes over time, and I can see this being turned on bankruptcy debtors who no longer seem worthy of our kindness.

While I am not ready to bring morality per se into my own debt forgiveness policy, Hurd’s paper does have me thinking about another form of blame, one with a commercial flavor, namely. blame in the  commercial law sense of allocating risks and losses by determining which party in a failed transaction was best able to avoid the loss. It is not so different than dealing with a failed international sale of goods, in which goods traveling from Bruge to Boston fall into the sea.  Law or custom will allocate this loss either to the one best able to avoid this loss or the one in the best position to spread the risk of loss. These principles apply to debt forgiveness as well.

In her article, A Theory of Discharge in Consumer Bankruptcy, Professor Margaret Howard argues that the best justification for the bankruptcy discharge is return of the debtor to productive economic participation and I agree. But perhaps there is more than one good justification for debt forgiveness.  Risk allocation is one of theories Professor Howard debunked. Professor Eisenberg  espoused applying risk allocation theory to debtor-creditor law and then argued that debtors were in the best position to avoid financial distress because they "know more about themselves and have greater control of their affairs than lenders do."  He may have  been wrong about who knew more, however, and thus about who should bear the risk.

According to Elizabeth Warren's talk at the Debt Symposium on information asymmetry, creditors now know far more about our credit habits and proclivities toward credit error than we could ever know about ourselves. Perhaps this information asymmetry, along with traditional concepts of risk allocation, suggest that it is creditors not debtors who are in the best position to avoid the loss of a failed credit transaction. This may provide yet another justification for debt forgiveness, especially if the creditor could never have reasonably expected the debtor to repay the debt.

Comments

[Jason Kilborn]

Awesome post, Nathalie! Sounds like the workings of a great law review article. Margaret's piece is a tough act to follow (I tried totally unsuccessfully), but your combination of the insights of the ABI/UI conference put a new and useful spin on the ongoing debate.

[Patches]

"creditors now know far more about our credit habits and proclivities toward credit error than we could ever know about ourselves"

I would go one further. Not only do they know more, they are the ones are helping to construct that information and furthermore, we can't know how they construct that credit rating. It's “proprietary”! ie. If something is not right, individuals will have a tougher time correcting the incorrect info because of their unfamiliarity with the disputing process. Creditors nowadays are far more adept at it and are actually framing individuals’ credit worthiness. ie... “Capital One”. They will not report how much of your credit limit you are currently using thus skewing the credit reporting in their favor. How? Other potential credit issuers will not and cannot know if you have maxed out the card or if you have only used a 1/3 of your limit, thus deterring, to some extent the issuing of credit by another institution. If a creditor is wrong in the reporting it is their word that the credit reporting agencies take not the debtors. Who’s paying the bills at the credit reporting agencies? Not the consumer. It’s the creditors. Yes “fair credit reporting” is an ACT but how many people actually even know what is on their credit report?

I guess I got of the subject a bit but I do think debt forgiveness is essential. My own spiritual beliefs promote it. Can I say Bible around here? As I recall “forgiveness” seems to be a reoccurring theme.

[Mike Dillon]

I'm waaaay over my head on this one and shouldn't even be commenting on this - of course that's never stopped me before. ;)

Based purely on your thoughts within this thread, Professor Martin, my initial reaction is to refer to the doctrine of "least sophisticated debtor". From my limited understanding of the industry I fully believe that Professor Warren is correct in stating that it is the creditors who both know far more about debtors credit habits and "who are in the best position to avoid the loss of a failed credit transaction."

I cringe every time I go to the grocery because each time someone learns a little more about my purchasing habits, as meager as they may be, thanks to the cursed "shopping cards". I can only imagine the wealth of info that Wal-Mart, through Sam's Club, Costco and BJ's accumulates each and every day. I won't even get into RFID technology but suffice it to say that "the boxes told us" is NOT a good thing for American consumers.

