Everything’s changing in bankruptcy world

by Mike Kroll

“Despite the stated intentions of lawmakers, many of the changes in this new bankruptcy law will make lives just that much more miserable for people already in desperate financial straights and make the prospect of a fresh financial start far less likely. Our founding fathers knew that the economic viability of our fledgling capitalist nation depended, in part, on a more enlightened approach to accumulated debt than Britain’s debtor’s prisons. That is why they specifically included bankruptcy in the establishment clause of the Constitution that sets out the powers of Congress. This new law may pay off for the credit card companies but I am convinced that it will backfire on everyone else.” Galesburg attorney Barry Barash, nationally reknowned specialist in personal and business bankruptcy law.

While bankruptcy law can trace its lineage to the Constitution itself and is, therefore, a matter of federal jurisdiction, Barash says that state statutes, particularly those relating to exemptions, have a huge practical impart on individual debtors and vary widely from state to state. The Federal Bankruptcy Code currently in effect was last updated in 1978 when it completely replaced an act that dated back to 1898. In less than a month, all this changes yet again. President George W. Bush signed the new bankruptcy law on April 20th and most of its provisions go into effect 180 days later — on October 17th. Bankruptcies filed after that date will be very different and experts such as Barash are confident that there will be an almost immediate and precipitous decline in the number filed— at least initially.

“Most attorneys who handle bankruptcies have been very busy with cases where people want to beat the deadline but few of us want to be among the first to test the legal waters after October 16th,” noted Barash. “For those of my clients who can afford to wait, I plan to delay many filings until after January 1st. By then we will not only have a better feel for how the new laws will work in practice but also Illinois residents will benefit from a relaxing of the existing miserly exemptions. Most Illinois exemptions double beginning next year and that can make a real difference for many clients.”

Exemptions are an important part of bankruptcy law and one that differs greatly from state to state. Some states, like Florida and Texas, offer comparatively generous exemptions. One of the key reasons for bankruptcy law is to insure a modicum of common sense and reason in the management of debt that exceeds an individual’s ability to repay. Exemptions are theoretically designed to shield certain types of personal property from seizure and liquidation so that the debtor and family may be able to continue a somewhat normal life as their economic life is capsized.

In most cases the exemptions permit a bankrupt individual to maintain a residence, own a modest vehicle and maintain savings earmarked for retirement or education. Bankruptcy cases are always filed in United States Bankruptcy Courts located in every state but how the courts discharge cases is very dependent upon the local state rules regarding exemptions and the validity of claims by creditors.

The most common form of personal bankruptcy has historically been Chapter 7 — a liquidation of non-exempt assets with a managed disbursement to creditors and elimination of most outstanding debt. Under Chapter 7 bankruptcy, many unsecured creditors get little or nothing in exchange for forgiving accumulated debt. This impacted credit card companies in a big way and they played a huge role in shaping the new bankruptcy law. Most state and federal taxes, as well as student loans and child support, constitute debts that cannot be discharged or forgiven. Proponents of the new bankruptcy law, including members of Congress and credit card companies, argue that too many Chapter 7 personal bankruptcies have abused the system. In 2004 more than 1.1 million individuals filed under Chapter 7 accounting for better than seven-out-of-ten personal bankruptcies filed last year. One key goal of the new law, that most experts agree has been accomplished, will be to significantly reduce the use of Chapter 7 personal bankruptcies.

While Chapter 7 rules can be applied to both individuals and businesses, the alternatives are more specific to the type of entity. Unlike Chapter 7, the remaining forms of bankruptcy are collectively termed as debt reorganization. In these cases, fewer debts are forgiven outright and a Bankruptcy court trustee determines a workable repayment schedule for a greater proportion of the remainder. Lawyers refer to this as a supervised rehabilitation of the debtor according to a court approved plan. Proponents of the new bankruptcy law see Chapter 7 as too easy a way out for irresponsible debtors; one that actually can encourage financial irresponsibility.

Under the new law, a much greater proportion of debtors who elect to file for bankruptcy will be required to do so under the reorganization chapters. Chapter 11 pertains to businesses and Chapter 12 to “family farmers.” Chapter 12 was set to expire at the end of 2004 but the prospect for its continuation and permanent status is said to have influenced many Senators and Congressmen from agricultural states to support the new law.

In the case of personal bankruptcy, the alternative is Chapter 13 which replaces the immediate relief from oppressive debt with a five-year court supervised plan of debt repayment. Under Chapter 13 a determination is made of the amount of reasonable and necessary expenses that are subtracted from the individual’s household income to determine the amount of disposable income. A schedule of payments must be designed by the debtor and his attorney, approved by the Bankruptcy Court that devotes every penny of disposable income toward repayment of debt and assures a “meaningful payback” to unsecured creditors such as credit card companies. This is a much longer, painful and drawn-out process that many experts believe actually reduces the likelihood of financial rehabilitation for many forced into bankruptcy by traumatic life events such as illness, divorce or unemployment.

