In debt
and loving it

Michigan banker Gus Patterson is a busy man. He works in a booming area of banking.

Patterson doesn't have to get out and sell-business in his line just rolls right in with the morning mail. In a given day, Patterson picks up between 15 and 20 new leads. In fact, he's so busy that he spends two days a week just handling the paperwork for all the business that comes his way.

Business is especially brisk right now, and Patterson says if seasonal trends hold, his fall season will be even busier.

Patterson is assistant vice-president and bankruptcy control officer for Flint, Mich.'s Citizens Banking Corp.

In his years of contesting bankruptcies, Patterson has seen it all-Chapter 7s, Chapter 13s, "Chapter 20s" (13s that degenerate into 7s), and more.

Yet there are things about the record filings of bankruptcies that consumer lenders are seeing today that have even this veteran shaking his head.

"You just can't believe the down-and-out people I see in court who have gotten $30,000, $40,000, even $50,000 worth of credit card lines," says Patterson. "They run them up and when the string runs out, they file for bankruptcy."

But more bothersome to Patterson are the folks who run up debt in pursuit of a lifestyle they can't afford. He sees them as a cunning bunch, who exploit a liberal bankruptcy law when things get too hot.

"That kind of debtor galls me more than the dumb ones," says Patterson.

And a newer risk that especially worries Patterson is the compulsive gambler-a growing threat because of the proliferation of places to wager.

Bankers and other consumer lenders are seeing such problems all around the country. While Chapter 13 provides a great deal of protection to debtors who want time to repay all or a portion of their debt, Chapter 7 cases are rarely dismissed and hold out the promise of a free ride-a discharge that substantially wipes clean the credit slate. Bankruptcy isn't even a bar to obtaining new credit after emerging from court anymore.

Even as consumer credit has reached further down into the quality barrel, it has also expanded in directions never seen before.

Stories circulate, for instance, of college students graduating with credit-card debt in the thousands. Rumors fly about pre-teens going into hock with retailers.

As the chart accompanying this article shows, personal bankruptcies broke the 1 million mark in 1996, and predictions are that 1997 filings will hit even higher levels. Already, in 1996, roughly one household out of 100 filed bankruptcy in some form.

Could the picture get much darker?

Yes.

Forecast: Cloudy, chance of floods
The Bankruptcy Reform Act of 1994 set up a National Bankruptcy Review Commission that will make recommendations to Congress on revising the Bankruptcy Code. The group's report is due Oct. 20 and all indications are that in the consumer area the recommendations will tip the balance of bankruptcy law still further in debtors' favor. Key players on the commission staff are considered pro-debtor, as are a substantial number of commission members.

While the Review Commission's recommendations are still being hashed out-it plans to meet this month to further consider its consumer-side proposals-creditor representatives expect little-to-no improvement in what Congress will see.

The commission's procedures provide for review of any recommendations that some members have objected to, but few people expect many reversals.

"I don't hold out any great hope for that" on the consumer-side recommendations, says Phil Corwin of Federal Legislative Associates, which is lobbying the bankruptcy issue for ABA. "There's no substantial issue that they've revisited that they've revised much."

And with the Aug. 11-12 meeting being the final one for substantive deliberations, consumer creditors feel the matter is set.

In fact, so negative for creditors is the set of consumer recommendations that Congress is likely to see that a coalition of creditor groups (including ABA) opted for a pre-emptive strike.

In mid-July this interindustry group, the National Consumer Bankruptcy Coalition, filed a long letter of grievances with Congress. The coalition wants to see Congress stamp the consumer recommendations "dead on arrival" and to start from scratch. The coalition's own agenda can be summed up as an effort to make bankruptcy more of a "needs-based" matter, reserving the most complete wipeouts of debt for debtors who have truly hit hard times, with other debtors pushed into court-supervised repayment to the extent possible. This approach has received little hearing from the commission, backers say.

"My hope is that the consumer credit industry will become concerned enough to fight back-or it will lose"

Creditor Attorney William Mapother

Unfortunately for lenders, the consumer credit industry has not enjoyed a great track record on Capitol Hill, according to consumer creditor attorney William Mapother of Louisville, Ky., a nationally known bankruptcy consultant. He says much more relief has been obtained, historically, in court, with appeals decisions adjusting decisions that have hurt creditors.

Mapother adds that the congressional pattern has been to undo such gains. He points out that several advantages battled for in court were eliminated by the 1994 reform law. He fears more of the same if the commission wins its points before Congress.

