abstract. Despite their differences, consumer and business Chapter 7 cases are administered by the same trustees under the same rules. This Note advances four normative arguments against this one-size-fits-all approach, using novel empirical research to emphasize its shortcomings. First, human debtors have rights that artificial entities do not. Second, trustees create different socioeconomic value for consumers and businesses. Third, trustees’ day-to-day work differs significantly across case types. Finally, trustees receive far less judicial oversight in consumer cases. Accordingly, this Note proposes two policy changes: (1) trustee compensation should differ for consumer and business cases, and (2) trustees should be allowed to specialize accordingly.

authors. Authors are listed alphabetically. Belisa Pang, Yale Law School, J.D. expected 2023; Yale School of Management, Ph.D. in Finance expected 2023. Emile Shehada, Yale Law School, J.D. expected 2022. We owe special thanks to Edward Morrison and Jonathon Zytnick for their foundational work on this subject. We also thank Jonathan Macey, Anne Mishkind, Roberta Romano, and the editors of the Yale Law Journal for their input and support. Finally, we express our appreciation to the Federal Judicial Center, the U.S. Trustee Program, and the bankruptcy courts of the Central District of California, the Eastern District of New York, the Northern District of Illinois, and the Southern District of Ohio, which provided the data necessary for this project.

Introduction

Bankruptcy law frequently treats businesses and consumers differently. For example, when using bankruptcy for the purposes of restructuring, corporations avail themselves of Chapter 11, while consumers avail themselves of Chapter 13. Under Chapter 11, corporations usually act as their own trustees (as debtors-in-possession), with Chapter 11 trustees available should the need arise.1 Consumer bankruptcies are always overseen by Chapter 13 trustees who are wholly separate from the consumer undergoing bankruptcy. These sets of trustees are different. The rules and standards that govern them are different. This follows from the fact that corporations and consumers require different treatment.

Chapter 7 defies this conventional wisdom. In stark contrast to the rest of bankruptcy law, Chapter 7 administers business and consumer bankruptcies using the same set of trustees. It commands these trustees to apply roughly the same set of rules to business and consumer debtors. This entangling of business and consumer bankruptcies appears to be more relic than purposeful design: differential treatment of business and consumer debtors has never been a prominent feature of liquidation bankruptcy. For example, the Bankruptcy Act of 1800 does not even contemplate a difference between commercial entities and natural persons.2 This is hardly surprising; in 1800, the concept of limited liability was still developing, and businesses were not meaningfully distinguished from their owners.3 The goal of Chapter 7 was straightforward: liquidate the debtor’s assets to compensate creditors. Whether the assets came from a corporation or a consumer was irrelevant; a sale was a sale.

Of course, the legal and economic backdrop for that uncomplicated notion of Chapter 7 has changed greatly since 1800.4 As corporations have become more complex, corporate law has developed into its own field. Chapter 7 trustees have changed their behavior accordingly; they (correctly) do not handle business and consumer liquidations in the same way. But Chapter 7 itself still fails to disentangle business and consumer liquidations, creating a system that is in tension not only with itself, but with bankruptcy law writ large. Indeed, the inefficiencies created by these tensions in Chapter 7 do not occur elsewhere in the Bankruptcy Code.

Consider the compensation of Chapter 7 trustees. Broadly speaking, the more debtor assets a trustee manages, the more compensation the trustee earns.5 Trustees administer assets in roughly 33% of corporate liquidations under Chapter 7. The assets in those cases are worth, on average, about $986,855.6 By comparison, in 6% of consumer liquidations, trustees administer, on average, a trifling $159,192.7 The other 94% do not involve unencumbered assets for which the trustee will be paid.8 Despite this enormous gap in assets, Chapter 7 dictates that trustees be compensated for both business and consumer liquidations according to the same scheme.9

This entangled trustee-compensation scheme yields serious, unwelcome consequences. Most significantly, it makes Chapter 7 consumer cases extremely undesirable to trustees.10 In turn, this creates the risk of inequitable and inefficient system-wide outcomes. To cut costs, trustees may underinvestigate consumer cases, resulting in an unjust windfall for some debtors. Alternatively, trustees may overzealously investigate every consumer case they get to make those cases worth their while, subjecting those debtors to excessive takings.11 The current scheme harms consumers seeking Chapter 7 protections even when there is no abnormal distortion of the ratio of business to consumer cases—in other words, even when times are normal.

