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Walking The Debt Plank

by david reich


Illustration by David M. Cutler

Talk to a bankruptcy lawyer these days—if you can find one with a moment to spare—and he or she will tell you that bankruptcy filings took a big jump this spring and are expected to remain unusually high until October. That’s when the new bankruptcy law kicks in. Passed in April by healthy majorities in Congress, the Bankruptcy Abuse Prevention and Consumer Protection Act runs more than five hundred pages, and lawyers, judges, and legal scholars are still trying to gauge its precise implications for themselves and for the typical consumer bankruptcy filer.
(A recent convocation at Boston College Law School explored the law’s implications for chapter 11 business bankruptcies. Papers from that symposium will be published in the fall in Boston College Law Review.) But while the details of the law may still be somewhat fuzzy in legal professionals’ minds, many have already formed strong opinions about the overall thrust of the law, variants of which had been kicking around Congress since the middle 1990s.

Where you stand on the new law seems to depend on your explanation of a decades-long explosion in personal bankruptcy filings, which even before the current blip, had risen from 300,000 per year in 1978 to 1.6 million in 2003, an increase of 1.3 million filings or more than 400 percent. Supporters of the law tend to argue that the boom in bankruptcies resulted from a combination of things, including the old law, which made filing bankruptcy too attractive, they say, and a sharp decline in public morality. They also contend that the new law will stop dishonest people from gaming the system by going on frivolous consumption sprees and letting their creditors eat the cost.

Opponents of the law blame the bankruptcy boom not on out-of-control consumers but out-of-control credit card issuers, whose marketing practices and interest rates encourage people to amass debt they will struggle to repay. People who subscribe to this school of thought argue that the new law, framed with the help of credit card industry lobbyists, will only make life harder for the growing numbers of honest but unlucky debtors and the judges and trustees who hear their cases.

Narrative A: Moral Lassitude

Earlier this year, Todd Zywicki, a law professor at George Mason University, testified before the Senate Judiciary Committee in favor of a bill known as S. 256, which would soon become the new bankruptcy law. Zywicki said the new law would curb what he saw as the rampant abuse and fraud underlying the explosion in bankruptcies, which went undetected under the old law, the 1978 Bankruptcy Code—or simply, “the Code.” Zywicki, who in 2002 taught bankruptcy and other courses as a visiting professor at BC Law, argues that the Code invited abuse by letting people file for bankruptcy regardless of their need for debt relief. He also says the Code allowed too many filers into chapter 7—so-called straight bankruptcy, in which most personal assets, if any exist, are liquidated and the proceeds distributed to creditors. Many people whom the Code permitted to file under chapter 7 actually had sufficient income to pay off part or all of their debts, according to Zywicki, who argues that such filers should be forced to file under chapter 13, in which debtors get to keep their assets but must agree to a multiyear payment plan.

Zywicki also faults the Code’s vocabulary. According to his working paper “Why So Many Bankruptcies and What to Do about It,” the drafters of the 1978 law “consciously purged the normatively laden but ancient term ‘bankrupt,’ substituting the more value-neutral term ‘debtor.’ Rather than being adjudged bankrupt, a case filing is described as an ‘order for relief’.” According to Zywycki, these linguistic changes, along with a general lowering of the country’s moral tone that he blames on the baby boom generation, have weakened the stigma of bankruptcy, thus lowering bankruptcy’s “social cost” at a time when the economic cost (in the form of legal fees) and knowledge cost (in the form of how much effort a debtor must expend to learn about the benefits of bankruptcy) were also dropping.

Professor Ingrid Hilllinger, like some other opponents of the new law, does agree that the stigma of bankruptcy has eroded over time. Hillinger attends bankruptcy hearings along with her students as part of the bankruptcy courses she teaches at BC Law. “Are [bankruptcy filers] ashamed?” she asks. “Yes. Do they cry? Yes. They’re very embarrassed.” Even so, she says that “bankruptcy is a more accepted way of dealing with a very serious problem” than it used to be four or five decades ago.

But even those who grant the point about weakening of stigma may disagree with the moral conclusions that supporters of the new law draw from it. What if, for example, some or all of those excess filers—the million plus more people who are filing for bankruptcy nowadays than were filing in the late 1970s—are not the free riders described by supporters of the new law but are instead honest debtors who wouldn’t have filed except for the weakening of stigma and the lowering of other barriers? Isn’t it a good thing that they now avail themselves of the fresh start provided by bankruptcy law? Aren’t they, in fact, the very people the law was written for?

