Consumers, Lawyers Gear Up for 'Creditor-Friendly' Bankruptcy Law

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The new bankruptcy law will make it easier for small-business owners to collect debt, but they will have a tougher time if they end up on the other side of the fence – facing bankruptcy and trying to save their companies.

The Bankruptcy Abuse Prevention and Consumer Protection Act was signed into law last week after eight years of lobbying by banks and credit card companies who viewed the current law as too easy on gamblers, shopaholics and other overspenders who used bankruptcy proceedings as a financial planning tool.

According to the Federal Reserve, 43 percent of Americans spend more than they earn every year, and 1.6 million filed for bankruptcy in the year that ended June 30, 2003.

The law has provoked a slew of criticism from bankruptcy lawyers who believe the new rules are too punitive. They are urging anyone considering bankruptcy to file now, before the bulk of the rules go into effect in October.

Experts see some benefits for small-business owners, however. Under the new law, they will be reimbursed in full if they delivered their goods or services 20 days before the filing. Under the old law, small companies would not get paid until after the court approved the bankruptcy plan, and even then they would get a fraction of what they were owed, Fortune magazine reported.

It also will be easier for small business to collect from individuals who file for bankruptcy protection because many will no longer be able to file for Chapter 7, the kind of bankruptcy that wipes the slate clean, allowing individuals to walk away from their debts. “The new bill is very creditor-friendly,” Samuel Gerdano, executive director of the American Bankruptcy Institute (ABI), told Fortune. “And small businesses are often creditors.”

But a “creditor-friendly” bill is not so friendly if small-business owners are the debtors. The paperwork and reporting requirements are more burdensome under the new law, which says that a trustee can determine the business doesn't have a good chance of surviving and move the case from Chapter 11 to Chapter 7, under which a company's assets are sold off to pay creditors.

Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys and co-editor in chief of Collier on Bankruptcy, said that many entrepreneurs use their credit cards to pay for expenses at first, planning to reimburse themselves later. He estimated that about 20 percent of consumer bankruptcies are actually business bankruptcies. Under the new law, if a judge decides to that an entrepreneur's debt is personal, he may have to file for Chapter 13 and pay more debt than required under Chapter 11.

"I've always had my doubts that people contemplate bankruptcy when they go into debt," Sommer told Fortune. "Maybe small-business people will be less likely to take risks. The theory is that one of the purposes of bankruptcy is to encourage people to take risks and start businesses, because if you fail, then you can get a fresh start.”

Other the criticisms include:

  • Excessive costs and burden for filers. Consumers will have to pay for credit counseling and finish a financial management course before debts can be erased. Filing fees will go up, documentation will increase and legal fees will rise because lawyers must verify paperwork since they will be considered liable for their clients' mistakes or cheating. “I think the bill is pretty mean-spirited and pretty wrong-headed, and I am encouraging my clients to file in advance of it," Houston consumer bankruptcy attorney J. Thomas Black told the Christian Science Monitor.
  • A one-size-fits-all set of guidelines. Under the old law, the judge could decide whether individuals could file for the more lenient Chapter 7 bankruptcy, which erases debt, or Chapter 13, which requires more payback. The new rule requires use of a “means test” to determine whether debtors have at least $6,000 over five years ($100 per month) to pay creditors. If so, they must file under Chapter 13. "The problem with the means test is the calculation is an artificial one, both on the income and expense side," said Jeff Morris, an ABI attorney and resident scholar. For example, a debtor's current monthly income is figured by averaging income from the previous six months. "Let's say you work for five months at $6,000 a month, and then are laid off for a month and file bankruptcy," Morris said. Under the means test, " you have a monthly income of $5,000, when essentially it's zero."
  • Informal bankruptcies will continue. Consumer advocates are enraged that aggressive lending strategies have not been curtailed. If lenders and credit card companies were more selective, fewer consumers would go belly-up in the face of the unexpected, such as job loss, divorce or medical costs. Because the new law will make it more difficult to file for bankruptcy, some experts predict more “informal bankruptcies,” where consumers will change their address, hang up on creditors and try to fly under the radar. "So if you look at bankruptcy statistics a couple years from now, [proponents of the bill] are going to be ready to declare victory, but they will be overlooking a whole subclass of people who are laying low and living a little bit on the fringe," said Lawrence Ausubel, an economics professor at the University of Maryland in College Park who has studied the practice of informal bankruptcies, according to the Christian Science Monitor. "No matter how you look at it, that's bad for society."

Morris, of the American Bankruptcy Institute, sees only a short-term decline in bankruptcies after the new law goes into effect. "The thing that makes people file for bankruptcy is not the statute. It's lack of money, and that happens whether the bankruptcy code says X or Y," he said. "If you can't buy food, you don't worry about the niceties of the statute."

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