“In my experience, many individuals are forced into bankruptcy by circumstances beyond their control,” explained Barash. “When the credit card companies and their allies in Congress passed this new law they cast a very wide net that will ensnare many beyond the financially irresponsible at whom the changes are supposed to be aimed. The economic circumstances we find ourselves in today mean that more of us are at risk of suddenly losing our jobs or facing medical bills beyond the limits of our health coverage or the very real financial crisis of a divorce. A significant number of existing bankruptcy filings are due to bad investments, even among well educated or those presumed to be financially sophisticated. These are exactly the kinds of people who historically made use of Chapter 7 bankruptcy to get back on their financial feet. With the new tests now in place, many will now be forced into Chapter 13 instead.”

The new law establishes a series of critical pre-filing requirements that were aimed at preventing people with the capacity to repay many of their debts from using Chapter 7 to escape responsibility for them. The process now begins with what Barash refers to as the “ticket in,” a new requirement that an individual must complete a financial counseling course offered by a court-recognized non-profit credit counseling service. Such counseling starts at a cost of about $80 and, in many cases, such services are geographically removed from debtors in small towns or rural areas. The debtor is also obligated to provide a wide variety of financial records and a complete credit bureau report prior to filing. Barash warns that there is also a “ticket out” that must be punched to gain final court approval of the reorganization plan; a second and separate approved financial management course must be completed to receive a discharge.

Realistically, Barash cautions that a bankruptcy lawyer is likely to require upfront payment for these items in addition to his normal fees adding upwards of $400 to the upfront costs incurred by anyone interested in filing for bankruptcy.

A debtor also needs to pass a means qualification test to determine eligibility for Chapter 7 versus Chapter 13. If demonstrable monthly income is less than the court-specified median income in your state you can file Chapter 7. Otherwise you must complete a disposable income calculation to determine if your five-year total of disposable income would exceed $6,000 and equal 25 percent or more of your unsecured debt or simply exceed $10,000. In practice, what this means is if you are determined to have $167 or more in monthly disposable income, Chapter 7 is no longer an option. As Barash points out, except for the very poor, this is a bar set so low as to preclude almost working- or middle-class individuals from the Chapter 7 option.

If you are already confused, let me assure you that we haven’t begun to scratch the surface of this new law. Barash is convinced that the complexity is only partly due to the many changes and intricacies of the new statute. “A key factor absolutely no one yet has a handle on is how the courts themselves will shake this out. While the Constitution itself mandates uniformity in the application of Federal Bankruptcy law, it is already established law that what this really means is geographic uniformity — not a single national legal standard or even a state standard. In some cases, geographic uniformity will be determined at the county level! There is sure to be confusion and differing interpretations across the various Bankruptcy Courts themselves as well as attorneys and most certainly the clients. There are many hidden facets in this new law that people just don’t know about, including many attorneys. That is why many are getting out of this area of law. Bankruptcy is now no longer a game for dilettante, amateur or other non-specialist. During the initial three to six months following October 16th, you will see attorneys take on bankruptcy cases and fumble through them to the disservice of both their clients and the system. Meanwhile I expect a huge influx of people getting bankruptcy cases filed just under the wire.”

Barash is convinced that the new law will have a broad range of negative unanticipated consequences. “Right off the bat, this law is bad for our economy. We are now penalizing those with capital from taking risks with their investments. That isn’t good for the national economy but it is even worse for areas like our that are struggling. The founding fathers had a more sophisticated understanding of how this country’s economy would work than the elected officials who passed this law.”

“Bankruptcy is the relief valve of the free enterprise system. Under this new law, I expect to see a rise in the cash and underground economy. We will also see a huge increase in people who are non-compliant debtors.”

While experts like Barash can discuss and debate the intricacies of the new law, there are important lessons for the rest of us. First, Barash pointed out that the bankruptcy bar was already a small area of specialty and one he expects to get much smaller. That means that we — as potential clients — will have a harder time locating qualified attorneys to handle bankruptcies. In Galesburg, there are two attorneys who handle the bulk of the cases and have demonstrated expertise in bankruptcy law: Barash and Pam Wilcox of Stoerzbach Morrison, PC. Second, not everyone would benefit from rushing to file under the current bankruptcy law. This is actually a complex calculation that can only be determined in consultation with your attorney or accountant and after all personal financial records are reviewed and organized.

Barash suggests some preliminary steps before contacting attorneys. “Gather your financial paperwork together and begin the process of documenting your financial life. List all the debts owed as well as all the assets, making a point of accurately noting their equity value. Conduct a realistic appraisal of your personal and family strengths. What kinds of resources can you and your family bring to bear on the situation? Develop a realistic budget of monthly income and expenses and assess the stability of both. And finally, examine the stability of your family and marriage and consider the implications on your financial future. Any good bankruptcy attorney is going to ask you to conduct this self-examination before you begin the process.”

“I’m telling people who call my office now that if they are serious about filing right now, I will take time to meet with them but if they are just now beginning to explore their options it is probably too late to beat the deadline.”