Even Todd Zywicki concedes that “it’s good the barriers have fallen in many cases. It’s good that the people who need to be in bankruptcy don’t face those barriers anymore.” He also admits he doesn’t know what percent of the excess filers are abusing the system and what percent are just people down on their luck—those who can’t pay off credit card debt because of personal calamities like medical emergencies, divorce, or loss of income. Disaggregating the two groups would be “very, very hard,” he says. “But the stigma question is what was animating Congress.…What caused Congress to stick with this bill for [the eight years from the bill’s first introduction to the time of its passage] is that they think there’s a moral question, a question of personal responsibility that underlies” the increase in bankruptcy filings.

Could Congress conceivably have gotten it wrong? Bankruptcy lawyers interviewed for this article estimate that 1 percent or less of bankruptcy filers are abusing the system. And Doreen Solomon, standing chapter 13 trustee for the eastern district of Massachusetts, reports that for the last two years, the United States Trustees Office, which oversees chapter 7 filings, “has aggressively been reviewing cases filed in chapter 7 and directing cases where the debtor has an ability to pay to chapter 13, so the current system has already been working to ferret out potential abuse.”

Narrative B: “I Owe My Soul to the Company Store”

Nineteen hundred seventy-eight, year one of the bankruptcy explosion, according to supporters of the new bankruptcy law, was, of course, the year the old Code was enacted. But it was also the year of a Supreme Court case that utterly transformed the bankruptcy landscape—or so say the bankruptcy law’s opponents. In Marquette National Bank of Minneapolis v. First of Omaha Service Corporation, the court ruled that parties loaning money to out-of state borrowers were governed by their home state’s usury law—or by no usury law if their home state didn’t have one. After Marquette, big credit card issuers such as MBNA and Citicorp flocked to states with permissive usury regimes, places like Delaware and South Dakota.

Supporters of the new law see no connection between the bankruptcy boom and the Marquette decision. Marquette aside, they say, credit card lending is a competitive business, with some 6,000 credit card issuers nationwide, and interest rates on cards have dropped substantially over the years—from 17.03 percent in 1978 to 12.91 percent in 2003, according to a report by the Federal Reserve Board of Governors.

But this leaves out a crucial piece of the puzzle, says Edward Janger, a professor at Brooklyn Law School. Janger points out that, thanks to new technologies, national credit reporting came of age right around the time of Marquette, allowing a credit card issuer in Delaware or South Dakota to estimate the default risk of borrowers nationwide. Between national credit reporting and Marquette’s de facto usury deregulation, lenders could now tailor interest rates to risk and make money regardless of a borrower’s location or ability to handle debt.

“If you’re lending more money to riskier borrowers, it’s not a surprise that you’re seeing more bankruptcies,” Janger says, especially when rates charged to people with weak credit histories can top 35 percent—despite the lower average rates cited by the new law’s supporters. Even at 25 percent, a credit card holder making the minimum monthly payment of 2 percent of outstanding balance will only fall deeper and deeper into debt, while enriching the credit card issuer. It’s a newfangled version, say some opponents of the new law, of the old-time debt peonage that Tennessee Ernie Ford sang about in his 1950s hit tune “Sixteen Tons.”

Anecdotes from a couple of bankruptcy lawyers show how eager some credit card issuers are to do business with financially troubled consumers. Robert S. Simonian, a partner in the Fall River, Massachusetts, firm of Bucacci and Simonian, who represents debtors in personal bankruptcy filings, says a recent client, a single mother of three children who had never earned more than $18,000 a year, had accumulated $112,000 in credit card debt by the time she filed for bankruptcy. “By all appearances,” Simonian says, the client had used her credit cards to help pay living expenses, and her debt had grown so large in part because of high interest rates and fees. Assuming she could devote her entire income to paying off the debt, and assuming a zero percent interest rate— both, of course, absurd assumptions—she would have to work six years to pay off her cards; in reality, she would have stayed in debt for decades, or forever, if not for the fresh start of bankruptcy.

