Bankruptcy Policy in Light of Manipulation in Credit Advertising
Tel Aviv University - Buchmann Faculty of Law
Hebrew University of Jerusalem - Faculty of Law
Theoretical Inquiries in Law, July 2006
This article argues that when credit suppliers market and advertise their credit products, they utilize and enhance consumers' cognitive biases, particularly their optimism bias and illusion of control. We apply the concept of manipulation to this practice. The biased and manipulated debtors attribute unrealistically low probability to negative life events, and high probability to positive life events. As a result of the manipulation, the biased debtors are triggered to borrow more than they would have borrowed otherwise. This additional borrowing may contribute to the default of these debtors and to their eventual bankruptcy. Empirical studies of the causes of bankruptcy show that before their default, bankrupts often experience negative life events such as loss of job, illness, accident or divorce, which decreased income, increased expenses, or both.
The bias and its manipulation justify legal intervention. The first justification is the restoration of debtors' autonomy and the rationality of their decision-making and choice. The second justification is distributive. Sophisticated, repeat, diversified, superiorly informed and non-biased institutional suppliers of credit gain from it. This is evident in the more aggressive marketing of credit in recent years to lower income deciles. The debtors lose as they suffer the stigma of failure, the higher costs of post-bankruptcy borrowing, possible loss of residence and job, and some of the direct monetary costs of bankruptcy. The third justification is externalities to the state, to non-manipulating creditors of any manipulated debtor, and to the debtor's family. Running the bankruptcy system imposes costs on the state. Maintaining asset-less, job-less or low-income discharged debtors is also borne in part by society and its tax payers. The more restrictive the exemption and discharge rules in a legal system and the more generous the safety net in different welfare states, the higher the externalities. Bankruptcy imposes externalities to family and other dependants of the bankrupt. Further, manipulative lenders increase their share of the bankrupt's assets at the expense of non-manipulative lenders. This constitutes an externality from one creditor to another.
Intervention can take place at two distinct stages. The first is the pre-landing-transaction stage. Here intervention can take the form of "asymmetric paternalism": regulation that prohibits manipulative practices and regulation that discloses information and de-biases potential borrowers. The use of tax and insurance is also considered. The second stage is the bankruptcy process stage. This can be general, dealing with exempt assets, discharge and fraud policies. It can be case specific, developing doctrines that would allow the rejection or demoting of specific claims by manipulating creditors in specific cases. The relative advantages and disadvantages of each stage and each type of regulation are discussed.
The prescriptions for intervention in this article are tentative and partial. Its main contribution is bringing together bodies of literature on cognitive biases, consumer decision making, lifetime cycle, social influence, advertising and marketing, behavioral law and economics, economic analysis of bankruptcy and socio-legal studies of bankruptcy. By combining these bodies of literature, the article provides a new perspective on bankruptcy and credit and offers a promising framework for future work.
Number of Pages in PDF File: 48
Keywords: Consumer Bankruptcy, Credit Regulation, Consumer Decision Making, Optimism Bias, Life Events
JEL Classification: D12, D18, D91, K2, M31, M37
Date posted: January 24, 2006