Rebalancing the Bankruptcy Code

JURIST Guest Columnist Todd Zywicki, Professor of Law at George Mason University School of Law and a Fellow at the James Buchanan Center for Political Economy, says that the new federal bankruptcy legislation signed into law this past Spring weeds out fraud and abuse while preserving a "fresh start" for debtors...



After eight years of trying, Congress finally enacted the comprehensive, bipartisan bankruptcy reform bill this Spring. Notwithstanding widespread misinformation about the bill's effect in the mainstream media and the halls of academia, the legislation passed both the House and Senate with over 70% support, including substantial Democratic support. Indeed, the bill was supported by every Republican in both Houses, and the overwhelming majority of centrist Democrats. Opposition emanated almost exclusively from the far left of the Democratic Party, but even then one-quarter of the Congressional Black Caucus supported the legislation. The broad bipartisan support for the legislation indicates the recognition that the legislation provides a necessary rebalancing of America's bankruptcy laws to reduce the fraud and abuse in the system, to restore the ethic of personal financial responsibility, and to preserve the fresh start for those who need it.

The past quarter-century in America has witnessed the most extended period of economic prosperity in American history—strong economic growth, low unemployment, low interest rates, and record levels of wealth accumulation owing to booming stock gains in the 1990s and rising home values throughout. Nonetheless, consumer bankruptcy filings, which stood at slightly over 300,000 per year just twenty-five years ago, have risen to five times that level today—over 1.5 million annual filings. Many of those filing bankruptcy today are those for whom the system is intended—families who are down on their luck due to job loss or other misfortune. But the paradox of spiraling bankruptcy rates in the face of unprecedented economic prosperity reflects the fact that many bankruptcies today are not the result of economic hardship, but an overly generous bankruptcy system that provides strong incentives to file bankruptcy and does little to deter fraud and abuse.

Why should we care about bankruptcy fraud and abuse? Because bankruptcy fraud costs all of us, but especially small businesses and those consumers who pay their bills. At the Presidential bill-signing ceremony, I sat next to a man and his son who own a small family-owned lumber store in rural New Jersey. When a deadbeat buys $500 or $1,000 in lumber on store credit to build a deck on his house, and then files bankruptcy rather than repay it, they explained that those losses have to be made up somewhere. Either other consumers have to pay higher prices, the family business (already struggling to keep pace with Loew's and Home Depot) has to write it off the bottom line, or they have to reduce costs by laying off employees, cutting wages and benefits, or reducing customer service.

The FBI estimates that roughly ten percent of bankruptcy filings have some amount of fraud in them, usually outright lying and concealment about the assets and income that a debtor has to pay to his creditors. To attack this problem, the legislation creates new safeguards for the government and creditors to identify and punish fraud, replacing the "honor system" that rested almost exclusively on the debtor's veracity. Bankruptcy filers will have to submit copies of tax returns and pay stubs with their bankruptcy petitions, and bankruptcy filings will be randomly audited for accuracy. Bankruptcy lawyers will be required to undertake minimal efforts to verify the accuracy of the debtor's sworn statements in her bankruptcy papers. Bankruptcy mills who advise debtors to file bankruptcy using false Social Security Numbers will now face enhanced penalities. Each of these safeguards and others in the legislation are simply sound, common-sense approaches to try to curb some of the fraud that is currently endemic in the system.

True, some of these safeguards will make it marginally more difficult for honest filers to declare bankruptcy as well as fraudulent filers. But just as we realize that we can't rely on the "honor system" when it comes to paying taxes or prosecuting insurance fraud, the past two decades has demonstrated the naïvete of relying on the honor system alone for bankruptcy filings.

The bill also cracks down on various bankruptcy abuses. 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 and eliminates such pernicious traps as the second-class treatment of certain marital dissolution obligations, such as property settlements. Philip Strauss, formerly the principal attorney for the San Francisco Department of Child Support Services, testified that the domestic support provisions in the bill constitute a "'wish list' of amendment to the Bankruptcy Code aimed at facilitating support collection." Strauss notes that almost all of the national child-support collection organizations in the country endorsed the legislation.

The legislation also lengthens the permissible period for repeat bankruptcy filings from six years to eight and tightens up on abuse of the notorious unlimited homestead exemption. The legislation places limits on those who purchase new expensive homes within two years of filing bankruptcy, imposes a 40 month waiting period before those who relocate to a new state can avail themselves of the new state's homestead exemption, and finally, creates a 10 year reachback period to attack homesteads acquired to defraud creditors. Thus, whereas prior law permitted O.J. Simpson and WorldCom's Scott Sullivan to purchase mansions in Florida while leaving their creditors holding the bag, the bankruptcy reform legislation closes the most notorious homestead exemption loopholes.

