Consumer Bankruptcy Basics
Conquest, War, Famine, Death—these the Book of Revelations tells us are the Four Horsemen of Apocalypse, no matter what that later apostle known to the sporting gentry as Grantland Rice wrote some nineteen centuries later. Yet in the arena of consumer bankruptcy, neither prophet was right. Here and now those dread specters are: Divorce, Illness, Unemployment, and Overspending. These now are the harbingers of economic doom that spell the end of the “good life” for so many of the economic refugees that seek relief in this “Court of Last Resort”.
In re Rice 94 B.R. 617, 618 (Bkrtcy.W.D.Mo.,1988)
The above quote was written in 1988. Since that time the court of last resort and the deadly specters for consumer bankruptcy have changed in one respect because the overspending was fueled by the breach of the “economic social contract” that had existed between lenders and debtors from the beginning of this country in 1776 to the late 1990s.
The economic social contract provided that lenders would evaluate the debtor’s ability to pay a particular loan. If the debtor could not afford a particular loan, the loan would be denied by the lender. The debtors could rest easy that their application for credit was thoroughly analyzed by the lender. As a result the debtor did not have to double check the lender. The lender’s interest in the debtor’s ability to pay was a natural consequence of the lender wanting its loan repaid. Unknown to debtors but well known to the lenders, there was a seismic shift in the “economic social contract” beginning in the 1990s and so pervasive by the year 2007 that the “economic social contract” was broken and discarded entirely by lenders.
The decimation of the economic social contract came about as a result of the widespread adoption of the securitization process in all consumer lending. Securitzation is one of those ideas that looks great on paper but when put into operation leads to financial disasters. In its simplest form, a lender sells off the loan that it has generated into a pool of assets that in turns offers securities backed by the loan. The security is then an asset backed security. The pools are sold to investors eager for good returns on investments backed by assets. It offers a more concrete perception of the investment. The ability of brokerage firms to sell the pools is only limited by the assets available to “back them”. The need to have product soon overwhelms any quality controls and the desire for quality control is soon replaced by math theories that the mixture of assets produces a sum greater than its parts. Thus the theory is that the invincible pool can survive large scale defaults.
Given that many consumers relied on the “economic social contract” the overspending category now has grown as a substantial factor in the realm of consumer bankruptcy.
The other major change to occur since the 1988 decision is the changes to the Bankruptcy law. In 1994, Congress made various changes to the Bankruptcy Code. In conjunction with those changes, they commissioned a study to review the code for changes and improvements. This study was conducted through the Brady Commission. Creditors, with a natural distaste for the bankruptcy process, anticipated that the Brady Commission would provide numerous changes to the system.
Contrary to the creditors’ expectations, the Brady Commission did not view the bankruptcy system as severely broken and in need of dramatic repairs. The commission report found limited changes were necessary. Despite this report in 1997, the creditors wanted large scale changes and began efforts to change the law as early as 1998. The so called Bankruptcy Reform was enacted in 2005. It was designed to limit access to the system by raising procedural speed bumps. One procedural road bump was the pre-filing credit counseling requirement. The asserted value of this pre-filing counseling was that many people filing may not need bankruptcy. After the passage of this requirement, the providers of the counseling themselves concluded it was largely useless and that the overwhelming majority of those forced to spend time and effort to determine if bankruptcy was necessary were persons who clearly needed to file bankruptcy.
Today, consumers have two potential avenues for relief under the Bankruptcy Code. That may file a Chapter 7 or a Chapter 13. Chapter 7 is basically where the debtor agrees to exchange his or her non-exempt assets for a discharge of his or her obligations to most creditors. Non-exempt assets are those assets for which there is no law that permits the debtor to retain even if the debtor owes creditors. The theory behind permitting certain assets to be exempt from the reach of the debtor’s creditors is that reducing debtors to penniless status does not ultimately serve any useful purpose.
Chapter 13 is formally known as a debt adjustment plan. The debt to be paid by a debtor is adjusted to such amounts that he or she can afford to pay over a set period of time. There are a series of benefits potentially available to a debtor who elects to enter into a Chapter 13 plan. These potential benefits are discussed below.
The election to file a Chapter 7 for a consumer debtor is now governed by a means test and a provision that permits cases to be denied based on abuse. The means test consists of two parts. The first part is whether or not the debtor’s household income (less expenses of non-filing household members) for the six full months prior to filing exceeds the median income for a like size household in the state where the case is filed. If the debtor’s income is below the median then he or she has passed the means test and they may elect to file a Chapter 7. If the debtor’s income exceeds the median income, then the debtor’s expenses must be analyzed to see if the debtor could afford a monthly payment that will pay out certain minimums. If not, then the means test no longer applies. If they can make monthly payments that amount to a certain level, then that consumer debtor may not be able to file a Chapter 7.
The Chapter 7 is often most appropriate for those who find themselves overwhelmed with debt and needing a fresh start. The Chapter 7 usually starts your financial life over by exchanging your non-exempt assets for release from your existing debts.
The Chapter 13 debtor enters into a payment plan by which the debtor agrees to make a series of regular payments to a trustee, who in turn makes distributions to the debtor’s creditors in accordance with the plan approved by the bankruptcy court. The plan can provide a mechanism for a debtor to make up past due payments on se
cured debts such as a mortgage or a car loan. The debtor can also provide for payments on tax debts and can eliminate some of the interest and penalties that would otherwise accrue outside of a bankruptcy proceeding. The Chapter 13 also permits a debtor to modify certain secured debts under the right circumstances. For instance, if the debtor has a first and second mortgage on their home, and there is no equity in excess of the balance of the first mortgage, the second mortgage may be treated as an unsecured creditor. Any unsecured creditor is not entitled to payment in full unless the debtor can afford the unsecured creditors in full. Additionally, the Chapter 13 debtor retains control of all of their assets – exempt and non-exempt if the debtor’s plan will pay the debtor’s creditors payments equal to the value of the debtor’s non-exempt assets.
In the end the selection of which Chapter of bankruptcy for a consumer debtor requires analysis that is often enhanced by experience measured by years as well as cases.
* Scott C. Borison has been practicing law since 1987. He has represented several thousand debtors in consumer bankruptcy proceedings. He has regularly been invited to speak on bankruptcy and related topics by both local and national organizations. He has been recognized by his peers locally being named the bankruptcy attorney for several years through the Frederick Magazine attorney poll.
Disclaimer. This blog entry generally discusses certain aspects of bankruptcy. Since it is a general review, it does not address various exceptions that may apply to a person’s individual situation. It cannot and should be used as a substitute for retaining the services of an experienced bankruptcy attorney to review and analyze your particular situation.