Working Families Use Bankruptcy Legitimately

The Credit's Proposal to Overhaul the System is Misguided

Contact:  Gary Klein, John Rao

September 17, 1997

The fact that more American families are using the bankruptcy system does not justify enacting a credit industry wish list of changes to the Bankruptcy Code. "Millions of hardworking American families are overextended due to the explosion of credit card solicitations in the last ten years," according to Gary Klein, a staff attorney at the National Consumer Law Center (NCLC) in Boston. "It is not valid to conclude that greater use of the bankruptcy system is connected with greater abuse of the system. The vast majority of bankruptcy debtors are facing foreclosure, repossession, utility shut-off, wage garnishment or debt collection harassment. The system already has adequate tools to address the occasional cases involving fraud." According to NCLC's John Rao, "consumers are being snookered if they accept the argument that bankruptcy is bad because it drives up creditor costs." In reality:

• There is no legitimate evidence that bankruptcy losses have any impact on consumer prices or interest rates. Consumer lending continues to be one of the most highly profitable businesses in the United States.
• The bankruptcy system is being scapegoated by the credit industry. Most of the debts which are addressed in the bankruptcy system wouldn't have been paid back under any scenario. A percentage of any group of borrowers are going to be vulnerable to unexpected financial problems. That percentage increases with credit card solicitations to risky borrowers like college students and others who can afford only their minimum payments.
• The credit industry could reduce the number of filings itself, by accepting payment agreements and taking other reasonable actions to work with borrowers experiencing financial problems. Aggressive collection tactics drive hundreds of thousands of American families into bankruptcy every year.
• Even if there is a slight increase in consumer interest rates due to the availability of bankruptcy (a connection which is unproven), that small interest rate premium functions as an insurance policy for every American. Every consumer is vulnerable to unexpected financial problems, and may need access to a system which provides for financial rehabilitation and a fresh start.

According to Klein, "the concept of a fresh start has its roots in Biblical law. We live in a society which places enormous financial pressures on working families. Now is not the time to cut back on the availability of a system which provides a second chance to the unfortunate in the form of a fresh financial start."

PROVIDING EFFECTIVE BANKRUPTCY RELIEF

STATEMENT OF THE NATIONAL CONSUMER LAW CENTER

Thank you for this opportunity to suggest an agenda for the Commission to improve relief available under the Bankruptcy Code for honest, but unfortunate, consumer debtors. The National Consumer Law Center was a leading participant on behalf of low and moderate income consumers during discussions about reform in the 1970's. We continue to publish practice manuals on bankruptcy for consumer lawyers, to teach at seminars across the country, and to advocate for low income debtors in court and in the political process. We appreciate the offer to participate in a more extended presentation on behalf of consumer debtors which has been scheduled for the Commission's meeting in May. However, because the Commission's consumer working group expects to offer a set of proposals before the May meeting, we have requested this brief opportunity to share our ideas about an appropriate agenda in the area of consumer bankruptcy. The following suggestions for reform are built on an apparent consensus which has emerged after substantial testimony by representatives of a wide range of interests in the bankruptcy system. Everyone has agreed that a significant majority of debtors are having real financial problems and need help. Families across the country are facing foreclosure, repossession of automobiles, loss of heat and other utilities, back-breaking wage garnishment, the stress of aggressive creditor collection activities and unmanageable medical costs. These American families need a fair opportunity to get an effective fresh start. We appreciate the willingness of the creditor community to concede this point in its testimony in December and during the meetings held by the American Bankruptcy Institute last month. Your recommendations to Congress will be measured, in large part, by the degree to which they protect and strengthen the effectiveness of bankruptcy relief for debtors with legitimate needs. Our recommendations for your agenda thus fall into two broad categories. First, we ask that you reverse a disturbing trend which has eroded the fresh start. Second, reforms are needed to improve the success rate for debtors in chapter 13. Reversing the Erosion of the Fresh Start The fresh start has been the cornerstone of bankruptcy since biblical times and throughout the history of our nation's insolvency laws. Several recent trends have undermined the effectiveness of the fresh start and should be reversed:

• Exceptions to the discharge should be limited. In recent years, there has been an unfortunate trend to load up the Code with new categories of exceptions to discharge. Existing exceptions should be limited to the extent possible and no new exceptions should be recommended. In particular, exceptions to the discharge for student loan debts and condominium assessments should be reexamined.
• Reaffirmations should be eliminated or restricted to situations where defaults are waived on legitimately secured debts. This has been the subject of substantial testimony before the consumer working group. Abusive creditor practices in this area seriously undermine the fresh start and should be prohibited. Effective sanctions including statutory penalties must be available to make the Code work.
• Baseless creditor nondischargeability actions must be brought under control. Creditors have obtained substantial leverage by bringing nondischargeability actions based on "implied fraud" and other groundless legal theories. Debtors cannot afford to pay their attorneys to litigate these cases and often settle claims which have no merit. The Code should have clear standards in this area and must provide adequate sanctions for untenable creditor claims.
• Protections against post-bankruptcy discrimination should be clarified and strengthened. Code section 525 was intended to provide broad protections to bankruptcy debtors and former debtors against governmental and private employer discrimination. However, section 525 has been very narrowly interpreted by some courts. These courts have seized upon the language "license, permit, charter, franchise or other similar grant" to hold that a governmental entity may discriminate in benefit programs, such as a mortgage assistance program or provision of public housing benefits. Other courts have held that the language of section 525(b) concerning employment discrimination does not protect against discrimination in hiring. If the fresh start is to work effectively, former bankruptcy debtors must be free from discrimination based on bankruptcy as they go forward.
• Effective exemptions are necessary in states which opt out of the federal scheme. States such as Maryland, South Carolina, Ohio and Delaware have opted out of the federal exemption scheme, but provide no meaningful state law alternatives. This precludes many residents of those states from obtaining a meaningful fresh start. The commission should recommend that a floor be set on the opt-out from the federal exemptions so that states cannot impose limitations which are more restrictive than those available under the Code.

