What’s Wrong With The Commission’s Consumer Bankruptcy Proposal

Web posted and Copyright © July 18, 1997, National Consumer Bankruptcy Coalition

The National Bankruptcy Review Commission has adopted a package of consumer bankruptcy proposals for Congressional consideration. Unless these actions are revisited and substantially revised at the Commission’s last meeting in August 1997, its final recommendations are clear. We believe they are fundamentally flawed and, if enacted into law, would make filing for bankruptcy much more attractive and would encourage and condone avoidance of financial responsibility by individuals who could repay a significant part of their debts. Here’s why—

Excessive Exemption Levels — The Commission has adopted a proposal for uniform federal bankruptcy exemptions in chapter 7, replacing the current system under which two-thirds of the states have opted out of the federal exemption scheme and adopted their own standards.

While we believe the concept of uniform national exemptions is worthy of Congressional consideration, the exemption levels recommended by the Commission, ranging up to $140,000, are far too high. They would make filing for bankruptcy much more attractive than under current law, resulting in an even higher level of bankruptcies than today’s record filings. They would permit debtors to retain substantially more assets after bankruptcy than is permitted by current law, and would allow debtors to protect substantially more assets in bankruptcy than could be shielded from collection attempts under current state law exemptions. They would also encourage a ratio of chapter 7 liquidation plans to chapter 13 plans significantly higher than the 3 to 1 proportion we see under current law. Even if no other Commission recommendations were adopted, enactment of these excessive national bankruptcy exemptions would invite major new bankruptcy abuse.

There is simply no evidence that inadequate state exemption levels are a problem for debtors under current law. At present, 95 percent of all chapter 7 filings result in "no asset" cases in which the debtor has no equity in property above applicable exemption levels; therefore, there is no asset liquidation to provide any payments to unsecured consumer lenders.

Consumer lenders are not alone in their concern about this proposal. The National Association of Bankruptcy Trustees advised the Commission that adoption of similarly generous exemption levels would have the adverse results outlined above. That association also estimated that it would result in more than 99 percent of all chapter 7 filings resulting in "no asset" cases, which would deprive the bankruptcy trustee system of its financial underpinnings. Finally, it stated that such action would substantially worsen the public perception of bankruptcy abuse as individuals avoid obligations they have the ability to repay — a prediction with which we agree entirely.

The Departments of Justice and Treasury have also voiced significant concern over this central Commission recommendation. In a June 18 letter to Commission Chairman Brady Williamson from Francis M. Allegra, Deputy Associate Attorney General, the Justice Department made known that it was "concerned that the asset levels tentatively adopted by the Commission are too high in light of the historical purposes of allowing property to be claimed as exempt." In regard to the recommended "homestead bonus" of $30,000 per couple (an additional exemption for personal property for debtors who do not own a home), the Department stated, "We believe that this figure may be too high and that more careful study is needed to ensure that the proposed exemption does not encourage debtors to simply walk away from their obligations." The Department also objected to the proposed exemption for unlimited amounts in an IRA or 401(k) plan, and noted that "the adoption of generous exemption levels could also have a negative impact on the ability of the United States to collect debts outside of bankruptcy."

The Justice Department letter was accompanied by a memorandum from Jonathan Gruber, the Treasury Department’s Deputy Assistant Secretary for Economic Policy. That memo makes clear the outrageous nature of these recommendations, which would permit a couple to emerge from chapter 7 discharge with up to $140,000 in home and personal property equity, and unlimited retirement savings! According to the Treasury Department’s calculations, adoption of the recommended exemption levels would allow a couple to emerge from a chapter 7 bankruptcy with a net worth between the 60th and 75th percentile for all U.S. households — even before adding in the unlimited exemption for retirement assets! Households with this level of net worth should be encouraged to work out their financial problems outside of bankruptcy, or be required to commit to a chapter 13 plan in which unsecured lenders receive substantial repayment. They should not be enticed or permitted to use chapter 7 bankruptcy as a financial planning tool to enhance their net worth at the expense of others.

These recommended exemption levels are also too high in comparison to current law. For example, the Commission recommends a federal homestead exemption ranging from a low of $30,000 to a high of $100,000, subject to state law determination. But the present federal homestead exemption was doubled to $15,000, and indexed going forward for inflation, by the 1994 Bankruptcy Reform Act. Thus, the Commission’s recommended floor for the federal homestead exemption is double the maximum ceiling set by Congress just three years ago! As the Treasury memo points out, the Commission has proposed to raise the homestead exemption in 25 states, and to raise the non-homestead personal property exemption level in 48 states.

