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What
bankruptcy reform means to consumers
By Holden
Lewis • Bankrate.com
In most courts, you are innocent
until proven guilty. But that might not be true if you declare bankruptcy
in a few months.
Congress wants to make it so onerous and grueling
to declare bankruptcy that fewer people will even try. A proposed
revision of the bankruptcy code would make it more difficult for
insolvent people to cast off their debts and get a fresh start.
Instead, more debtors would be forced into debt-repayment
plans.
The proposed overhaul of bankruptcy law (see
highlights), which is expected to pass and has the president's
support, is designed to encourage people to avoid bankruptcy court
altogether. It requires debtors to try to work out repayment plans
through counseling agencies before they can step into bankruptcy
court.
A presumption of abuse
Debtors who declare bankruptcy anyway are likely to encounter officially
sanctioned suspicion. Under the proposed law, if you earn more than
half of other families of the same size, and you declare bankruptcy,
the court is required to assume that you are cheating. It's called
a "presumption of abuse." If you can't prove that you're
not abusing the bankruptcy system, you'll have to find a way to
pay your debts.
It's like being presumed guilty until proven
innocent.
The presumption of abuse is part of a "means
test" to determine whether a debtor deserves to have some or
all debts wiped away. The means test will determine whether a debtor
can declare Chapter 7 bankruptcy, in which the court forgives all
debt that is not backed by collateral, or Chapter 13 bankruptcy,
in which the debtor repays some or all debt during three to five
years of court supervision.
Or the court could order a debtor to stop abusing
the system and pay those bills as promised.
"It's going to be tougher to file for
bankruptcy," says Frank Torres, legislative counsel for Consumers
Union, publisher of Consumer Reports. "This bill isn't going
to stop anybody from going into financial crisis."
Lenders disagree. "People who are truly
in need of relief will be able to get it," says Lynne Strang,
spokeswoman for the American Financial Services Association, which
represents finance companies, credit card issuers and auto lenders.
The bill's intent, she says, "is to deter
people who have some means of paying back some debts or who want
to use the bankruptcy system as a financial planning tool."
What the means test means
About two-thirds of consumers who file for bankruptcy do so under
Chapter 7. Those people kiss their credit card bills goodbye and
get a fresh start -- although they're shackled for years with a
horribly damaged credit rating.
The credit card industry argues that more debtors
should go into Chapter 13, instead, and pay at least a portion of
their credit card bills. The means test will push more debtors into
Chapter 13.
Under the means test, if you have more than
$100 a month left over after paying approved expenses (no cell phones,
no restaurant meals, no nights out at the movies), you will be pushed
into Chapter 13. Even if you net less than $100 a month after expenses,
you can be pushed into Chapter 13 if you could pay 25 percent of
your credit card balances over five years.
If the means test doesn't give debtors pause,
maybe the requirement to give the court copies of pay stubs and
income tax returns will -- especially when they know that creditors
can view those documents. Creditors can even ask a judge to dissolve
a bankruptcy decree because the debtor is late filing such paperwork.
On the bright side, the proposed bankruptcy
law does not call for the resumption of debtor's prison, which Charles
Dickens wrote about so movingly in Little Dorritt.
Bankruptcy reform will take effect six months
after President Bush signs it into law. If there is a rush to bankruptcy
court in the meantime, it will be because debtors understand that
the revised bankruptcy code is harsher than the current one.
"We can't allow deadbeats to get away
with stiffing creditors," Iowa Sen. Charles Grassley said in
recent debate. "That is why our bankruptcy bill is here. That
is what it is all about: Imposing some responsibility on people
who can pay their debts."
Rumblings from the congressional
lab
In some ways, the proposed law is a social experiment. It requires
several agencies to study the law's effects and report them to Congress.
Chief among the experiments is a requirement that debtors abide
by Internal Revenue Service guidelines that detail what constitutes
reasonable spending. Congress wants a report in two years that describes
how the guidelines affect debtors and bankruptcy courts.
The IRS guidelines describe reasonable expenses
for food
and clothing, transportation
and housing.
Some guidelines are nationwide, and some are applied by region or
county.
According to the guidelines, it is reasonable
for a single person earning $1,000 a month to spend $198 on food
and $43 on clothing, while it is reasonable for a single person
earning $4,000 a month to spend $325 on food and $129 on clothing.
