Vern McKinley *

As a period of historically low unemployment approaches the seventh year of economic expansion, the courts strained under the weight of a record 1.35 million consumer bankruptcies in 1997. Consumer filings make up 95 percent of all bankruptcy filings. Legislation in 1994 created a National Bankruptcy Review Commission (NBRC) that reported its findings on October 20, 1997. Unfortunately, the Commission's recommendations would likely make the current bankruptcy situation even worse.

The Constitution grants Congress the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States." Like the Commerce Clause, this power was intended to facilitate the free flow of interstate commerce, as summarized in the Federalist Papers: "The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed into different States, that the expediency of it seems not likely to be drawn into question."

Modern bankruptcy law has evolved from a means to facilitate collection of debts to a means to acilitate evasion of debts, as it provides an attractive opportunity for consumer filers to cleanse themselves of debt. Prerequisites to filing are few, as insolvency is not required and a filer can be of any income level. On the other hand, the relief available is extraordinary. A discharge, which releases a debtor from the obligation to repay debts, offers the debtor a "fresh start."

A filer is also able to choose the most attractive filing option. Chapter 7, the "liquidation" chapter, chosen by roughly 70 percent of filers, allows consumers to walk away from their debts within a few months. There is not even a requirement that future income be committed to paying creditors in this chapter. The only requirement is that the debtor offer up assets not exempted under federal law or under the laws of states that opt for their own exemptions.

Chapter 13 allows for "adjustment of debts of an individual with regular income." A debtor choosing this option is put on a plan to pay off as much debt as possible over a period of up to five years. In contrast to Chapter 7, this chapter allows debtors to shelter assets from creditors.

The following have been cited either as reasons for filing or for the record level of filings:

Economic Cycle/Joblessness-The record number of filings for 1997 during a lengthy economic recovery is counterintuitive. One would expect that when economic times are bad, filings would rise and when conomic times are good, filings would fall. But that has not been the pattern the last 20 years. As the economy enters into recession, the rate of filings increases over prior years, but as the economy nears the end of recession or enters into recovery, the number of filings actually declines. Then four to five years into recovery, filings increase dramatically, ultimately to record levels. This is the phenomenon we are seeing today. This pattern suggests that bankruptcy now has less to do with bailing people out of economic hardship when the economy goes sour and almost everything to do with letting people quickly and easily out of their debts, especially during good economic times.

Medical Bills and Divorce-Another reason cited for filing bankruptcy is large medical bills. Since such a large portion of medical bills is paid by third party providers, health care consumers have little incentive to contain health care costs, leading to enormous debts for the uninsured or underinsured. Fixing the system is important, but is independent from the analysis of bankruptcy. Many filers also blame divorce for their decision to file, but divorce is likely not the cause of the recent surge in filings since the early 1980s. Although the divorce rate rose steadily throughout the 1960s and 1970s, it has flattened throughout the 1980s and 1990s.

Easy Access to Credit Cards-A recent report by the Consumer Federation of America places the blame for the recent increase in bankruptcies on "aggressive credit card marketing by issuers, chiefly banks, who have increasingly been targeting low and moderate income households." The Consumer Federation's answer to this perceived problem is for credit card companies to voluntarily offer credit cards only to households with a "reasonable" ratio of total credit lines to total income, which they would set at 20 percent. If the voluntary approach does not work, the Consumer Federation urges lawmakers to "compel responsible marketing and granting of credit by issuers."

This legislative approach would have the government dictate to consumers how to make their credit decisions with a one-size-fits-all formula that would not take into account the individualized circumstances of consumers. The recent expansion of credit availability to lower-income households is actually a positive development.

Reduced Social Stigma-It is difficult to measure this decreased stigma, but one indicator is the sheer number of people filing, as there have been ten million filings over the past twenty years. Roughly half of filers learn of the bankruptcy option from friends or family. Another indicator of a decreased stigma is the willingness to file bankruptcy more than once. This group makes up ten percent of filers.

The Lawyer's Role-Coinciding with the recent increase in bankruptcy rates was a 1977 Supreme Court case that protected advertising by attorneys as commercial speech under the First Amendment. Prior to that time, many states forbade most types of lawyer advertising. Furthermore, existing financial incentives actually encourage a high-volume, full-time bankruptcy practice.