The Treasury memo states, "We would favor more modest asset exemption levels, applying to a combined asset amount." It suggests a range of $30-50,000 for combined homestead and personal property, which would allow debtors to emerge from chapter 7 bankruptcy between the 41st and 51st household net worth percentile. That prudent suggestion, rather than the Commission’s excessive recommendations, should be the starting point for Congressional consideration. One guiding principle for your future actions should be that chapter 7 should not permit borrowers to wipe out their unsecured creditors and emerge with a net worth in the top half of all American households.

No Screening of Abusive chapter 7 Filings — Consumer lenders repeatedly urged the Commission to recommend adoption of a needs-based bankruptcy system to curb growing chapter 7 abuse. Such a system would continue to make chapter 7 relief available to those in need of it, but would require those with the income and ability to make substantial repayment to their lenders to do so. New data was presented to the Commission documenting that a significant percentage of current chapter 7 filers have the ability to make substantial repayment, but are not required to do so by the current bankruptcy system.

Despite all this input, the Commission’s adopted recommendations have failed to address the needs-based bankruptcy proposal. They have even ignored our suggestion that conflicting court decisions regarding the proper definition of "substantial abuse" of chapter 7 be reconciled, and that lenders no longer be barred from bringing evidence of substantial abuse to the attention of the judge or trustee.

The failure to address chapter 7 abuse, in combination with the excessive chapter 7 exemptions discussed above, will shift even more bankruptcy filings out of chapter 13 repayment plans and into chapter 7. If the Commission’s recommendations were to be adopted, the only debtors likely to begin and complete a chapter 13 plan would be those requiring that Chapter’s "superdischarge" of obligations obtained through fraud (including tax fraud), misrepresentation, and intentional torts.

Reaffirmations Banned — Currently, a chapter 7 debtor may reaffirm; that is, legally recommit to pay a debt that would otherwise be discharged in bankruptcy. Debtors entering into legally binding reaffirmations receive a host of procedural protections against unwise decisions. Reaffirmations are an important recovery tool for lenders. But, as the Commission heard from debtors’ attorneys, they are also an important tool for those debtors who wish to retain an asset securing a loan, such as an auto used to commute to work, or to maintain a line of credit or charge account necessary to maintain a business or household.

The Commission has recommended that all chapter 7 reaffirmations be banned. Adoption of this recommendation in regard to unsecured debt would deprive creditors of potential recovery and debtors of the ability to maintain a line of credit that may be a critical component of a meaningful "fresh start." We also believe that this proposal raises a Constitutional issue by substantially impairing freedom of contract without serving a significant or legitimate public purpose.

In regard to valuable property which secures loans, such as autos, the Commission has recommended that debtors be permitted to keep and use them without legally obligating themselves to make full payment! Debtors would be allowed to keep an auto or other expensive asset so long as they maintained regular payments. This would place secured lenders in a position of unacceptable risk. If the property were damaged or destroyed in an accident, or developed maintenance problems, the borrower could simply cease payments and the creditor’s only recourse would be to repossess the damaged goods.

Rather than banning this important restructuring tool in chapter 7 cases, Congress should extend the availability of reaffirmations to chapter 13.

Cramdowns of Second Mortgages — Under the Supreme Court’s 1993 Nobleman decision, and subsequent Congressional action, all loans secured solely by residential real estate are protected against "cramdown" in bankruptcy. This means that the makers of home equity loans and other second mortgages know that they will retain a full security interest in the realty regardless of temporary fluctuations in property values. As a result, these loans are a low-cost and important refinancing tool for individuals seeking to consolidate higher interest debt, make home improvements, start their own business, or finance children’s education.

The Commission has recommended providing protection against cramdown only to purchase money mortgages. This would make second mortgage lending substantially more risky. As a result, the supply of home equity loans would contract and their pricing would increase. This proposal is also particularly unfair because it would apply to bankruptcies filed, not loans made, after the effective date, placing tens of billions of dollars of existing mortgages into a higher risk category than was contemplated and underwritten at the time they were extended.