"All the commission's proposal does is erase victories we have had in court," says Mapother. "They want to wipe out everything good. They want to do nothing but forgive debt. My hope is that the consumer credit industry will become concerned enough to fight back-or it will lose."

Renovations, not reconstruction
Wisconsin attorney Brady C. Williamson downplays the importance of the National Bankruptcy Review Commission, which he chairs, versus the historical role of the '70s-era Commission on the Bankruptcy Laws of the United States, that helped bring about the first major rewrite of federal bankruptcy law in 40 years.

Back when Congress formed the earlier group, says Williamson, a partner in the Madison law firm of LaFollette & Sinykin, major portions of the nation's bankruptcy laws were broadly considered to be outdated. He explains that the original commission, therefore, found that getting its job done would require changes to the very architecture of the bankruptcy law. This resulted in legislation that rewrote the old bankruptcy act, culminating in the new law's designation as the Bankruptcy Code.

By contrast, says Williamson of the modern commission, "we don't have any architectural changes on the drawing board. The current law still works. But there are some areas that need attention. We'll be suggesting ideas to make the system better than it is, not to replace it." Indeed, the Bankruptcy Reform Act of 1994, which created the present commission, specifically states that "the Commission should be aware that Congress is generally satisfied with the basic framework established in the current Bankruptcy Code."

The result has been a somewhat more focused effort, rather than a shotgun approach to bankruptcy reform. Williamson notes that the commission has spent much of its time on three issues: small-business bankruptcy; consumer bankruptcy and future claims. The latter refers to bankruptcy cases involving massive settlement issues, such as those involving asbestos, that would break a corporation in the absence of a Chapter 11 opportunity to manage the payments.

The legislative language goes on to caution the commission not to "disturb the fundamental tenets and balance of current law." Of course, some creditors, particularly those on the consumer-lending side, might argue that changes discussed by the commission have bordered on the architectural level and would change the balance.

"The Commission should be aware that Congress is generally satisfied with the basic framework established in the current Bankruptcy Code"

Bankruptcy Reform Act of 1994

Williamson acknowledges that much that the commission has taken on has been controversial, particularly in the consumer-credit arena. "Congress wanted the commission in part to take on controversy in a non-legislative format," says Williamson. "Over the last few months, we have had contributions from debtor as well as creditor interests. We're not trying to make any one set of interests happy."

Consumer creditors' representatives don't see it that way. They say the commission's work in the consumer area has been dominated by staffers and commission members with pro-debtor agendas. The National Consumer Bankruptcy Coalition calls what the commission is developing on the consumer side nothing short of a conversion of the Bankruptcy Code into "a perverse system of bankruptcy on demand."

The Commission's work-in-progress
Here are the broad outlines of what the commission will recommend, barring substantial revision at its August meeting:

Exemptions. States would no longer set options for exemptions of assets from Chapter 7 bankruptcy estates-now they can not only set up exemptions as an alternative to federal exemptions, but can also determine that residents of their states can only use their state's schedule of exemptions (two-thirds have done so). Proposed federal exemptions could range up to $140,000, much higher than currently permitted. Under the proposal, states would retain some voice in permissible homestead exemptions.

Creditors fear that Chapter 7 will become irresistible.

Among the new twists in the commission's proposal would be an unlimited exemption for certain retirement savings. "Far from signifying excessive wealth, retirement funds have become a middle-class necessity, especially in light of the diminishing adequacy of Social Security funds and other deferred benefits," argued a commission staff memo. "...bankruptcy should not discourage what other federal policies and common sense encourage." Indeed, the staff noted that some states have already explored or adopted degrees of retirement savings protection.

"A uniform approach to retirement funds, with as little change to upset past retirement planning, seems appropriate," the memo continues.

Statistically speaking, what's going on in consumer bankruptcy?

