Are Bankruptcy Professional Fees Excessively High?

This article analyzes trustee compensation in Chapter 7 bankruptcy, the most common bankruptcy system for U.S. firms and individuals, focusing on the moral hazard problem arising from trustees' incentive structures. Trustees, private attorneys appointed by the Department of Justice, liquidate debtor assets and receive commissions set by law under 11 U.S.C. §326, which feature kinked marginal rates (e.g., 25% on the first $5,000, declining thereafter). Using detailed data on nearly 20,000 corporate Chapter 7 asset cases from 2006 to 2015, the study exploits discontinuities ("kinks") in the commission schedule to estimate a structural model of trustee effort and moral hazard. The findings reveal that while trustees do exert effort that increases liquidation values, the current statutory commissions are substantially higher than the creditor-recovery-maximizing level; the optimal commission is estimated at roughly 2%-3%, far below the median realized commission of 13%. Lowering trustee commissions to this optimal level would reduce trustee incentives and sale values modestly but nonetheless increase creditor recovery by about 15.7% in typical small-business bankruptcies. The study also finds that the current commission structure effectively causes small-business and consumer creditors to subsidize large-business creditors, as smaller cases face higher marginal commissions. These results suggest that reforming trustee compensation could significantly improve creditor outcomes and reduce direct bankruptcy costs without substantially impairing trustee participation.