Putting Back the Bite: With the march of time, personal bankruptcy has become a relativelypainless way to shirk debt. Tough measures before Congress may make it harder to avoid thehurtAuthor(s): MICHAEL HIGGINSSource: ABA Journal, Vol. 84, No. 6 (JUNE 1998), pp. 74-77Published by: American Bar AssociationStable URL: http://www.jstor.org/stable/27840293 .

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BANKRUPTCY LAW

measures before Congress may ^^E^j^^^^"

BY MICHAEL HIGGINS

The best career move in show business lately may be going broke.

Actress Kim Basinger, who filed for bankruptcy in 1993, hardly looked down on her luck when she picked up an Academy Award ear lier this year. Burt Reynolds, who filed in 1996, also was nominated for an Oscar this year. And singer Toni Braxton, a five-time Grammy win ner, filed for Chapter 7 in January, only a few months after reportedly turning down a recording contract worth more than $10 million.

To critics of the laws that gov ern personal bankruptcy, the spate of bankruptcies of the rich and fa mous provides evidence that lax legal standards allow well-heeled individ uals to shirk legitimate debts. <cYou would think that with the generous incomes [some celebrities] could pro

Michael Higgins is a reporter for the ABA Journal. His e-mail ad dress is higginsm@staffabanetorg.

ject, they would be in a mk position to repay," com-

jH plains Rep. George W.

r? Gekas, R-Pa., sponsor ^w??fi of a tough reform bill. 4

Worse yet, Gekas ^^f^|pFi and others say, middle class Americans seem to be follow ing the celebrities' lead. Over the past decade, personal bankruptcy filings have exploded, from fewer than 500,000 in 1987 to more than 1.3 million in 1997, even amid a ro bust economy. Over the same peri od, filings of business bankruptcies dropped from 82,446 to slightly more than 54,000.

Bankruptcy law has come a long way since the days of ancient Rome, when debtors could be sold into slavery upon default, and the days of the colonial debtor prisons. In the United States, the Consti tution essentially federalized bank ruptcy law. Especially since the U.S. Bankruptcy Code of 1978 went into effect, the personal bankruptcy sys tem has become much more user friendly, in some cases being treat

A debtor has to pay the price.

ed more like another finan cial planning tool than a measure of last resort.

But now, several bills in Con gress are seeking to reverse that trend.

It is not clear whether Congress will pass any bill this year, but most bankruptcy experts say some kind of reform is on the way. Most of the cur rent proposals involve some kind of means testing, which could radical ly limit the ability of people with high incomes to wipe out their debts.

Means testing "seems to have an awful lot of momentum at the mo ment," says Nashville lawyer Ernest B. Williams IV, who chairs the Con sumer Bankruptcy Committee of the ABA Section of Business Law.

But consumer groups and some

74 ABA JOURNAL / JUNE 1998 ILLUSTRATIONS BY JOHN HAYES

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bankruptcy lawyers are skeptical. They say means testing would be nightmarishly complex and would punish honest debtors struck down

by job loss or medical catastrophe. A hard-line means test says,

"in effect, 'We don't care about the things that happen in the normal vicissitudes of life; pay the damn bank/

" says Jeffrey L. Solomon of

New York City, who chairs the Bankruptcy Committee of the ABA General Practice, Solo and Small Firm Section. "It's really that mean spirited."

Experts Pender Surge in Filings No one knows for certain why

filings have surged so dramatically. The villains cited most often include a booming economy that spurs over confident spending, aggressive mar keting by credit card companies, advertising by bankruptcy lawyers and widespread casino gambling.

Many experts agree, too, that as bankruptcy has become more common, the social stigma against it has diminished.

"People are more comfortable with debt," observes Sam Gerdano, executive director of the American Bankruptcy Institute, a nonprofit group of 6,000 lawyers, judges and trustees. "They live in a country

Ms

Down on his luck but not locked up.

that has had a huge budget deficit. They shop at bankrupt retailers, travel by plane on formerly bank rupt airlines. They may live in Orange County [Calif.], a formerly bankrupt county.*

Banks and credit card compa nies, the leading institutional cred itors for consumer debt, certainly do not like the surge in personal bank ruptcies, especially since some 70 percent of filings are made under Chapter 7 of the Bankruptcy Code, which means creditors are not like ly to be repaid in full.

In Chapter 7 cases, debtors may keep some exempt property, such as certain amounts of home equity or

personal belongings. (Under state laws, exemption levels vary widely.) In each case, the court appoints a trustee to sell the rest of the prop erty and use the proceeds to pay creditors in order of priority. Re maining debts are discharged.

Generally more appealing to creditors is Chapter 13, under

which a debtor establishes a plan to repay debts over time.

The credit industry claims per sonal bankruptcies cost the econ omy more than $40 billion last year, in part by driving up interest rates for respon sible borrowers.

