Banking and Financial Services Sections

The Changing Tide in Bankruptcy

Is a Powerful Storm on the Horizon in Western Massachusetts?

“It is said,” Ralph Waldo Emerson noted, “that the world is in a state of bankruptcy, that the world owes the world more than the world can pay.”
Like many other areas of law, bankruptcy unfortunately rides the ebb and flow of politics. History demonstrates that bankruptcy-law expansion and contraction is often based on societal factors and perceptions, including economic growth or recession, employment rates, interest rates, and — maybe most importantly — the public perception of bankruptcy effectiveness.
As the U.S. Constitution leaves bankruptcy regulation squarely in the hands of Congress, this power has been exercised several times. One of the most significant revisions was the implementation of the Bankruptcy Reform Act of 1978, which created the modern day Bankruptcy Code and set the foundation for the bankruptcy system we use today.
To promote efficiency and protect the integrity of the federal bankruptcy system, the act established the U.S. Trustee Program as a component of the Department of Justice to monitor the conduct of bankruptcy parties and generally act to ensure compliance with applicable laws and procedures. The U.S. trustee also identifies and helps investigate bankruptcy fraud and abuse in coordination with U.S. attorneys, the Federal Bureau of Investigation, and other law-enforcement agencies. Essentially, the primary role of the U.S. trustee is to serve as the watchdog over the bankruptcy process. As stated in the their mission statement, “the mission of the United States Trustee Program is to promote the integrity and efficiency of the bankruptcy system for the benefit of all stakeholders — debtors, creditors, and the public.”
The inherent premise of bankruptcy is the creation of a system that gives good, honest, hardworking people a fresh start. Over time, the bankruptcy system became an effective way for many Americans facing extreme financial hardship to discharge significant debt. In fact, in the early ’80s, annual consumer filings hovered around 300,000. However, by 2004, the number of filers had skyrocketed to 1.5 million. These increasing numbers became a great concern to the lending community, which was forced to write off ever-increasing amounts of discharged debt.
Interested in examining the reasons behind the increasing number of bankruptcy filers, Congress formed the bipartisan, nine-member National Bankruptcy Review Commission in 1994. When Congress created the commission, it did not feel consumers were abusing the bankruptcy system, or that the code needed to be restructured to respond to increased credit-card use; rather, the commission’s work was more investigative, as it was charged with “reviewing, improving, and updating the code in ways which do not disturb the fundamental tenets and balance of current law.” Following an exhaustive three-year investigation, and despite enormous lobbying pressure from the credit-card industry, in 1997 the commission produced a voluminous, 2,000-page report that ultimately rejected any significant changes to the bankruptcy system.
Unfortunately, a minority number of committee members were fundamentally unsatisfied with the conclusion of the committee’s findings, and wrote dissents because they felt the installation of credit counseling and a ‘means test’ were warranted to limit Chapter 7 bankruptcy only to those who could prove they lacked the ability to repay their debts. Specifically, four dissenting members sought significant change in the bankruptcy laws because they perceived a societal harm was occurring. They believed society no longer perceived bankruptcy as morally offensive and, as such, bankruptcy was now being used an easy first resort (instead of the intended last resort) that allowed someone to walk away from their debt responsibility without significant consequence.

Under Attack
As some members of the lending industry were upset that the commission report failed to recommend restricting bankruptcy eligibility, a few lenders instead attacked the majority’s conclusions in the report as being incorrect, and went further by extracting and using the dissenting commission members’ comments to target Congress and justify the need for significant change in the bankruptcy system. Over the next eight years, spurred on by banking-industry lobbyists, Congress worked on and revised various versions of a new bankruptcy law that focused primarily on reshaping Chapter 7 bankruptcy.
Citing questionable data that had been presented to the committee, the House reports show that Congressional supporters came to believe that liberal bankruptcy laws were filled with loopholes that encouraged abuse, and this in turn increased credit costs for all Americans. The lender lobbyists claimed that the current bankruptcy laws imposed an annual $300-$500 surcharge on all responsible Americans who did not file bankruptcy, and as such, the rest of us were the ones ultimately responsible for paying debts discharged in bankruptcy. Successful lobbying convinced some in Congress to think of bankruptcy as basically another governmental benefit (like food stamps), as opposed to its prior status as a right.
This shift in thinking was significant. Instead of a person filing bankruptcy and obtaining the right to a fresh start, someone in financial distress must now first prove they are deserving of bankruptcy protection before becoming eligible for a fresh start in bankruptcy.
In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which in turn was signed into law by President Bush. Although there are many parts to the law that affect both individuals and businesses, the primary thrust of BAPCPA was to cut down on abusive or fraudulent filers in the bankruptcy system. As Congressman F. James Sensenbrenner Jr. (R-Wis), one of the bill’s key supporters in the House, argued, “this bill will help restore responsibility and integrity to the bankruptcy system by cracking down on fraudulent, abusive, and opportunistic bankruptcy claims.” This was accomplished by the law primarily doing three things:
• BAPCPA created a new, complex, mostly mathematical analysis known as the ‘means test’ to determine Chapter 7 bankruptcy eligibility and abuse. This task had previously belonged to bankruptcy judges; however, it appears Congress felt bankruptcy judges were either unable or unwilling to perform this duty, and thus Congress removed this subjective component. BAPCPA instead created a largely automated and mechanized formula to determine abuse. If the means test demonstrates that a Chapter 7 bankruptcy filing is ‘abusive,’ the bankruptcy case is either dismissed (meaning the debtor is put back in the same debilitating financial position they were in before they filed bankruptcy), or they might instead be able to convert to a Chapter 13 bankruptcy. Known as a reorganization, a Chapter 13 is designed to create a long-term repayment plan for debtors (often running three to five years) in which the debtors repay some or all of their obligations. In addition to often being two to three times more expensive to hire a lawyer to do a Chapter 13 bankruptcy, the monthly payment and extended time commitment make the process untenable for most Chapter 13 debtors.
• The new law required all debtors to take two classes as part of the bankruptcy process. First, unless a debtor meets a very narrow group of exceptions, a pre-filing credit-counseling class must now be taken within 180 days before filing bankruptcy. The class is designed to require the debtor to review the opportunities for available credit counseling and assist them in performing a related budget analysis. After filing bankruptcy (and before the debtor can receive a discharge and finish the case), the debtor must also take a financial-management education class to help him or her understand budgeting and other financial basics with the hope that this information may reduce the need to file bankruptcy in the future.
Again, the message Congress sent with these changes was that it lacked confidence in the bankruptcy process. Specifically, it become apparent that Congress felt lawyers were doing an inadequate job counseling their clients about their bankruptcy and non-bankruptcy options, and lawyers were perhaps instead pushing people who really didn’t need to file bankruptcy into bankruptcy simply to earn a legal fee.
• Finally, the law sought to stop repeat bankruptcy filers by extending the time of eligibility between bankruptcy discharges from six years to eight years. Apparently, judges, the U.S. trustee, and lawyers were not able to prevent what Congress deemed ‘abusive repeat filers,’ so Congress decided to again take charge and simply extend the time for which repeat filing is a possibility for everyone.
The theoretical justification behind BAPCPA is that it would first inhibit and reduce bankruptcy filings; in turn, bankruptcy-related losses to lenders would be drastically reduced. Those lenders would then pass on the savings to the rest of us in the form of lower interest rates. Although this theory was unproven at the time of passage, it was known that BAPCPA would make bankruptcy harder to file and more expensive, and would automatically carve out a group of people who would now be ineligible for Chapter 7 relief.

