The New Bankruptcy Law
By: A. B. Jacobs
On April 20, 2005, President Bush signed legislation designed to overhaul the federal bankruptcy laws. The consummation of this project, in the works for nearly a decade, was no small accomplishment. Its enactment required overcoming the objections of labor organizations, consumer advocacy groups, and the leadership of the Democratic Party. The 2004 elections that gave the Republican Party congressional domination, particularly their 55-seat majority in the Senate, made this possible.
For a brief historical background, the concept of bankruptcy is relatively modern, dating in this country to 1800 when Congress adopted the first national bankruptcy law, modeling it after a British statute of the time. Prior to that time, unpaid debts were treated as criminal offenses throughout the world. In ancient Rome, creditors were literally able to divide the body of an insolvent debtor or to enslave him and his family. Under the laws of England during the reign of King James I (1603-25), a debtor unable to explain insolvency was placed in the public pillory and might be put to death if his failure to pay creditors was considered improper. But with the development of trade and commerce, steps were taken to ameliorate the condition of the debtor. Modern legislation dealing with bankruptcy generally contains the basic principle that a person unable to pay debts in full may be discharged of them by giving up all property for ratable distribution among the creditors. The U.S. bankruptcy laws have been modified and remodified over the past two centuries, principally in 1898 when Congress passed the fourth national bankruptcy law, establishing many of the procedures currently in effect. Thereafter periodic modifications were enacted, with the last significant overhaul occurring twenty-five years ago.
America's financial landscape has evolved during the past quarter century. Innovation in the marketing of goods has reached a level previously unimagined. The credit card, created as a shopping convenience, has mutated into a device in which its use (and misuse) is epidemic. Consumer borrowing, once held in check by realistic limits, is today a national scourge. Understandably, when citizens find themselves extended beyond their limits, they seek a way out. The bankruptcy court is often the answer, with 1.56 million Americans filing in 2004, double that of a decade earlier. The method most popularly chosen is that under Chapter 7 of the Bankruptcy Code by which the debtor may retain selected assets, together with their accompanying obligations, while renouncing all other indebtedness. As expected, credit card debt held by wage earners of modest means, often extending into the tens of thousands of dollars, is now systematically repudiated. The answer by the nation's creditors to this predicament is as you might expect: enactment of a law prohibiting the use of Chapter 7.
With the scene set, we'll consider the provisions of this law that will become effective in October 2005. Although the legislative verbiage extends to 500 pages, its intent is captured with two major changes.
Means test for Chapter 7 eligibility.
Any debtor whose income equals the state's median income and who can pay $100 per month over five years is ineligible to file. The alternative in that case must be to file bankruptcy under Chapter 13, resulting in court-ordered repayment plans. With a national median family income of $42,654, the exclusionary net will sweep wide.
Mandatory Consumer counseling.
Individuals who seek bankruptcy protection must obtain credit counseling at their own expense from "an approved nonprofit credit counseling agency" (not unsurprisingly, often affiliated with a credit card company). In addition to this requirement that can extend for up to six months, bankruptcy fees, currently at about $750 and $2,500 for Chapters 7 and 13 respectively, are expected to double. You may add to that the financial-education course which debtors must complete within 18 months of filing before their debts may be discharged.
Now that you're aware of the changes, let's consider the standard arguments, pro and con. The pro side, favored by banks, credit card companies, and other assorted creditors, is easily understood. They maintain that the current system permits unscrupulous debtors to flagrantly ignore their debts, thereby passing these costs on to creditors. They further contend that honest citizens who reliably pay their bills are the real victims of opportunists that default on their obligations, as the costs must be passed on to the general public. To emphasize their arguments, they point to persons who run up massive credit card bills, only to default on them when it becomes convenient. Those on the con side see things differently. They decry the measure as one that guts a safety net essential to many who encounter financial problems not of their making. They offer as examples persons who have lost a spouse, been laid off from a job, or incurred large medical expenses. They further allege that the credit card companies have contributed to the problem by extending credit to vulnerable consumers.
As you might guess, I harbor some opinions that I'd like to pass on for your consideration. To begin with, the supporters are correct that some deadbeats do take advantage of the rules. As an example, a one-time close associate could serve as a poster boy in depicting the abuses possible. Because of personal financial difficulties, he systematically ran up 5-figure balances on multiple credit cards, collecting the proceeds in cash while dutifully servicing each card with minimum payments. With maximum credit limits achieved, and over $65,000 safely secreted, he filed Chapter 7 Bankruptcy, and got away with it quite neatly. But, as I consider the effect of these revisions, he could perform exactly the same operation with no difficulty. The new law will not deter a sophisticated conniver from defrauding creditors with impunity. So what will it really accomplish? I'm convinced that it will insure exactly what its sponsors intend: It will permit America's lending institutions to target the mass of middle-class, middle-income, citizens, coercing them to further extend their borrowing, while safe in the assurance that most will never get away. Perhaps it was pure coincidence that on April 14, the day on which the House of Representatives gave its final approval to the legislation, I received in the mail a solicitation from Citibank, one of the nation's largest credit card issuers. The pitch was an offer for a free iPod in conjunction with my application for their credit card, prominently boasting "0% APR on balance transfers until August 1, 2006." It required closer scrutiny with a magnifying glass to locate the fine print in the literature stating "All your APRs may automatically increase up to the default APR if you default under any Card Agreement that you have with us ... The default rate equals the U.S. Prime Rate plus up to 23.99%." Is there any doubt that the credit card companies know, with statistical certainty, exactly what percent of the general population will, within a prescribed period of time, default on "any Card Agreement"?
Though it was a long time in coming, the law will soon go into effect. Exactly what it will bring in family disruption and misery is incalculable. The simple fact is that a substantial portion of the population is incapable of astutely handling money. Uncontrolled borrowing, whether the result of a lack of sophistication, unexpected financial reverses, or a psychological impulse to spend, leads many to the brink of insolvency. But further, in the event of a major decline in the economy, particularly a real estate collapse, the number of persons affected will be formidable. If the safety valve of Chapter 7 Bankruptcy becomes unavailable, it's difficult to know what will be the final result.
Al Jacobs has been a professional investor for nearly four decades. His business experience ranges from real estate, mortgage, and securities investment to appraisal, civil engineering, and the operation of a private trust company. In addition to managing his investments on a day-to-day basis, he is a featured financial columnist for both online and print publications. He is the author of Nobody's Fool: A Skeptic's Guide to Prosperity. You may subscribe to his financial Newsletter, "On the Money Trail," at no cost or obligation, by visiting http://www.onthemoneytrail.com/.