Reform is about "telling the people / /r\ who are out there / ?fmm paying their bills f mwB ? that they're do- / / ing the right f jg thing," says ?? ^^^^ ?? George Wal- ^^^^ |^ lace, counsel to ^^^#4^H the American Fi nancial Services As- JftpM sociation in Washing- ^KaTJ

Consumer advo cates, however, say ^^^^H most of that $40 bil- H||^HH lion is simply credit U?H^ that should not have j been extended in the first place. They say creditors could not collect that money regard less of the structure of bankrupt cy law. These advocates also doubt that credit card issuers would ac tually lower interest rates even if they were to get the reforms they are seeking.

In 1994, Congress created the National Bankruptcy Review Com mission to consider the problem. Last October, that commission is sued a 1,300-page report on all fac

ets of the Bankruptcy Code. The report contained 172 rec

ommendations, including random audits of bankruptcy filers, a feder al cap on property exemptions, and a bar against consumers discharg ing credit card charges made with in 30 days of declaring bankruptcy.

But the report, which did not call for strict means testing, seemed to ignite more controversy than it settled. Creditor groups argued that the report did not go far enough to stop the bankruptcy boom. Con sumer groups argued that in some areas it went too far. Both camps turned to Congress.

Focus on Means Testing Some members of Congress

have been eager to take on the chal lenge, and myriad reform propos als, from the fundamental to the highly technical, have been submit ted in the House and Senate.

But the growing debate clearly centers on means testing.

The goal of the means testing approach would be to keep high-in come debtors out of Chap ter 7 bankruptcy and

f"P

....... ...

. . . . . . . . . . . . . . . . . . . . . . .

In the red but still sitting

pretty steer them instead to Chapter 13, where they would?in theory, at least?repay more of their debts.

Bankruptcy judges now can block debtors from Chapter 7 if they detect a "substantial abuse" of the process, but that rarely happens.

ABA JOURNAL / JUNE 1998 75

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IP

JEFFREY SOLOMON Means testing is mean-spirited and sends the message: "We don't care about the things that happen in the normal vicissitudes of life; pay the damn bank."

For the most part, it falls to bankruptcy trustees to alert judges to substantial abuse. But pursu ing suspected abuse can take 20-50 hours, says Southfield, Mich., lawyer Lawrence Friedman, treasurer of the National Association of Bankruptcy Trustees. That is a lot to expect, he says, from trustees who earn only about $60 in the standard no-asset bankruptcy and perhaps $6,000 in a case in which they liquidate $50,000 worth of property.

And in practice, the substantial abuse standard is unclear and large ly toothless, Friedman says.

That is why banks and credit card companies favor Gekas' bill, which takes its consumer bankrupt cy provisions largely from a bill in troduced previously by Rep, Bill

McCollum, R-Fla. The Gekas bill would replace

the substantial abuse standard with a means test to keep debtors out of Chapter 7 if they: 1) earned more than 75 percent of the national me dian family income; and 2) could repay their secured debts (such as home mortgages and car loans), pri ority debts (including child support and taxes) and at least 20 percent of unsecured debts over five years.

Gekas says that if the bill had been in effect last year, it could have saved lenders about $4 billion.

But many consumer groups favor a competing means test that

Rep. Jerrold L. Nadler, D-N.Y., has proposed. It rules out Chapter 7 on ly for debtors who have household incomes of more than $60,000 and can repay their unsecured debts in three years, or as they come due.

That formula is more cautious about saddling debtors with repay ment plans they can't meet, says Da vid Lachmann, a Democratic staff er on the House Judiciary Commit tee. Lachmann calls the Gekas bill "a very inflexible formula."

Targeting the Big Abuses In the Senate, Charles

E. Grassley, R-Iowa, and Richard J. Durbin, D 111., are trying to steer a middle course. Their bill wouldn't force judg es to follow any formu la. Instead, it would allow judges to keep debtors out of Chap ter 7 upon a showing of mere abuse, rath er than substantial abuse.

Their bill "attempts to catch the big abuses, without clogging up the system with little abuses," a Durbin staffer says.

Between means test

ing and other proposed changes, the potential shift in the law is huge,

Flashback: No mope

free ride?

ABAJ/ARNOLD ADLER

says Williams of the ABA's Business Law Section. "If [the bills by] Gekas or Grassley are passed as drafted, it will be the most significant change to con sumer bankruptcy law since the 1978 Bankruptcy Code."

For consumer advocates, that may be too much sweeping change, too soon. They say re formers have not considered how difficult it will be to apply means tests in real life.

The lawyers who represent debtors say the vast majority of Chapter 7 filings are true hard luck cases: low-income people carrying too much debt who are blindsided by job loss, divorce, health problems or other un foreseen expenses.