We fail to see how subjecting home lenders to greater risk and reducing the availability of low-cost consumer credit serves any valid public purpose.

Automatic Conversion to chapter 7 — Under current law a debtor who has filed in chapter 13 must complete his repayment plan to receive a bankruptcy discharge. The Commission has proposed to let debtors file in chapter 13, utilize its financial restructuring benefits, and then convert to chapter 7 and receive a full discharge in that Chapter. Creditors could only object if the conversion violated the inadequate time bars against repeat filings in chapter 7 (discussed below). The proportion of completed Chapter 13 plans would undoubtedly decline if automatic conversion/discharge was made available, reducing lender recovery and excusing borrowers from their own proposals for financial self-restraint and responsibility.

Furthermore, automatic conversion to a chapter 7 discharge for defaulted chapter 13 plans will strip creditors of many rights and provide debtors with a short cut around many due process safeguards in the present bankruptcy system. First, automatic conversion/discharge will not provide enough time or opportunity for creditors to research and file a complaint objecting to discharge on the basis of such grounds as fraud, load up, false financial statements, or for objections to exemptions. There is no provision for a new meeting so that creditors can examine the debtor. In addition, we see little or no opportunity to negotiate reaffirmations (if they are still available) with debtors, and no provisions for the liquidation of non-exempt assets which is a condition for the normal chapter 7 discharge. In short, this automatic conversion creates a massive escape hatch for debtors to feign a chapter 13 and then obtain a chapter 7 discharge in violation of a broad array of creditors’ legal rights.

We believe that debtors who have filed in chapter 13 and utilized its restructuring benefits should only be permitted to convert to chapter 7 if there has been a material change in their financial circumstances which makes it impossible to fulfill their repayment obligations.

Unnecessary Valuation Hearings — Under current law, creditors retaining a security interest in goods purchased with their credit extensions need only file a proof of claim with the court to protect themselves in a chapter 7 case. The Commission has recommended that such security interests be automatically voided in regard to all property valued at less than $500. Further, the recommendations would require the creditor to petition the court for continued recognition of the security interest in each and every item for which a security interest is claimed, and would require the court to hold a valuation hearing in regard to each item.

This recommendation would raise a substantial new procedural bar to lenders’ maintenance of valid security interests and would place a very large and unnecessary new burden on a bankruptcy court system which is already strained to the breaking point. We find it remarkable that some members of the Commission voiced objections to our proposal for a needs-based bankruptcy system incorporating a simple administrative screening of chapter 7 cases on the grounds that it would place too large a burden on the system, yet are willing to call for judges to hold hundreds of thousands of separate hearings annually to determine the value of a riding mower or home theater system.

Inadequate Repayment Template — The Commission would require debtors in chapter 13 to make repayment based on a graduated template keyed to adjusted gross income (AGI). As discussed above, the ability to automatically convert to chapter 7 and receive a discharge would substantially reduce the percentage of chapter 13 filers completing repayments. And, while we support the concept of uniform repayment guidelines for chapter 13, the formula advocated by the Commission is far too generous to debtors.

The Commission contemplates nominal repayment by debtors with adjusted gross income (AGI) of less than $20,000, rising to a maximum of 7 percent for AGIs of $75,000 or above. This means that a debtor with monthly AGI of $6,250 would be required to make monthly payments to unsecured creditors of only $437.50. Such a repayment schedule is far too lenient for a debtor with such substantial income.

In its June 18 letter to Chairman Williamson, the Department of Justice observed that "the template approach currently under consideration...may well be too lax for most debtors." We concur.

"False Claims" — The Commission has recommended that the courts be authorized to order lenders who file "materially false claims" to pay costs and the debtor’s attorney fees even if the filing was an unknowing mistake. There is no corresponding provision providing for sanctions against debtors who file false schedules of debts, income, and assets. This unbalanced recommendation is curious, as the Commission received little testimony about false claims by creditors, but heard repeatedly that debtors’ filings were often incomplete and generally unreliable. In fact, one bankruptcy judge told the Commission that debtors’ schedules were often "fiction."

Again, the Justice Department characterized this as "a new and troubling proposal... We neither understand the purpose, scope or effect of this proposal, and are concerned about creating a new one-way fee shifting provision, especially if it covers mistakes... We would prefer that the Commission abandon this concept entirely."