The credit card issuers “knew or should have known her income, and they knew or should have known her level of debt,” Simonian asserts, “and they kept giving her credit.” Turning Zywicki’s personal responsibility argument on its head, he adds, “There seems to be little accountability in the credit card industry.”

Even more bizarre—though apparently not atypical—is an incident recounted by Mark Berman ’76, a partner in the Boston office of Nixon Peabody. Berman, who represents businesses in chapter 11 bankruptcies, sometimes takes a personal bankruptcy case as a favor to a business client. In one recent case, he says, “I put an individual through chapter 7. The day he received his discharge [of debt], he took me to lunch, and when I offered to pay, he said, ‘No, I just got a new credit card in the mail, and I want to use it.’ ”

Ironically, credit card issuers view people who have just emerged from bankruptcy as attractive borrowers because they can’t declare bankruptcy again for six years—eight years when the new law takes effect. Again, as Janger points out, at interest rates of 25 percent or more, a borrower who makes the minimum monthly payment can after four or five years have paid out an amount equal to the balance on her credit card plus a healthy premium without having made even a dent in her indebtedness.

Not all opponents of the new law dislike every one of the its provisions. BC Law’s Hillinger, for instance, applauds the elimination of a part of the old Code that allowed embezzlers and other criminals in chapter 13 to escape civil judgments resulting from their illegal conduct.

Abuse Prevention

Mark Berman, for his part, likes a provision allowing creditors to move for dismissal on the grounds that the debtor can actually pay off his debts—a feature of the 1978 Code that had been eliminated by a subsequent act of Congress. “What bothers me about the [2005] legislation,” says Berman, “is that, to deal with a group of abusers, instead of targeting those abusers, [the bill’ drafters] target all filers.” Nor does the law attempt to stop credit card banks from aggressively marketing to people with shaky finances and then charging them 35 percent for the privilege of having been marketed to. “Is it reasonable,” Berman asks, “to have a law that ignores that side of the equation?”

The new bankruptcy law runs 501 pages, and opponents object to many provisions, but most often they single out four key changes for their harshest words:

• People who earn more than the median income for their state are ineligible for chapter 7 if they can also pay their creditors $100 a month or more, according to a means test originally devised by the IRS for use with apprehended tax evaders. If the court decides that a bankruptcy filer has failed the means test, the filer can either drop the case or convert to chapter 13, agreeing to a monthly payment plan.
• Chapter 13 payment plans, which currently run three years, after which the court discharges the rest of the unpaid debt, will now run five years, meaning more payments to creditors or more financial strain for bankruptcy filers.
• All bankruptcy filers, even those who got into financial trouble because of job loss, divorce, or a medical emergency, face the expense of mandatory credit counseling before they file and of a money management course that they must take before discharge.
• Under a new “due diligence” requirement, lawyers must investigate their clients’ financial situation; they face fines, court costs, and other penalties if their clients are found to have submitted incorrect financial statements.

How will these changes affect bankruptcy filers and bankruptcy law practice? “The typical filer, someone down on his luck, won’t be affected at all,” says Zywicki. “Eighty percent of filers make below their state’s median income. The people who will be affected are those engaging in fraud or filing abusively to avoid debts they can repay.”

Others say this picture is simplistic, ignoring ground realities of bankruptcy. The means test, they maintain, is inflexible; it will take all discretion away from the court and push people into chapter 13 who have no real ability to repay debts. Even under the Code, two thirds of chapter 13 filers fail to complete their payment plans, and must either convert to chapter 7 or face being sued by creditors. When the means test is added to longer payment schedules for chapter 13 bankruptcy, even more chapter 13 plans will fail, predicts Robert Simonian, who says he often finds himself arguing with penniless clients who vainly hope to keep their house or car by filing under chapter 13. “I say, ‘You have to let the house go; you have to let the car go. You can’t afford this payment plan, and you’re going to have to convert to chapter 7,” Simonian reports. “If [Congress was] going to rewrite the law,” he jokes, “they should have made it harder to go into a 13.”

While people can argue over whether more chapter 13 plans will fail under the new law, filers forced by the law into chapter 13 will inarguably be paying their lawyers more than they would have paid under chapter 7. Chapter 13, a more complicated process, costs at least twice as much in legal fees, says Jonathan Braun of the Blanchard Law Office in Boston’s Dorchester neighborhood, who represents debtors in personal bankruptcy cases.

