Bankruptcy Code Changes: Will it be Cheaper and Easier for Debtors?

The New York Times Editorial Page recently published an Op-Ed piece by Ronald Mann (http://www.nytimes.com/2010/03/12/opinion/12mann.html?ref=opinion), professor of law at Columbia. Mr. Mann’s Article suggested major changes to the Bankruptcy Code to make bankruptcy cheaper and easier for debtors. The Article suggested that the current bankruptcy system is “too difficult and expensive for the people who use it. The system has always been complicated, but in 2005 Congress made things worse by changing the rules to make it harder for bankrupt people to avoid paying their outstanding bills. Now that the recession has exposed the flaws of the system, Congress should go back to the drawing board and drastically simplify the bankruptcy system.”

Ridiculous. First of all, it is true that the changes to the Bankruptcy Code enacted in 2005 made it slightly more difficult to completely avoid paying all of your outstanding bills. What’s wrong with that? Mr. Mann ignores the fact that the amendments to the Bankruptcy Code exist to prevent abuse of the Bankruptcy system, not to punish those most in need of traditional Bankruptcy protection. And that is exactly what the new amendments do.

Without a Bankruptcy system, the theory goes, people that have an unrelenting mountain of debt will lose motivation to work and contribute to society. These debtors find themselves in a hopeless situation; their creditors will just take any of the assets are able to accumulate through hard work, so why even try. The Bankruptcy system is premised on the idea that debtors should be able to realize a “fresh start” through a Bankruptcy filing. This system reflects a policy of encouraging people to file Bankruptcy and emerge as productive members of society with an ability to move on with their lives free of their previous debts.

The 2005 changes to the Code make it harder for a debtor to receive a discharge of all of his or her debts through a Chapter 7 liquidation case. Instead, the Code requires an analysis of whether a debtor has the ability to repay some of his or her debts through a Chapter 13 plan. This is called the “means test.”  If the debtor has sufficient “disposable income” – i.e. money left after paying reasonable necessary household expenses, such as a reasonable mortgage or a reasonable car payment – then that disposable income must be used to repay a portion of the debtors outstanding debts for a period of three to five years. The system does not allow consideration of unreasonably high mortgage or car payments. Gone are the days of Debtors crying poor because their BMW lease payment eats up too much of their monthly cash flow.

Forcing debtors that have sufficient funds to repay a portion of their debts hardly upends the fresh start policy of the Bankruptcy Code. Rather, the new requirements reflect overwhelming public sentiment that Bankruptcy should only be used by good faith debtors that, due to unforeseen circumstances such as loss of a job or unexpected medical expenses, find themselves with no choice but to discharge their debts through Bankruptcy.

The changes to the Code are designed to end the routine Chapter 7 liquidation cases that were filed by classic “overspenders.” Prior to 2005, it was not uncommon for individuals making more than $100,000, driving luxury automobiles and renting luxury apartments, to discharge tens of thousands of dollars in credit card debts. Simply put, there was nothing in the Bankruptcy Code to really stop them unless it could be proven that the Bankruptcy was filed in “bad faith,” an extremely fact sensitive (i.e. costly for the creditor) consideration. Now, these people must repay some of their debts through Chapter 13 bankruptcy.

Mr. Mann recognizes this fact: “Congress’s 2005 reforms also directly discouraged filings under Chapter 7 (the option typically used by people with few assets) and encouraged filings under Chapter 13 (the traditional procedure for homeowners).” Mr. Mann advocates for overspenders or, more likely, those that made poor financial decisions through the purchase of an overvalued home. As Mr. Mann points out: “If the bankruptcy system was doing its job, the mortgage-driven financial crisis should then have led to a sharp increase in filings under Chapter 13. Homeowners unable to keep up with their mortgages should have been able to file for relief under Chapter 13, resolve their problems and move on with their lives. Yet the share of Chapter 13 filings fell in 2009 to only 28 percent of all filings, from 42 percent in 2006. That’s another perverse result of the 2005 reforms: Chapter 13 does not let people avert foreclosure by paying the actual value of their homes, even when their bubble-era mortgages far exceed realistic market prices. In fact, a “special rule” for home mortgages allows lenders to prevent normal bankruptcy relief for borrowers. Thus, the reforms created a system that makes it harder to file for Chapter 7 while doing nothing to make Chapter 13, once the savior of homeowners, useful in this sort of mortgage crisis. . . . If debtors want to keep assets against which they have borrowed, they should have to pay the fair value of the assets, but nothing more.”  

The key phrase in Mr. Mann’s tirade against the “new” system is “this sort of financial crisis” and the key philosophy is that debtors should only have to pay for the current value of their homes to keep them. 

And therein lies the policy debate. This financial crisis involves many debtors that simply cannot afford their homes but that own them due to the subprime lending that was prevalent in the market several years ago. Now that thousands of those subprime mortgages have gone into default, the debate is whether to protect the debtors that cannot afford their homes. However, the Bankruptcy Code is not, and never has been, designed to increase homeownership or protect assets that debtors cannot afford. Altering the Bankruptcy Code to suddenly assist debtors in homeownership to the detriment of creditors is not only contrary to the capitalist principals on which this country is founded, but it would also be an unconstitutional violation of the creditors’ rights. Mr. Mann’s policy suggestions simply go to far.

I say let the Bankruptcy system continue to protect good faith debtors that find themselves in Bankruptcy due to a life altering event. The system is a luxury, not a right. Bankruptcy provides a safety net for catastrophic and life altering events, not poor decision making and foolish overspending, and should not be used to involuntarily redistribute assets from creditors to debtors.