As the National Bankruptcy Review Commission and its Consumer Working Group have deliberated, an incredible amount of data has been trotted out to support various camps' views on consumer bankruptcy. Other data has also been published during the commission's tenure. Here's a sampling of the sometimes divergent findings: "Abuse appears to be a small but significant problem in both consumer and business bankruptcy cases," according to a survey of both debtor and creditor lawyers conducted by the American Bankruptcy Institute, a nonpartisan group. "Abuse," concluded the study, "does not appear to be the type of systemic problem justifying the wholesale revision of bankruptcy law." The same study reported that two-thirds of the lawyers cited ease of obtaining personal credit and credit cards; job loss; and financial mismanagement, as the leading causes of personal bankruptcy. Medical problems and marital/family problems were cited by somewhat fewer respondents-57% in each case. A study by the WEFA Group, cited in testimony by Visa, stated that the impact on bankruptcy filings of the number of bank credit cards per adult was "quite small." A representative of the Congressional Budget Office noted in testimony that personal bankruptcy filings increase during periods of economic expansion-even morseo than in recessions. Further, the CBO representative said that filings correlate closely with household debt-to-income ratios, suggesting that socioeconomic factors such as reduced stigma, lawyer advertising, and the 1979 shift in the Bankruptcy Code may not have played a significant role in increased filings. * A study sponsored by Visa and MasterCard found that 53% of debtors in selected Chapter 7 personal bankruptcies examined had no income to fund Chapter 13 repayment programs. Yet, at the other extreme, 25% of the debtors studied could have repaid at least one-third of their non-housing debt within 60 months of filing. * Visa and MasterCard both maintained that "there is little evidence to support assertions that the extension of credit cards to less affluent Americans is a significant factor in the rise in bankruptcy. ... Ninety-nine percent of credit card holders do not file for bankruptcy. MasterCard and Visa cards account for only 8% of all consumer debt-a percentage far too small to be the cause of bankruptcy." The Consumer Federation of America, in a report, stated that "The single most important reason for ... expanding debt is relentless, aggressive credit card marketing by issuers." USA Today's survey of people who filed for bankruptcy in 1996 ranked the causes cited by the debtors. Among them: credit card bills, 63%; pay cut or job loss, 50%; mismanagement of debt, 37%; and medical bills, 28%. Filers had an average of six cards when they declared bankruptcy. And 89% of the 1996 filers said they continue to receive credit-card offers. A USA Today poll of the general public found that half felt bankruptcy was an unacceptable way to settle debt problems-but that 43% thought it was acceptable.

In fact, the uniformity proposed for exemptions is a theme seen in other aspects of the commission's proposals, which sometimes concern issues that have been decided differently in different jurisdictions. Commission Chairman Brady Williamson has placed great stress on the Constitution's mandate that Congress create "uniform laws on the subject of bankruptcies." (Emphasis added.)

"Cramdowns." Home-equity borrowers-even some of those who borrowed before the commission reports to Congress-would be permitted to seek reduction of their secured borrowing from actual secured loan value to a level based on property market value. (The commission's likely recommendation does not affect purchase-money mortgages.)

Reaffirmations. Persuading the soon-to-be-discharged Chapter 7 debtor to reaffirm debt is a standard tool of the consumer credit manager, with benefits for both borrower and lender. The lender puts the credit back into the performing category, and the debtor may be able to continue to have the use of a car securing a loan, for instance, or to keep one credit card. Reaffirmation of such debt is frequently the unsecured creditor's only hope of any recovery in a Chap. 7 filing.

Reaffirmation practices evolved in response to controls on the process that go back to the Bankruptcy Reform Act of 1978. These controls were developed out of concern that debtors, without some court oversight of the reaffirmation process, would lose some of the benefits of bankruptcy. Reaffirmations, therefore, are subject to strict control today and must be agreed to and approved before a debt is discharged.

The commission would put an end to all consumer reaffirmations, both of secured and unsecured debt. Beyond this, the commission will likely recommend that some filers be permitted to hold onto collateral, such as cars, so long as they stay current on payments. This is a one-sided sort of reaffirmation-with all upside and no downside for the debtor. The creditor might regain control of the collateral, following renewed delinquency, only to find it in damaged or worthless condition.

Claims of creditors bullying borrowers into reaffirming debt played a part in the deliberations of the commission; not unnoticed, too, was the recent Sears case in which the retailer agreed to pay millions to debtors who had been misled into reaffirming.

Automatic conversion. This recommendation would institutionalize the "Chapter 20" gambit. Chapter 13 filers would be permitted to switch easily to Chapter 7. Creditors predict that such a change would result in cramdowns of home-equity, auto, and other loans first, using Chapter 13, followed by further erosion of creditor interests by shifting into 7, with its clean-slate approach.

Student loans. Currently, guaranteed student loans must be paid for seven years before they can be included among loans eligible for a bankruptcy discharge. The commission would do away with this control for most student loans.