Meanwhile, the due diligence requirement may also add to legal costs for all bankruptcy filers, no matter which chapter they’re filing under. While this part of the law is imprecisely drafted, it will clearly mean “a lot more work for counsel,” says Gary Cruickshank, a sole practitioner in Boston who also serves as a chapter 7 trustee. “Under the new law, you can’t just rely on what the client tells you. You’ll have to look at several years’ tax returns, a couple of years of credit card statements, and then there’s certification of what they own, so someone from your office is going to have to go to their house and see how much furniture they have.”

With the cost of credit counseling and financial education heaped on top of the added legal fees, some predict an increase in pro se bankruptcy filings. While this may work out for chapter 7 filers, says bankruptcy trustee Solomon, “in chapter 13, debtors are usually trying to save their house, and if they are not careful, relief from stay can be granted, and the bank may foreclose on the house anyway. Debtors also don’t know how to avoid liens, and they don’t know to file [for a homestead exemption] before they file bankruptcy (which affects how much they have to repay to creditors). The pro se debtor also causes problems for the court because they don’t file proper pleadings or respond promptly to court orders.”

Of those who don’t file pro se, a significant portion may opt out of the bankruptcy system altogether, opening themselves to creditor actions, says Stewart F. Grossman ’73, a chapter 7 trustee and a partner in the Boston firm Looney and Grossman. Based on his experience in the field, he predicts that of those who opt out, many will face court-mandated payment plans that they will fail to fulfill—and unlike bankruptcy filers, they will never receive even partial debt forgiveness. “They’ll wind up in the state court system, being brought before the judge … on a regular basis,” Grossman says, “and that’s going to be a very negative, hopeless feeling those people will have. You lose your self-esteem.”

While many middle-class people may suffer this fate, the wealthy come out fine in the new legislation, Grossman adds. Unlimited homestead exemptions in states like Texas and Florida remain intact under the law, allowing people who do enough pre-planning to pour their assets into pricey real estate that can’t be touched by creditors. Meanwhile, those who can afford asset protection trusts can continue using them to exempt their assets from liquidation in bankruptcy. “Even the [law’s] provisions on IRAs and 401(K)s limit the exemption to what is reasonably necessary for the maintenance of the debtor and the debtor’s spouse,” says Mark Berman. “How many poor people do you know who have asset protection trusts?”

Along with ending abuse of the bankruptcy system, the name of the new law implies that it will also protect consumers. Just how this might work is suggested in language used by President Bush when he signed the bill. “These commonsense reforms,” Bush said, “will make the system stronger and better so that more Americans, especially lower-income Americans, have greater access to credit.”

One wonders what the president was thinking about. With credit card offers, many pre-approved, arriving almost daily in mailboxes across the land, Americans in every income bracket already enjoy easy access to credit. Disturbingly easy, some would say.

According to another economic argument proposed by supporters of the new law, curbing bankruptcy abuse will lower costs to credit card issuers, who will then pass their savings along to honest borrowers. Four hundred dollars in savings per consumer on credit card interest is a figure often cited by the bill’s supporters. This, however, is more a promise than an actual feature of the bill, which contains no provisions on interest rates. (Indeed, an amendment to the law that would have capped interest rates at 30 percent was rejected overwhelmingly by the Senate.)

Zywicki argues that the competitiveness of the credit card market will assure that rates go down along with costs to lenders, but others note that the costs of lending haven’t borne a close relation to interest rates on credit cards.

In a posting on the Talking Points Memo website, Harvard Law School professor Elizabeth Warren offers this analysis of credit card issuers’ economics:

Much larger [than the cost of writing off bad debts] is the cost of funds, which is the amount [that credit card issuers] must pay to borrow the money they lend out. From 1980 to 1992, that cost fell from 13.4 percent to 3.5 percent, a stunning decrease.… In the same time period, the average credit card interest rate rose from 17.3 percent to 17.8 percent.…When the cost of funds dropped nine times in 2001, instead of passing along the cost savings, the credit card companies pocketed a windfall of $10 billion in a single year.”

Ingrid Hillinger shares Warren’s skepticism about the promised savings to credit card holders. She says, “You want to place a bet that credit card interest rates will go down? Let’s just watch.”