"These are not dishonest people," says Terence M. Fene lon, a lawyer in Naperville, 111.,

who chairs the Bankruptcy Committee in the ABA Section of Family Law. "These are peo ple who are looking at the world with rose-colored glasses: 'The

new job is just around corner. We're going to dig ourselves out of this/ Then they get to the point where, one day, reality sinks in."

To measure whether a Chapter 7 bankruptcy filer can afford to re pay debts, for instance, the Gekas bill would look to Internal Revenue Service estimates of normal living expenses. But many legitimate debt ors will have expenses?major auto mobile repairs, medical care for a relative?that do not fit neatly into the 1RS mold.

76 ABA JOURNAL / JUNE 1998

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"Having to run into court every time you have an extraordinary ex pense is ridiculous," says Solomon of the ABA Bankruptcy Committee.

Under the Gekas bill, Solomon says, "If you've got a choice between paying the boiler repair guy or

making your plan payments, you'd better be prepared to freeze or go to court and get permission to fix your boiler."

Opponents of means testing say it also encourages people to run up their debts, since individuals who owe huge sums are more likely to qualify for Chapter 7.

And even if the means test moves more people into Chapter 13, that does not mean creditors

will get paid, consumer advo cates note. Right now, about two-thirds of Chapter 13 re payment plans fail. Presum ably, the success rate for debt ors who are forced into Chap ter 13 would be even worse.

Advocates of means test ing say the criticisms are ex

aggerated. It would be easier to administer a set formula than the vague substantial abuse test, they argue.

And Gekas' bill would al low Chapter 13 bankrupts to adjust to catastrophic events, so that they are not forced into Chapter 7.

"We means test our other social welfare programs," says

Wallace of the American Finan cial Services Association. "I just can't understand folks who say,

Well, it really isn't worth it.' "

Given the fervent pursuit of means testing, it is somewhat surprising that the chances of passage for another bankruptcy reform are in doubt.

The problem is the lack of uniformity in homestead ex emptions set by the states. In five states, most notably Texas and Florida, unlimited homestead ex emptions allow wealthy debtors to emerge from Chapter 7 bankrupt cies still owning multimillion-dollar homes.

In these states, "Deadbeats get wealthier while legitimate creditors, including the U.S. government, get the short end of the stick," says Sen. Herbert H. Kohl, D-Wis., who introduced a bill in 1997 to cap the homestead exemption nationwide at $100,000.

Grassley and Durbin adopted Kohl's bill as an amendment to their

bill in April after carving out an exception for family farmers. The National Bankruptcy Conference? a nonpartisan group of 67 acade mics, judges and lawyers?favors the cap concept. So do many credi tors.

Gekas' bill would make it some what harder for debtors to move to jurisdictions with more generous exemption limits, but it does not contain a homestead exemption cap. Gekas says that there are not enough votes in the House, where a states' rights philosophy holds sway, to pass one.

Many bankruptcy lawyers say that concerns about high ceilings on homestead exemptions in a few

U.S REP. of pMpfe gain control over their credit card debt "just stupefies me."

states miss the point. A bigger problem, these law

yers contend, is homestead exemp tions that are too low. More than half the states allow Chapter 7 bankrupts to keep only $15,000 or less in home equity.

Putting the Blame on Plastic Meanwhile, consumer advo

cates say the real target of reform should be credit card companies that bombard consumers?at all income levels?with unsolicited credit applications, encourage them to carry a balance from month to

month, then expect Congress to

help them collect on the bad debts. So far, however, there does not

seem to be much momentum for tougher regulation of credit card companies.

Creditor groups say about 96 percent of credit card holders pay on time under the terms of their agreements. And even among peo ple who are bankrupt, credit cards account for only about 15 percent of total debt.

Creditor groups also note that, beyond the bankruptcy debate, there is a longstanding national policy in favor of extending credit broadly, so low-income people are not shut off from capital.

For his part, Gekas simply points out that no one is forced to sign up for a credit card. He scoffs at the notion of debt ors "tempted beyond the human capacity to withstand," and adds, "That argument just stupefies me."

So can the reform ers improve the bank ruptcy system?

Gerdano with the American Bankruptcy Institute answers: "We don't have a conclusion on who's won the argu ment yet. It's a close call."

But Gerdano con tends that reform ad vocates have the bur den of proof. They must show they can change the system for the bet ter. And they must real ize that resources that go to resolving personal bankruptcy cases will not be available to deal with the more demand

ing business cases.

"Judges now basically never see a Chapter 7 bankruptcy case because 95 percent are no-asset cases," Gerdano says. "There's a

zero-sum game going on here. There's only so much judicial time to go around."

Gekas concedes that his legis lation may be taking bankruptcy law into uncharted territory, but he argues that the potential benefits are worth the risks.

"The opponents are going to say, It'll cost,'

" Gekas says of his

reform plan. "We say, 'What did it cost to get us here?'

"

ABAJ/RICHARD NOWITZ ABA JOURNAL / JUNE 1998 77

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