March 15, 2005,
For eight years, Congress has attempted to enact comprehensive bankruptcy-reform legislation, but has been frustrated by extraneous issues and procedural difficulties. Last week, by a vote of 74-25, the United States Senate passed the legislation. It will now move to the House, where swift approval is expected (prior versions routinely garnered over 300 votes), and then to President George W. Bush, who has indicated that he will sign it. This overwhelming bipartisan support has not, however, kept the bill from attracting a great deal of criticism in the press and blogosphere, including criticism by many who usually do not agree with Paul Krugman. In fact, the criticisms are based on half truths, distortions, and fundamental misunderstandings about key aspects of the legislation.
The legislation addresses two problem areas of modern bankruptcy law: the consumer-bankruptcy crisis and the problem of small-business bankruptcies. The consumer-bankruptcy provisions have drawn most of the criticism, so I will focus on them.
Krugman writes, “The bill would make it much harder for families in distress to write off their debts and make a fresh start. Instead, many debtors would find themselves on an endless treadmill of payments.” This is flatly incorrect.
The bill is designed to rein in the small minority of fradulent bankruptcy filers who are having an outsized effect on credit markets. It will not prevent any innocent, good-faith filers from filing bankruptcy and getting a discharge. It preserves the fresh start for those who need it.
The FBI estimates that roughly ten percent of bankruptcy filings have some amount of fraud in them, usually outright lying and concealment about the amount of assets and income that a debtor has to pay his creditors. To attack this problem, the bill creates new safeguards to make it easier to sniff out fraud. Debtors will have to file their tax returns with their bankruptcy petitions, and bankruptcy filings will be randomly audited. Last year there were 1.5 million consumer bankruptcies in America. If the FBI is right, in 150,000 of those cases bankrupts were just lying about their assets. A debtor who fails to disclose his boat, Porsche, Corvette, and Ford Excursion, and values his home at $120,000 less than he paid for it to mention one case investigated by the Department of Justice is not a “family in distress” as most of us think of the phrase.
The bill cracks down on various abuses as well as on fraud. For instance, it eliminates a number of obstacles that currently interfere with the ability of divorced spouses to collect alimony and child support from a bankrupt father. Philip Strauss, formerly the principal attorney for the San Francisco Department of Child Support Services, calls these provisions in the bill a “‘wish list’ of amendments to the Bankruptcy Code aimed at facilitating support collection.” Almost all of the national public child-support collection organizations in this country, as Strauss notes, have endorsed the bill. Maybe deadbeat fathers who use the bankruptcy code to evade their responsibilities are the “families in distress” that Krugman is worried about?
Maybe the critics are concerned about the portions of the bill that make it easier to detect and punish fraudulent “bankruptcy mills” that steal people’s money? That increase penalties for such practices as “advis[ing] debtors to use a false Social Security number” when filing bankruptcy? Or maybe they are upset that under the reforms, serial bankruptcy filers would now be able to file bankruptcy only once every 8 years, rather than only once every 6 years? Oh, the horror! To be allowed to file bankruptcy only once every 8 years! Is that really the second coming of debtors’ prisons?
Finally, the bill imposes several important new safeguards to prevent abuse of the notorious homestead exemption. Bankruptcy filers are allowed to retain property that is considered necessary for a debtor to make a “fresh start” in life after bankruptcy. In most states, this allows a bankrupt to collect some amount of accumulated equity in his home, car, retirement accounts, and the like. In some states, such as Texas, Florida, and several farm states, bankrupts are entitled to protect their entire homestead, regardless of amount. It has been reported that O. J. Simpson recently moved to Florida to avail himself of the state’s unlimited homestead exemption and thereby avoid seizure of his mansion to pay his multimillion-dollar civil judgment. Under current law, this is perfectly legal.
The bankruptcy-reform legislation tightens up this loophole. For example, it disallows the homestead exemption if the homestead was purchased with intent to defraud creditors, as in O.J.’s case. It also makes it harder to use the exemption to protect against judgments for securities fraud, thereby limiting the ability of those such as Florida resident and WorldCom executive Scott Sullivan to hide behind Florida’s homestead exemption to evade collection of judgments against them. Fortunately Simpson and Sullivan have Paul Krugman and others working to make sure that they will face no “endless treadmill of payments” on their liabilities.
MEANS AND ENDSThe most important and controversial provision of the legislation is the “means-testing” of chapter-7 bankruptcy relief. Under current law, a person filing bankruptcy has two options. The debtor can file in chapter 7, the “liquidation” provision, which permits debtors to simply surrender all their assets and get a full discharge of unsecured debts a few months later. Or the debtor can file in chapter 13, under which he enters into a court-supervised repayment plan for a period of 3 to 5 years, during which he pays all of his “disposable income” to pay off what he can of his unsecured debt. To calculate the debtor’s available “disposable income,” a judge uses his own subjective preferences to determine the debtor’s allowed living expenses.
The means-testing provisions of the bill will bring some rationality to this system. Those who make above the state median income (adjusted for family size), and can repay a substantial portion of their debts without significant hardship, would be required to file in chapter 13. At the end of the chapter-13 plan, this high-income filer would still get a discharge, just as other bankruptcy filers do. There is no “endless treadmill of payments,” just a requirement that high-income debtors repay what they can.