But the COVID-19 pandemic has been anything but normal. As such, it has made Chapter 7’s entanglement of business and consumer bankruptcies all the more relevant. The pandemic may precipitate abnormally high levels of consumer bankruptcy, reducing trustee compensation and incentivizing the aforementioned collection behaviors.12 While large-business Chapter 11 bankruptcy filings (i.e., business cases involving over $50 million in assets) nearly tripled between September 2019 and September 2020,13 total consumer-bankruptcy filings dropped by 28% in that same time frame.14 This decline is attributable to stopgap policies that halted collection on prepandemic consumer debt and extended cash support.15 In the second quarter of 2020 alone, there were approximately 281,000 fewer consumer cases than would have been expected from historical trends.16But these policies did not eliminate that debt: given the nature of the government’s policy of relief-by-deferral, it would stand to reason that most—if not all—of these would-be cases will materialize in the proximate future, when indebted consumers’ deferred payments become due.17 If and when those consumers do file, our novel empirical evidence from the analogous post-2008-financial-crisis bankruptcy boom strongly suggests that they will face undercompensated trustees determined to make up the shortfall in compensation by subjecting consumers to unfair levels of investigation.18

At the same time, the pandemic’s impact on American households and businesses has also brought significant legislative attention to bankruptcy issues.19 For example, while Congress for years consistently ignored pressures from practitioners and academics to raise trustee compensation,20 it introduced and enacted the Bankruptcy Administration Improvement Act (BAIA) of 202021 in less than five weeks.22 Yet this “fix” was arguably more of a condemnation of Chapter 7 than a vote of confidence: Congress chose to prop up Chapter 7’s entangled scheme by subsidizing it with proceeds from Chapter 11’s largely disentangled scheme.23 It is clear, then, that the Act is not the end of the discussion. There is still a need and opportunity for intelligible reform of Chapter 7’s monolithic approach to business and consumer liquidations. Congress’s remarkable responsiveness to bankruptcy issues in the wake of the pandemic makes this a ripe moment to harmonize Chapter 7 with the rest of bankruptcy law by disentangling Chapter 7 trustees.

Other literature often discusses the difference between business and consumer bankruptcy (both liquidation and reorganization alike) by focusing on only one of the two.24 While there is scholarship criticizing Chapter 7 on various grounds, little (if any) scholarship has identified a crucial source of the inefficiencies created by Chapter 7: its one-size-fits-all approach to the role of trustees in consumer and business liquidations. The gap in the literature has been revealed in large part by recent empirical papers that have demonstrated the distortions created by Chapter 7.25 This Note is the first to leverage these fresh empirical insights to challenge Chapter 7’s entangled regime directly, in favor of a disentangled one.

Part I of this Note provides necessary background on the role of trustees in Chapter 7. Section I.A briefly defines and compares consumer and business bankruptcy. Section I.B provides an institutional background on trustees’ powers. Section I.C lays out the ways in which Chapter 7 governs these powers, focusing in particular on Chapter 7’s sole differentiation between consumer and business bankruptcies and its trustee-assignment protocol. Part II marshals empirical evidence to elucidate the alarming distortions created by Chapter 7’s failure to properly differentiate between business and consumer liquidations in its trustee-compensation scheme.

Part III then uses the evidence in Part II to present four normative arguments in favor of formally differentiating Chapter 7 trustees’ roles with respect to business and consumer liquidations. First, consumers are fundamentally different from businesses, a powerful insight reflected throughout most of bankruptcy law. Second, from an economic perspective, the social benefit created by the trustee is different in consumer and business cases. Third, a trustee’s work is different in consumer and business bankruptcies. Fourth, trustees interact differently with other parts of the judicial system depending on whether the debtor is a consumer or a business.

Part IV then proposes two realistic, actionable policy changes. First, consumer and bankruptcy cases should be managed by two different groups of trustees with different specializations. Second, trustees should receive more fixed compensation for consumer bankruptcy than for business cases. Part V concludes.