I've been making the credit/crack analogy for awhile with regard to the mortgage industry. Sure there is plenty of blame to go around - but if the "exotic" loan products were not created by lenders/manufacturers to begin with, then brokers/dealers would not have been able to sell them and borrowers/users would not have had access to them. Of course, it's sometimes a fine line walked between protecting consumers from egregious, unscrupulous lending actions and protecting consumers from *themselves*. But with the sheer volume of information gathering and industry lobbying taking place I'd have to hedge on the side of protecting the consumer.

Find a way to level the playing field and give the consumers the same tools and level of access to Washington that the mortgage, banking and credit industries have and I'll be a bit more willing to call it a fair fight. But until then.....

[Randy]

I do not equate discharge with forgiveness. Discharge is simply a bar that tells creditors they cannot attempt to collect on the debt owed.

I think that the purpose of discharge is to reward debtor honesty in the bankruptcy process. Without a discharge, what incentive does a debtor have to be honest about what they have and the degree of trouble they are in.

I have been a chapter 7 trustee since 1991, and I can tell you that the vast majority of debtors do not reconcile their bank statements, nor do they know until they file bankruptcy, how much money they owe to their creditors. The level of financial ignorance is astounding, but common. That said, I do not think it should play into discharge.

I think it is enough to simply acknowledge to Debtors that if they are open and honest about their financial condition for at least the moment when they file, they can obtain a bar that prevents their creditors from suing them.

[Patches]

"Forgiveness"...."Discharge"....."Discharge Injunction"... it’s all… "Hope"... hope for a "Fresh Start". I think we can all at least guess what life would be like without "it".... A person without "hope" is someone who has nothing to lose. Someone knew what he was talking about when he said “to forgive is divine”. What would society be like if we had a bunch of “hopeless” people running around? They would all be running to Canada illegally for "hope".

[s paley]

So I'm a simple guy, and can't keep up with all the legal machinations, but your point makes sense. I mean in virtually every area of our lives and the law we get second chances, nothing is supposed to hang over our heads forever. Isn't there even a law about this...the rule of nothing-is-forevermore or maybe its perpetuities?
Keep writin'!
SP

[Patches]

Faith, Hope and Charity. The greatest of these is Charity. 1 Cor 13:13. All three live together is says. Faith btw is defined as follows: Faith is the substance of things "hoped" for and the evidence of things not seen. ie. "I know I can't see it and everything is telling me to give up but I know I will make it!"(hope against all hope). Even faith takes a back seat to charity. Ok..Ok... I'll stop now because I know some people are just not going to be into it but some "ideas" are as true today as they were back then. There is a place for forgiveness and it’s not just for the “Big Guy Upstairs” to appropriate. There is a benefit for both parties the Forgiver and the Forgiven. It does not say "the greatest of these is (getting) charity".

[Ken Doran]

I see the semi-automatic liberal discharge and the wide open, non-usury-limited consumer credit market as a complementary pair. They have evolved together over recent decades, and either would likely have taken a different form without the other.

[AMC]

Are there really a lot of western industrialized countries that don't have some sort of bankruptcy laws that include a discharge? I just don't know of any, and my impression is that the former eastern block countries have been working on adding bankruptcy laws to their books.

From the "Jubilee Year" in the bible, to the Roman "broken bench", to concept of bankruptcy being part of the U.S. Constitution - I don't see bankruptcy as something that modern societies have shied away from.

Debtors' prisons simply don't work - they cost too much, you have to feed 'em, and it doesn't do anything to resolve the underlying debt problem.

Bankruptcy may be a poor solution to the problem of debt - but it is the best we've been able to come up with. The alternative is the growth of an underground, untaxed economy. Imagine if every debtor lived like those who owed federal taxes before "offers in compromise" became fashionable: Money buried in every backyard, under-the-table jobs to avoid garnishments, the government not getting their cut, people living essentially outside of our society. We couldn't afford it, even on the consumer side.

