Todd J. Zywicki *

The need for reform of the consumer bankruptcy law is evident. Despite the low unemployment, steady economic growth, and general prosperity of recent years, consumer bankruptcy filing rates continue to soar, eclipsing 1.4 million filers last year, approximately 1% of American households. Yet again, filings last year set an all-time record. Filing rates jumped 29% from 1995 to 1996, and then jumped again by 20% from 1996 to 1997, and now stand at a level more than 50% higher than the number in 1992, during the height of the last recession. Of course, we all lose when some people file bankruptcy rather than paying their bills, as those losses are passed on to the rest of us in the form of higher downpayments, higher interest rates, and more stringent late costs and fees.

Most bankruptcy debtors have two options when they file bankruptcy: Chapter 7 "straight" or "liquidation" bankruptcy, or a Chapter 13 repayment plan. Under Chapter 7, the debtor totals up all of her assets on hand at the time of filing, subtracts out all of her "exempt" property, and distributes this quotient pro rata to all of her unsecured creditors at the time of bankruptcy. Because of the generous nature of most exemption schemes and the presence of secured claims against many of the debtor's most valuable assets, 95% of Chapter 7 cases are "no asset" cases that make no distribution at all to unsecured creditors, and those that do are usually very small. Moreover, because many of these exemptions apply to property such as houses and automobiles, middle class debtors tend to benefit the most from them. Alternatively, the debtor can elect Chapter 13, which obliges her to repay her creditors out of her future "disposable income," which is essentially her future income as adjusted for her living expenses. Last year 72% of all personal bankruptcy filings were under Chapter 7. Given the low repayment rate in Chapter 7, many debtors would repay significantly more of their debts if they instead proceeded under Chapter 13, with the greatest impact coming from middle class and upper-middle class filers who now simply walk away from their debts.

In response to this, last summer Congress drafted a bankruptcy reform bill aimed at forcing upper-middle class debtors who can repay a substantial portion of their debts with minimal hardship to do so. The general thrust of reform efforts is to implement a formalized regime of "means-testing." As passed by the House, means-testing would require a bankruptcy filer to elect Chapter 13 instead of Chapter 7 if her annual income was above the national median income (adjusted for family size), could repay 20% or more of her debts over a five year period, could pay at least $50 per month into a plan, and had no significant hardship. Under the Senate version, the effect of means-testing would be discretionary rather than mandatory; if the debtor qualified under the mean-testing requirement, this would give the court grounds to dismiss the petition for "abuse" under Section 707(b) of the Bankruptcy Code, but this action would not be required.

A conference version of the bill opted for a weak version of means-testing that would have given a bankruptcy judge discretion to transfer a debtor from Chapter 7 to Chapter 13 on motion of a creditor and where the debtor earns more than the national median income and can afford to repay either $5,000 or 25% of debts over five years. Even this modest form of means-testing was still too much for the White House, which threatened to veto the bill. In the end bankruptcy reform floundered last session, but a new bill based on the conference bill has already been introduced this session.

Several recent empirical studies suggest that there exists a relatively small but readily-identifiable group of upper-income bankruptcy filers who meet the means-testing criteria. For a family of four, the national median income is approximately $51,000; thus, means-testing wouldn't even be relevant until a filer passes that threshold. Two studies by Ernst & Young and one by the Credit Research Center at the Georgetown School of Business suggest that roughly 10% of bankruptcy filers meet the "means-testing" criteria. Although the total numbers of people affected are relatively small, however, the impact of these provisions is dramatic. The same studies indicate that those affected by means-testing would have had the ability to repay over 60% of their unsecured nonpriority debts, or approximately $9 billion worth of the debt at stake in Chapter 7 cases. In sum, there is a relatively small, but well-defined group of upper-income debtors who could repay a substantial portion of their debts with minimal hardship.

Reasoned critics of means-testing have launched two lines of attack at the concept of means-testing: first, that it rests on invalid assumptions about the probable financial benefits of means-testing; and second, that even if it would increase the amounts collected through the bankruptcy process, it would do so only at the cost of significantly higher administrative costs that would offset any gains in collections. Both of these arguments are incorrect.