Again, we concur entirely.

Student Loan Discharge — At the start of this decade, responding to abuses in the student loan program, Congress revised upward the amount of time, from five to seven years, that guaranteed student loans would have to be paid before being eligible for a bankruptcy discharge. The Commission has now adopted a recommendation that student loans (other than for medical school) be treated the same as any other unsecured loan. That is, a student loan could be discharged in a chapter 7 bankruptcy without a single dollar of repayment having been made.

While our member institutions participate in the federal guaranteed student loan program, the risk of this reckless proposal would fall directly on American taxpayers, who back both guaranteed and direct student loans. Student loans are generally extended to individuals with little or no employment or credit history, and with nominal income. They are made on the assumption that the education gained through the proceeds of the loan will help enable the individual to earn a higher future income and thereby repay the loan. Allowing students to discharge their student loans entirely, without any significant repayment having been made, by filing for chapter 7 shortly after graduation would invite substantial abuse of the program and result in multi-billion dollar losses to taxpayers.

While this unjustifiable proposal creates major risk for the taxpayers, not our members, it is strikingly illustrative of the excessively permissive approach which permeates the Commission’s consumer bankruptcy recommendations. It should be rejected as creating excessive risk to taxpayers. We believe that the proper policy is not only to retain the seven year repayment requirement for guaranteed loans, but to extend such protection to private sector higher educational assistance.

Inadequate Positive Provisions — We would be remiss if we failed to note that the Commission did make some recommendations which we support. Yet even these fail to go far enough, and do not even begin to counterbalance the negative provisions discussed above.

The authority for bankruptcy courts to issue in rem orders barring the application of the automatic stay to identified property could help end the "rent skimming" scams which have victimized debtors in various regions.

The proposal for random audits of debtors’ filings lacks enforcement teeth. We believe that when a random audit reveals that debtors have made material misstatements, their bankruptcy discharge should be revoked.

A national filing system identifying bankruptcy filings by Social Security number is long overdue, although its efficacy will be undercut by the ease with which unscrupulous individuals can obtain new Social Security numbers and other false identification.

The Commission’s call for debtors to have "the opportunity to participate in a financial education program" is inadequate. Participation in such a program should be a mandatory condition for obtaining a bankruptcy discharge. Just as bad drivers are required to attend traffic school to retrieve their licenses, those who have had financial accidents should be required to learn the economic rules of the road.

The Commission’s call for a bar on abusive serial refiling, while welcome, is inadequate. Rather than maintaining the current bar against receiving a chapter 7 discharge once every six years, the wait should be raised to ten years. One bankruptcy discharge per decade is all the law should sanction. And the Commission’s call to permit chapter 13 filings every two years or less would permit too much continued abuse.

Finally, while the consumer lending industry will work with Congress in regard to preferential credit reporting for chapter 13 filers, such benefits should only be available to those who complete a payment plan. And, as explained above, any incentive that credit reporting might provide for filing in chapter 13 would be completely overwhelmed by the Commission’s other recommendations, which would encourage more chapter 7 filings as well as rapid conversions of chapter 13 cases to chapter 7.

In conclusion, the Commission has assembled a package of proposed consumer bankruptcy "reforms" which would benefit unscrupulous or undeserving debtors at the expense of lenders and responsible borrowers, and would encourage more chapter 7 bankruptcy filings. Its recommendations condone and encourage outrageous and irresponsible financial behavior. Adoption of these proposals would substantially increase lenders’ risk and result in consumer credit becoming less available and more costly. The public’s overwhelming view that those who have the ability to repay should do so would be thwarted. And the public would likely view the resulting Bankruptcy Code as a perverse system of debt forgiveness on demand for the financially reckless.

The members of the National Consumer Bankruptcy Coalition are firmly opposed to Congressional adoption of these recommendations. We urge Congress to reject them and to turn its attention to establishing a needs-based bankruptcy system which will reduce the burden on the bankruptcy courts and restore public confidence in the system.

If you have further questions about this matter, please contact any of the following legal advisors to the NCBC:

Philip S. Corwin
Federal Legislative Associates
(202) 833-9820

George J. Wallace
Eckert Seamans Cherin & Mellott
(202) 659-6632

Robert F. Mitsch
Mitsch and Crutchfield, P.A.
(612) 292-9900

See Accompanying letter to Congress