Finally, the legislation imposes a system of "means-testing" eligibility for chapter 7 relief. As a result of generous exemptions and savvy pre-bankruptcy planning, 95% of chapter 7 bankruptcy filings result in no distribution to unsecured creditors, and usually only trivial amounts even where there is a distribution. If a debtor makes more than his state median income (adjusted for family size), and could repay more than $10,000 of his unsecured debt over a five-year repayment plan (after subtracting for numerous allowances), then he would be presumed to have to file in chapter 13 and repay what he can, rather than being allowed to file chapter 7 and walk away from her debts. Even then, the debtor would be entitled to demonstrate that he had "special circumstances" that should permit him to file in chapter 7 anyway. The expense allowances are quite generous—permitting not only a standard living allowance for food, clothing, shelter, etc., but also payments on acutal secured debt (such as mortgages and car loans), actual medical expenses, premiums for medical insurance, and up to $1,500 for educational expenses for dependent children. It is estimated that the means-testing provisions of the legislation will shift roughly 10% of filers into chapter 13, but because these will be high-income filers with the greatest repayment capacity, those affected would be able to repay some 60% of their unsecured debt on average. More fundamentally, nothing in the legislation prohibits anyone from filing bankruptcy; it simply conditions bankruptcy relief for high-income filers on repaying some of their debts as a condition for bankruptcy relief. Equally importantly, it leaves the roughly 80% of bankruptcy filers who earn below their state median income completely unaffected.

Overall, therefore, the reform legislation is a balanced, common sense, incremental effort to deal with known problems of fraud and abuse in the system. Why then has the legislation suffered such heated criticism by bankruptcy academics and professionals?

In part, the criticism seems to be based on the simple-minded notion that if the legislation is good for creditors (especially credit-card issuers), it must ipso facto be bad for consumers. But this argument fails to appreciate basic economics. Those consumers who pay their bills are the primary losers when others file bankruptcy rather than repaying their bills. As a society, it appears that we are all willing to pay a bit more for goods, services, and credit to permit honest and unfortunate debtors to discharge their debt and receive a fresh start. But we draw the line when asked to subsidize widespread fraud and dishonesty.

Nor should we be distracted from the necessity of the legislation by the political support for the legislation by the consumer credit industry. Of course, the consumer credit industry, as well as thousands of small businesses, stand to gain from the enactment of the bankruptcy reform legislation, and lobbied heavily for the legislation. But there were "special interests" on both sides of the bankruptcy bill. In particular, just as creditors stand to gain financially by a reduction in bankruptcy filings, bankruptcy lawyers and other elements of the bankruptcy industry stand to lose from the anticipated reduction in filings following reform. In fact, as Professor David Skeel observed in his magisterial history of bankruptcy law, American bankruptcy law traditionally has been guided strongly by the influence of bankruptcy lawyers. On net, the financial clout of these two powerful lobbying groups—lawyers and bankers—appear to have largely canceled each other out. As for the heated criticism from the academy, this may simply reflect the ideological views of the modern legal academy, which seems to be closer to that of Ted Kennedy, Bernie Sanders, and the small minority of stauncly liberal politicians who opposed the bill than the conservative and centrist politicians that overwhelmingly supported it.

What then explains the overwhelming political support for the legislation? For once Washington appears to have recognized what critics have not—that bankruptcy reform was an issue of personal and moral responsibility, and that the system had tilted too far toward becoming a tool for opportunism and dishonesty. As President Bush observed in signing the bill into law, "America is a nation of personal responsibility where people are expected to meet their obligations. We're also a nation of fairness and compassion where those who need it most are afforded a fresh start. The act of Congress I sign today will protect those who legitimately need help, stop those who try to commit fraud, and bring greater stability and fairness to our financial system."

The bipartisan bankruptcy reform legislation restores much-needed principles of personal responsibility to the bankruptcy system. Bankruptcy should be a last resort for those who need a helping hand, not a haven for crooks, deadbeat fathers, serial filers, opportunistic debtors who buy Florida mansions on the eve of bankruptcy, or high-income debtors who evade bills that they could pay but choose not to. There is absolutly no reason why responsible, hard-working Americans who live within their means should subsidize bankruptcy fraud and abuse by others. Balanced, common-sense bankrupty reform is not going to prevent honest, unfortunate debtors from getting the fresh start they need and deserve, but it will make it tougher for those who game the system to evade their financial responsibilities and stick the rest of us with the bill.


Todd J. Zywicki is Professor of Law at George Mason University School of Law and a Fellow of the James Buchanan Center for Political Economy.
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