Bankruptcy Courthouse in Dayton, Ohio.
BLOOMINGTON, Ind. – Bankruptcy courts across the United States and abroad claim to assign judges to individual cases randomly to promote fairness in the judicial system, but new research from the Indiana University Kelley School of Business suggests otherwise.
Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, Kristoph Kleiner, associate professor of finance at the Kelley School, found strong evidence that the assignment of cases is not random, but predicted by hedge funds.
“Far from being random, the assignment of judges to bankruptcy cases is predictable,” said Kleiner, also the Daniel C. Smith Fellow in Finance. “Sophisticated lawyers and investors routinely exploit this predictability to increase the likelihood of being assigned a preferable judge. Our results should help policy makers develop a more equitable judicial system.”
Kristoph Kleiner
The findings appear in the paper, “Justice Good As Random?” It is forthcoming at the Journal of Finance and co-authored with Niklas Hüther, assistant professor of finance at the University of Nebraska.
It has been presented at more than 20 conferences in North and South Americas and Europe, including the University of Texas AIM Investment Conference, where it won the Best Paper Award.
They were motivated by claims of forum-shopping within Chapter 11 bankruptcy, as illustrated when Purdue Pharma – facing more than 2,000 lawsuits totaling more than $2.15 trillion – chose to file in White Plains, N.Y.
The assignment process was criticized after a plan sought by the company’s owners, the Sackler family, was approved that would have exempted them from civil lawsuits in exchange for $4.5 billion in payments.
“The Purdue Pharma example showed that firms can often choose the district/office they file in, which allows them to gain access to their set of preferred judges,” Kleiner said.
“Our research shows the problem is even worse — companies can influence which judge they want assigned to their bankruptcy case by exploiting the predictability of assignments based on recent cases. We don’t want companies to be able to game the system and gain an unfair advantage.”
Judges can decide whether to convert a Chapter 11 bankruptcy reorganization filing to a Chapter 7 liquidation. While secured creditors prefer liquidation, unsecured creditors and equity holders generally recover more under reorganization.
Exploiting this distinction, Kleiner and Hüther found that relative to secured hedge funds, unsecured hedge fund creditors and equity holders are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases.
To influence assignments, the researchers found shrewd investors are aware courts try to balance workloads across judges. This means that if one judge already has a large case load, they are less likely to be assigned the next case, leading to predictability.
When sophisticated investors like hedge funds understand this predictability, they can attempt to influence the filing date and ultimately judicial assignment.
Kleiner said their results do not imply that judges and examiners are never assigned random cases. “For example, we find that small cases are largely randomly assigned both because small cases don’t impact caseloads and because they aren’t sophisticated parties trying to game the system,” he said.
“We’re not suggesting that anyone is doing anything illegal,” he added. “It’s just that the current assignment process can be readily exploited, leading firms to have unequal access to different judges.”
Their research identifies a need for a truly randomized process for assigning cases.
“The downside of a fully random assignment process is that some judges may at times be assigned several large filings in a short time period, which is a concern since past research finds judge busyness impacts judicial decisions,” Kleiner and Hüther wrote.
Alternatively, if policy makers increase the number of bankruptcy judges, investors will be less able to predict the next assignment even if the process is not fully random. Policy makers intent on a fairer judicial system should consider both proposals.
From an academic standpoint, Kleiner and Hüther also hope the econometric approaches they developed help academics deal with a lack of randomization and design better natural experiments to study the consequences of different judicial and legal decisions. In many areas of social science, researchers find a need for a natural experiment where some individuals are “treated” in the experiment and others are in a “control” group.
One common setting for such an experiment is where judges and other types of examiners make decisions that affect others. If the judge or examiner is randomly assigned to cases, then researchers can find a random reason for why some people are treated and others are in the control group.
“Our results show that future researchers need to be careful with these natural experiments when sophisticated parties can influence the assignment process, and therefore whether they are included in the treated group or control group. The econometrics approaches we develop in the paper will help researchers deal with this issue and continue to use this experimental approach in future research,” Kleiner said.