A much-publicized recent study sponsored by the American Bankruptcy Institute ("ABI") purports to demonstrate that the effects of means-testing would be significantly less than that identified above, and that only three percent of personal bankruptcy filers would be subjected to means-testing. Congressman Jerrold Nadler even alluded to this study in his press release announcing opposition to bankruptcy reform. Such heavy reliance on this single study of approximately 1,050 petitions selected from 7 districts is puzzling. First, given that 1.4 million consumers filed for bankruptcy last year (72% of whom filed Chapter 7), even three percent of the population is a large number. Second, it is peculiar that such a small and non-representative study of only 1,050 petitions from 7 districts would be given so much weight when compared to the more extensive, recent, and scientifically-controlled studies conducted by Ernst & Young, the Credit Research Center, and others. Critics of these studies have demagogued them as having been sponsored by the credit industry, but other than this "guilt by association" rhetoric, they have not identified any significant methodological flaws that undermine confidence in the results. The ABI study makes the peculiar assumption that the relevant law and regulations actually permit a debtor in bankruptcy to incur new debt of up to $20,000 to buy a new car. Unsurprisingly, this assumption is incorrect. The relevant regulations and law permit a debtor to pay off old automobile debt, but they do not permit a bankruptcy debtor to actually go out and buy a new car while in bankruptcy. Merely correcting this erroneous assumption doubles the number of people affected by means-testing to 6-7%, a number largely consistent with earlier studies.

Finally, there are significant non-economic benefits that accompany means-testing and which are not recognized in these numbers. A free economy and healthy civil society rest on the foundation of promise-keeping and reciprocity. We teach our children at a very young age to keep promises and to be cooperative and to reciprocate good deeds. Widespread consumer bankruptcy represents a repudiation of these moral concepts of promise-keeping and reciprocity, by rewarding those who purchase goods and services on credit and then walk away when the bill comes due. Thus, bankruptcy is a moral as well as an economic act. Telling upper-income debtors who can repay a substantial portion of their debt without significant hardship that they must do so sends an important moral signal that bankruptcy is a serious moral decision and should not be entered into lightly.

Those who argue that means-testing would result in an increase in administrative costs have failed to recognize that there are already substantial costs associated with the current regime in policing bankruptcy abuse by high-income debtors. Under Section 701(b), courts have the discretion to dismiss a debtor's Chapter 7 petition if it would otherwise constitute "substantial abuse." Most courts have applied this test under the rubric of a multifactor balancing test, of which the debtor's ability to repay her debts is the predominant factor, but must be considered in conjunction with several other factors. The results of this regime have been problematic.

The ambiguity and open-ended nature of this standard has led to wide disparities from judge to judge and case to case in what constitutes "substantial abuse." There is little predictability in the legal standard, as caselaw has provided no determinate answer as to how much a debtor must be able to pay before a finding of "substantial abuse" would be triggered and there is further no determinate answer as to how this factor should be weighed against the other factors in any given case. As a result, similarly situated debtors may face radically different results depending on the court, judge, or day in which they happen to appear. This regime of high legal uncertainty has led to unpredictable results in both real and perceived unfairness in the administration of the bankruptcy system. Moreover, the lack of a coherent rule has led to unnecessary and wasteful litigation as parties attempt to determine whether the court will find "substantial abuse" in any given case.

By contrast, statutory means-testing will establish a rule of decision that will substantially reduce the uncertainty associated with the current system. It recognizes that the courts already have identified the ability to pay as the primary factor to consider and channels the court's consideration of other factors in a more predictable manner, so as to minimize uncertainty and unfairness. By establishing a bright-line rule, means-testing will reduce the administrative costs associated with consumer bankruptcy. In 80% of cases the debtor will not even pass the minimum income threshold; thus, those debtors will not have to worry about means-testing at all. This compares favorably to the current regime where any debtor in any case could potentially be susceptible to a motion for dismissal for substantial abuse. The other factors relating to ability to pay can be disposed of through the development of a simple and inexpensive computer program, a prototype of which has already been developed. One argument in favor of the original House version of means-testing is that it establishes a rigorous bright-line test; thus, it would save more on administrative expenses than the more fuzzy and discretionary Senate version of means-testing.

* Assistant Professor of Law, George Mason University School of Law, and Co-Chair, Bankruptcy Subcommittee, Financial Institutions Practice Group. This article is adapted from Edith H. Jones & Todd J. Zywicki, It's Time for Means-Testing, 1999 BYU L. REV. __ ( Forthcoming March 1999).