Improving the Chances of Success for Debtors in Chapter 13 Most debtors choose chapter 13 in order to save the family home or an automobile which is used to get back and forth to work. The consequences of failure are therefore severe. Nevertheless more than half of all chapter 13 cases fail. Debtors then lose property of great value to their families, creditors do not get paid, and there is no fresh start. We ask that the commission examine ways to improve the success rate in chapter 13 by making it cheaper and more effective to those who need its relief.

• Trustees fees should not exceed the actual costs of administering chapter 13 cases. Present practice in most trustee districts is to charge a flat percentage of payments to all chapter 13 debtors, usually ten percent. Often this exceeds the actual costs of managing the trustee's office. Excess receipts are ultimately turned over to the federal treasury. This practice functions as a tax on debtors and creditors alike for use of the chapter 13 system. Trustees work hard and should be fairly compensated. However, their percentage fee should be no greater than necessary to maintain the office.
• Interest on arrears should be entirely eliminated. The Supreme Court's decision in Rake vs. Wade obliges debtors to pay interest on the arrears portion of a secured debt that they are attempting to cure. This payment is unfair and unnecessary because the lender is simultaneously continuing to charge interest on the full principal balance as it comes due. Interest on the arrears portion of the debt is not warranted under the contract and violates many state's laws by creating a mechanism for compound interest payments. Elimination of interest on arrears will help some debtors save homes and, in many cases, it will increase the dividend paid to unsecured creditors.
• Stripdown of non-purchase money home mortgages should be allowed and valuation standards should be set at liquidation value. To the extent a secured creditor is not really protected by the value of its collateral, it has an unsecured claim outside bankruptcy. A bankruptcy debtor should be able to keep property by paying a creditor (at present value) the amount that creditor would receive from a third party if it foreclosed or repossessed. Any other standard rewards the secured creditor for the threat value of repossession and acts as a payment preference over other equally legitimate unsecured claims.
• Incentives should be available to encourage consensual modification of secured claims. A major limitation for debtors in chapter 13 is that the obligation to cure defaults requires payments for housing which exceed pre-delinquency housing cost burdens. Outside bankruptcy this problem is being dealt with, in some cases, by consensual mortgage modifications which, by reamortizing the amount due, actually reduce the debtor's going forward payments. Consensual modifications under an agreed plan should be encouraged in chapter 13 by creating incentives for the parties. More cases will be successful under such an agreed plan and more money will be available for unsecured creditors.
• Statutory sanctions and attorneys fees are necessary to control proof of claim abuses. The Code and Rules contain a presumption in favor of the legitimacy of filed claims. This has led some less scrupulous creditors to file deliberately inflated claims. These include inflated claims for interest, costs, attorney fees, and escrow deficiencies. The presumption of validity then mandates an objection which some debtors cannot afford to pay their lawyers to bring. Successful objections to secured claims benefit all other creditors in most chapter 13 cases and should be rewarded by payment of fees by the party that has misstated the claim. Statutory sanctions should be available for deliberately inflated claims.
• Ability-to-pay should not be interpreted to require payment of a fixed percentage of unsecured claims. Courts in many jurisdictions continue to refuse to confirm plans unless a minimum percentage of unsecured debts will be paid. his prevents lower income debtors from having fair access to chapter 13. When a chapter 7 case is the only option, most often no unsecured debts are paid.
• An effective superdischarge should be restored. Non-dischargeable debts present many barriers to effective chapter 13 relief. Most importantly, debtors struggle to meet their debt burden on those obligations, because failure to do so results in unmanageable ongoing debts after bankruptcy. Nondischargeability in chapter 13 should therefore be limited to family support debts and other very limited classes of debts which will result in significant personal hardship to individual creditors if there is a discharge. Moreover, once those limited classes of non-dischargeable debts are delineated, the societal interest in having those debts paid requires that they be amenable to separate classification and paid in preference to other unsecured claims in chapter 13.

Finally, bankruptcy is the only significant American legal system which bars access to those who are too poor to afford its filing fees. The cost of filing has increased greatly over the years and now, ironically, many Americans are too poor to be bankrupt. The in forma pauperis pilot project has worked well in the jurisdictions where it has been tested. It should be expanded across the country to poor people who can establish that they qualify. Thank you, as always, for the opportunity to participate in the Commission's processes. Your attention to these issues is greatly appreciated.