Changes in Demographics-There is also evidence that the aging of the baby boom generation has contributed to the recent increases in bankruptcy filings. The prime years for bankruptcy filing are the peak borrowing years of age 24 to 54. The percentage of the American population in this category has increased from 34 percent to 44 percent over the last thirty years.

Changes in Legislation-A clear culprit in the rise in bankruptcies is the Bankruptcy Reform Act of 1978 that moved the Code in a decidedly pro-debtor direction. For the twenty years prior to the implementation of the 1978 Act, bankruptcies trended upward from roughly 100,000 filings per year to 200,000 filings per year, a yearly rate of increase of less than five percent per year. For the nearly twenty years since the 1978 Act, bankruptcies trended dramatically upward from 200,000 filings per year to 1.35 million filings per year, nearly a 12 percent rate of increase.

The National Bankruptcy Review Commission (NBRC)- The Bankruptcy Reform Act of 1994 established the NBRC which, on October 20, 1997, submitted its report. One example of how the report’s recommendations would actually increase filings is its treatment of the currently-existing exception to discharge for government-guaranteed student loans within the first seven years of coming due. Common sense suggests that one should not be allowed to become highly educated by borrowing money through a federal program, and then file bankruptcy and discharge the repayment obligation, leaving taxpayers to pick up the tab. The NBRC proposes to eliminate this exception and belittles such logic by arguing that "a debtor overloaded with consumer debts incurred to buy a car, a vacation or a pizza can resort to bankruptcy but a debtor who borrows to pay tuition and books cannot." However, the logical solution to an uneven playing field in discharging of debts is to make it more difficult to discharge loans for "a car, a vacation or a pizza." It does not take a great deal of imagination to onjure up images of lawyers placing ads that ask: "Student loans got you down? We can make them go away!"

Another example of the Commission’s approach involves individual states’ existing right to opt out of the current system of federal exemptions. The NBRC recommends the elimination of this option. Thus, in the opt out states where exemption levels are currently lower than the federal minimum, there would be an increased incentive to file under the NBRC recommendations.

The NBRC was given a clear opportunity to make proposals to bring bankruptcy filings under control. But it failed miserably by making proposals that at best will not alter the current rate of increase of bankruptcy filings, and at worst will cause the rate to increase. The Commission, much of which consisted of representatives of the bankruptcy establishment that benefits from the status quo, chose to listen to those parties who over the past twenty years have been arguing that bankruptcy should be a more readily available option, as opposed to a less readily available option.

Conclusions-A number of interconnected forces have driven up the number of bankruptcy filings, but the underlying cause is a legal structure that treats the act of escaping from debts as an entitlement. The many supposed "causes" of bankruptcy clearly rest on the underlying statute. Easy access to credit cards that many "consumer" groups decry would mean nothing were it not for a legal structure that makes irresponsible handling of personal finances a nearly painless problem. Encouragement from friends or relatives familiar with or attorneys specializing in bankruptcy would mean little if the choice to file was not such a lucrative one. Changing demographics may have caused an increase in the sheer number of people experiencing financial distress. But, the fact that a phenomenon such as the "prime age for filing" exists is troubling, and it is attributable to the underlying legal structure.

To restore the bankruptcy system to its Constitutional purpose of facilitating interstate commerce, all consumer debtors should commit to a plan where at least some future income and some assets are committed to repaying creditors. If the debtor expects no income over the ensuing five years, and has no assets to liquidate, then, and only then, should a discharge be considered. Because bankruptcy would become an exercise in financial planning, non-attorney providers, such as accountants and financial planners, should be allowed to prepare bankruptcy plans. Even under these stricter limits, discharge should be limited to once in a lifetime.

The current system of bankruptcy laws actually hurts consumers. The recent increase in filings has made lenders more hesitant to extend credit and a share of the costs of bankruptcy are passed along to other debtors. Congress should ignore the findings of the NBRC and independently make the necessary changes to bring to a close mounting bankruptcy filings and their adverse impact upon consumers.

*Vern McKinley (dmbvpm@aol.com) has worked as a financial analyst for a number of federal financial agencies including the Federal Deposit Insurance Corporation, the Federal Reserve and the Resolution Trust Corporation. He is currently an attorney in Washington, D.C. The views expressed are his own. This article is adapted from a more extensive article which appears in the current issue of Regulation magazine published by the Cato Institute (www.cato.org).