For business debtors, imagine if starting a new business and having it going bankrupt were an economic death sentence? New businesses have what, about an 80% failure rate? "Entrepreneur" would be viewed like lottery players are today. One of the main engines of job creation in this country would be turned off.

To me, the justifications for bankruptcy are fundamentally conservative. (Not "conservative" in the bastardized political sense we use today, but in outlook.) When someone asks a conservative for his support in removing a fence, the conservative person's first question is: "what purpose does that fence serve?" The idea is that things are there for a reason - concepts, practices, insitutions, all developed for a reason. So, you don't go an abolish funamental institutions without really understanding what function they serve.

I think that in addition to the practical purposes that bankruptcy serves, there is also a large, anti-revolutionary purpose. If you do allow the creation of a permanent underclass of debtors, if you crush the hopes of those who - for whatever reason - have more debts than they can pay, you create a revolutionary underclass. They have two hopes for a discharge of their debts - death and revolution.

In contrast, having a bankruptcy system offers hope for a fresh start to those who have suffered misfortune or made mistakes. And it dovetails with the American vision that anyone can, through hard work and a dream, rise up and have a better life than their parents did.

[Patches]

Dang AMC! You are legal history guru! Don't know too many people who know about the “year of Jubilee”. Wasn’t that in Deuteronomy somewhere?

Off subject a little. The other day when someone asked if I was a liberal or a conservative I told them conservative. I know some will disagree, and my best friend who is staunchly republican took a double take at me, but my dad explained to me the other day that the first true conservatives were for the concept of being fiscally responsible. It seems nowadays being “conservative” means you are for almost unbridled consumption and being “anti-abortion”. Although I am not quite as radical as “pops” I seem to have taken on some of that. Mom and Pop were into the “Mexican-American Civil Rights” movement back in the day. … Mom was actually on national news with one of the Kennedys, debating, back when. “Raza Unida Party” NOT the “Ramsey” crowd though. My first memories were of “Crystal City” Texas and the “Winter Garden” project.

[FJP]

I think Elizabeth Warren, AMC and Ken have all gotten it right in different ways. Another way to think about the question is to consider differing ways we could set up our economic and legal systems and what they would look like.

We could set up a world in which there was very little unsecured consumer credit, all home mortgages required 20% down, and all car loans were for 2 or at most 3 years so the loan was not likely to be upside down. This is in fact the world as it existed in the past, definitely before World War II and still somewhat up to about 40 years ago or so. I recently came across a magazine ad for Master Charge from about 1971, and even that recently they seemed to have to explain to consumers why they might want such a thing, and it was mostly geared toward being ready for emergencies.

But from where we stand today, could we roll the clock back to such a world without triggering a massive depression? Take a look at the contents of a middle class home in 1939 and their spending habits, how much they spent on travel, meals out, in-home entertainment (one radio and one Victrola), cars (correction, CAR, not more than one, if any), etc.

You could also have a world with no bankruptcy discharge but without creating debtor's prisons, but I think in order to do so and create incentives not to move too much economic activity underground, you would need to greatly broaden exemptions and keep creditors from taking more than a family can pay and still feed themselves and keep some sort of roof over their heads. Without bankruptcy courts, state courts would have to administer the fairness of that system through the garnishment and levy process. The net effect would be sort of like endless Chapter 13 without a discharge. Would the transaction/administration costs of that system really be much less than bankruptcy?

[FJP]

By the way, AMC is right about Eastern Europe. I have been in practice long enough to remember that time, and there was a boomlet of work for bankruptcy lawyers fluent in Hungarian, Polish, Czech etc., to go over there and write bankruptcy laws for the new post-communist regimes. In fact, at the time the international business community considered it a necessary element of a complete transition to a market economy to have Western style bankruptcy laws. In other words, having a familiar looking and reasonably transparent bankruptcy system helped give companies confidence in investing in these new markets.