The Results, Eight Years Later
After the passage of BAPCPA, did bankruptcy filing rates significantly decline? Yes and no. Although BAPCPA was signed into law on April 20, 2005, most of the law did not become effective until Oct. 17, 2005. The number of bankruptcy filings took a significant drop after BAPCPA’s effective date. Although this may seem to justify the need and effectiveness of BAPCA, a broader perspective is important.
In actuality, because of the six-month grace period, the publicity surrounding the law’s existence, and a general fear by those in financial crisis over whether or not they would remain eligible for bankruptcy protection after Oct. 17, large numbers of people who had considered bankruptcy even very briefly went ahead and filed for bankruptcy prior to the Oct. 17 deadline. Although the filing numbers plummeted to 600,000 the year after BAPCPA, it is important to note that the signing of the law caused filings to skyrocket to more than 2 million in 2005. As such, the numbers of filings after BAPCPA were negatively skewed, thus also skewing the perceived effectiveness of the law. Furthermore, since 2006, the filing numbers have generally trended upward, and are again at approximately pre-BAPCPA levels.
If the objective of BABPCA was to produce a long-term reduction in consumer filings based on implementation of a means test, credit counseling, and limiting repeat filers, Congress failed. In addition, it is interesting to note that, during the period where bankruptcy filing rates significantly fell following enactment of BAPCPA, despite Congress’s hypothesis, there is no evidence that the lending industry lowered interest rates on credit cards and other loans. Although theoretically saving hundreds of millions of dollars due to significantly fewer discharged debts, it appears some in the lending industry actually increased credit-card fees.
There is also evidence that BAPCPA failed to adequately encourage consumers to utilize debt more cautiously. In fact, during the first year that BAPCPA was in effect, revolving debt per household rose by 5.3% — higher than the rate of increase during any of the previous five years.

A Surge in Bankruptcy Filings?
Although BAPCPA seems to have failed in its primary objectives, experts are pondering the effect of its eight-year anniversary. Specifically, as that anniversary will occur this October, will there be a flood of new bankruptcy filings, as the enormous number of people who filed bankruptcy in 2005 will now be eligible to re-file?
As the economy has continued to struggle, and many people have not been able to financially rebound since their last bankruptcy filing due to the ongoing recession, lawyers in Western Mass. are preparing for a possible rush of large numbers of people needing bankruptcy assistance who will again become eligible to file bankruptcy this October.
In addition to lawyers, it also important that local banks and lenders be prepared to deal with a possible increase in bankruptcy notices. From a lender’s perspective, in anticipation of a possible filing spike, it would be prudent to have legal counsel review proper bankruptcy-notice protocol with loan and collection officers. Generally speaking, communications regarding a debt (both verbal and written) from the lender to a debtor in bankruptcy could be deemed a violation of the automatic stay, and expose the lender to sanctions.
Only time will tell if we will soon experience a spike in bankruptcy filings. As with most things in life, the best offense may be a strong defense — prepare for the worst and hope for the best.

Attorney Justin Dion is a professor at Bay Path College in Longmeadow, where he teaches in the Legal Studies Department, and is director of the Bay Path College Pro Bono Bankruptcy Clinic. He is also associated with the firm Bacon Wilson, P.C., in Springfield, and practices bankruptcy law; [email protected]

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