Payment template. Currently, Chapter 13 debtor plans pay anywhere from 100% of debts, albeit over an extended period, to some lesser percentage, subject to court approval. Just how low courts will allow repayments to go varies from jurisdiction to jurisdiction.

The commission would remove this disparity by setting up a national template for setting repayment on the basis of debtors' adjusted gross income.

While consumer creditors applaud the concept of uniformity, they object to the way the commission proposes to implement it. The proposed schedule would provide for repayments from a nominal level for people with adjusted gross incomes of less than $20,000 to a maximum of 7%-seven cents on the dollar-for those with incomes of $75,000 or more.

While all of the proposals listed thus far are negative for creditors, there are some positive recommendations too. These include:

National filing system. To ensure better control over limitations on how often a person can file for bankruptcy, a national recordkeeping system based on Social Security numbers would be set up. Creditors worry, however, that this could be evaded through falsified Social Security numbers.

Random audits. It is commonly charged, by creditors, that many aspects of what debtors declare when filing for bankruptcy is wrong, misleading, or incomplete. In fact, it is such errors that some creditor representatives count on when they attempt to obtain some leverage against the debtor.

The commission proposes to attack debtor error and fraud through random audits on debtor filings. Some creditors feel this is admirable, in principle, but point out that the proposal carries no teeth-they would favor barring any discharge to people whose filings don't stand up to audit.

Other creditors, who make a practice of investigating and challenging filings, feel they deserve the fruits of taking their extra steps.

Debtor education. Jawboning a bit, the commission supports a system of debtor education, to be participated in voluntarily. Creditors feel education should be mandatory.

Attorney Bill Mapother used to be a judge and often found himself dealing with juveniles who had gone wrong. He says he used to aim for rehabilitation, not just a sentence, and he doesn't see why rehabilitation shouldn't be part of the bankruptcy process. He would favor mandatory financial education for bankrupts-in his state, speeders and drunk drivers are required to take driver ed, so why not those who err in credit?

Beyond consumer bankruptcy
While most of this article has concerned consumer bankruptcy issues, the commission has reviewed and framed recommendations on many other bankruptcy matters, ranging from the status of bankruptcy judges and bankruptcy courts within the federal system to cases involving municipalities. The following recommendations, in various stages of the commission's process, represent only a brief sampling of what will be in the group's October report:

Small-business bankruptcy. The commission proposes special considerations for small-business cases under Chapter 11; firms with qualifying debt of $5 million or less would be covered. Certain streamlining and performance standards are incorporated in the proposal in an effort to help small businesses survive the Chapter 11 process while unclogging the portions of the bankruptcy system devoted to 11s.

Venue shopping. Corporate debtors generally enjoy some latitude in determining where they will file bankruptcy; critics complain that this can lead to "shopping" for more-sympathetic judges and for jurisdictions where past decisions or practices seem favorable to the debtor's particular circumstances. The commission proposes limits on the ability to choose the venue.

Farm bankruptcy. Chapter 12, the special "temporary" chapter for family farmers, was ushered in by the farm crisis of the 1980s but has stuck around through congressional extension. The commission backs making the chapter permanent. BJ

What the chairman thinks

National Bankruptcy Review Commission Chairman Brady C. Williamson tends to come at bankruptcy matters differently than many consumer lenders. For one thing, Williamson, though a veteran attorney as well as a law school instructor on bankruptcy, has mostly worked on commercial bankruptcies, rather than consumer-bankruptcy issues. Williamson, 51, was appointed to the commission and its chairmanship in 1996 by President Clinton following the death of the commission's original chairman, former congressman Mike Synar. Another thing that sets Williamson a bit apart is his strong reliance on the Constitution-bankruptcy courts aren't a place you hear that document being cited very often. He notes that the Constitution empowers Congress to enact bankruptcy laws-the founding fathers wouldn't have put that in if they didn't feel it was necessary. Today, with consumer credit being freer, more flexible, and more widely available than ever before, Williamson believes the need for bankruptcy laws has only been underscored. "The democratization of credit has been a wonderful thing for the economy," says the attorney, "but the bankruptcy system has to deal with the inevitable failures. There has to be a system to deal with the economic consequences of poor economic choices and economic misfortune." The fact that annual bankruptcy filings by consumers surpassed the 1 million mark in calendar 1996 gives further emphasis to the need for bankruptcy law, says Williamson. "Everyone would like to see fewer bankruptcies," says Williamson. "We think that some of our proposals would help in that regard. But there always has to be a safety net, for those who, through no fault of their own, are in over their heads."