They say it is reasonable for a family of three in Dallas to pay
$1,135 a month for housing and utilities and for a family of three
in Peoria to pay $856 a month.
The guidelines allow a family in Dallas that
has one car to spend $337 a month on car payments, fuel, insurance
and other transportation expenses, while a family in Peoria that
has one car can spend $231 for the same expenses.
There is disagreement over what these standards
mean. The IRS lumps housing and utility expenses together, but bankruptcy
courts prefer to separate them because it matters whether someone
is paying a mortgage or renting.
And what about the guidelines for transportation
expenses? Some debtors are making payments on cars, while others
own paid-for cars that will have to be replaced soon. Should those
debtors fall under the same guidelines? And what if a car has to
be fixed, but the repair cost exceeds the guidelines? Is it fair
to allow someone in Dallas to spend $106 more a month on transportation
than someone in Peoria?
No one in Congress has answered these questions.
Hiding in the sunshine
When people complain about deadbeats who abuse bankruptcy law, they
often tell anecdotes about wealthy scofflaws who move to Texas or
Florida, buy a big ol' expensive house on a golf course, wait a
few months and declare bankruptcy.
It happens all the time, because Texas and
Florida (and Iowa, Kansas and South Dakota) have unlimited homestead
exemptions. That means a bankrupt debtor can keep his or her primary
residence, no matter how valuable it is.
The proposed law would put a national cap of
$100,000 on the homestead exemption. The cap would apply for two
years after the purchase of a house. Under this plan, creditors
could force the sale of a bankrupt debtor's house. The owner could
keep the equity up to $100,000 and creditors could get the rest.
The two-year limit means that if a wealthy
scofflaw managed to move to one of these states, buy a mansion and
hold off creditors for more than two years before declaring bankruptcy,
he might be able to keep the house.
Remaining upside-down
Auto lenders hate a part of the current bankruptcy code that allows
bankrupt debtors to keep a car without making all the payments on
the loan. So they persuaded Congress to change it. The upshot is
that people who owe more than their cars are worth will not fare
well.
For example, let's say your car's Blue Book
value is $3,000 and you're paying $250 a month for it and you have
20 more payments to make. You owe $5,000 for a car that's worth
$3,000. Under current law, you could declare bankruptcy, give your
auto lender $3,000 and keep the car. Not so under the revamped law.
You would have to make the 20 payments, just as you had promised
you would make -- or allow the car to be repossessed.
IRA cap
In general, bankruptcy law protects pensions and retirement savings.
No matter how much money you have in your 401(k), creditors can't
touch it if you declare bankruptcy. In the past, Individual Retirement
Accounts were treated the same way, but not under bankruptcy reform.
Under the bill, the first $1 million saved
in IRAs will be protected from creditors. Any amount over that is
fair game for the debt collectors. What if you changed jobs and
rolled your 401(k) money into an IRA? Money in IRAs that comes from
rollovers from 401(k)s would be protected from creditors. It also
prevents creditors from grabbing money saved in education IRAs,
which are savings vehicles to pay for college.
The kids are all right
Bankruptcy reform does offer a few gestures toward consumers. The
bill says that "it is the sense of Congress" that "certain
lenders may sometimes offer credit to consumers indiscriminately,
without taking steps to ensure that consumers are capable of repaying
the resulting debt." It orders the Federal Reserve to study
whether that's true, and whether credit card issuers' policies contribute
toward consumer bankruptcies.
The Consumer Union's Torres snorts in derision
at that part of the legislation. "A study on the Hill is a
way of saying, 'We've got to have cover, we're concerned about this
issue, but we're not going to do anything about it,'" he says.
The bill calls for yet another study, this
time one on whether people are going bankrupt because of credit
card debt they amass in college.
Legislators rejected amendments that would have
reined in the activities of credit card companies on college campuses.
One would have capped credit limits for college students at $2,500
per card and strengthened parental supervision.
Another amendment would have required credit
card issuers to verify income before they could issue cards to applicants
under age 21, or to get a parent to co-sign or to require the young
applicant to get financial counseling first. That measure was defeated,
too.
Another pro-consumer measure in the bill requires
credit card companies to tell customers how long it would take to
pay off their balances if they make only minimum payments. For example,
a monthly statement might be required to say that making a 2 percent
monthly payment on a balance of $1,000 at a 17 percent interest
rate would take 88 months.
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