In determining whether the debtor can repay a substantial portion of his debts, the legislation makes allowances for a whole range of expenses right off the top. First, it creates a standardized slate of expenses based on the relevant family size and regional cost of living, for such things as clothing, food, transportation, etc., eliminating the subjective judicial navel-gazing of the current system. It then subtracts from your income all of the debtor’s actual payments on secured debts, such as a home mortgage, car loan, or the like. The debtor can subtract any actual expenses for health care for himself or a dependent, as well as payments for health insurance premiums. Finally, there is an allowance for children’s educational expenses. If after subtracting out all of these expenses, the debtor still can repay $10,000 or 25 percent of his debts over a 5-year period, then he would be presumed to have to file in chapter 13.
The debtor could rebut this presumption by showing “special circumstances” that make it too much of a hardship to file in chapter 13, in which case the debtor would still be permitted to liquidate his debts in chapter 7.
So how many people would be affected by means-testing? The estimates are that some 7-11 percent of current bankruptcy filers would be affected by the means-testing provisions of the bill. Roughly 80 percent of bankruptcy filers earn below their state median income, and so will get tossed out of the means-test immediately. For that 80 percent roughly 1.2 million of the 1.5 million bankruptcy filers last year the means-test will be completely irrelevant. They will be permitted to file chapter-7 bankruptcy just as under the current system. Roughly half of the remaining 20 percent of filers won’t be able to repay enough of their debt to meet the repayment criteria, so they will be dropped out as well and be permitted to file just as today. So in the end, only the highest-income filers with the largest repayment capacity will be affected.
But by targeting the most serious abusers of the system, the reform legislation will have a major impact on the bankruptcy system. This 7-11 percent of filers, on average, would be able to pay 60-65 percent of their unsecured debt in bankruptcy, such as credit-card and medical debt.
COSTS AND BENEFITSSome have observed that bankruptcy reforms may make it somewhat more expensive and difficult to file bankruptcy. That is likely true, but only marginally so, and it seems quite clear that the benefits of the reforms dramatically exceed the costs. Under current law, all debtors are already required to report their income, assets, and liabilities. So implementing the means-test does not require the debtor to report anything that isn’t required under current law. Having to file pay stubs and tax returns, too, seems like a modest imposition in light of the improved ability to detect fraud that the requirements will yield.
The bill will require debtors to try to avoid bankruptcy by seeking consumer-credit counseling before filing bankruptcy. This measure will help prevent unnecessary bankruptcy filings. It will also protect individuals from their own lawyers. In response to ubiquitous advertising by bankruptcy attorneys, many financially strapped debtors contact attorneys for advice about dealing with finances, only to find themselves stampeded into an unnecessary bankruptcy filing. (The lawyers get paid only if the client files bankruptcy.) A requirement to first attempt a voluntary repayment plan through consumer-credit counseling will provide a salutary check on the lawyers.
In an ideal world, the current “honor system” approach to bankruptcy fraud would work, sparing honest filers these modest expenses. But if the honor system actually worked, we could also eliminate the IRS and all restrictions on welfare fraud. Any system to stop tax or welfare fraud will inevitably impose some costs on innocent people; so too with stopping bankruptcy fraud and abuse. The question is whether the improved safeguards are worth those costs. In this case, that test is met.
Fraud and abuse in the bankruptcy system have real victims. Those victims include the unsuspecting divorcee who is sandbagged by the bankruptcy system when she learns that her property settlement has been discharged. They include small businesses that are forced to raise prices, curtail services, or lay off workers to compensate for losses resulting from bankruptcy filings. They include hospitals that are unable to buy new equipment or hire another nurse because of unpaid bills discharged in bankruptcy. They include young and low-income workers who are unable to buy a car because, thanks to our out-of-control bankruptcy system, they can’t get a loan.
They include every American who is forced to pay more for credit, goods, and services, because others file bankruptcy and walk away from debts they could pay but choose not to. This is unfair. And unnecessary.
These bankruptcy filers are not representative of the vast bulk of individual debtors in the bankruptcy system. But there are people who file bankruptcy not as a result of financial hardship as conventionally understood, but merely as a convenience to maintain an extravagant lifestyle at the expense of the rest of us. As the number of bankruptcy filings continue to rise, so does the number of those abusing the system.
I can’t see any reason why I or anyone else should have to pay higher interest rates or get worse service at the doctor’s office in order to preserve the “right” of some guy making $80,000 or $100,000 per year to walk away from debts that he could pay but does not want to. Yet that’s the way it is under current law. Those who are hurt the most are low-income and young borrowers who have the fewest credit options and can least afford to pay more for credit and goods because of the hidden “bankruptcy tax.” For all you critics out there is there someplace where I can send you my part of the bill so that you can allow bankruptcy fraud and abuse to keep going unchecked?
Todd Zywicki is a professor of law at George Mason University. He has testified before the House and Senate judiciary committees on bankruptcy reform.