Despite seven years of economic expansion, combined with historically low unemployment, the courts strained under the weight of 1997’s unprecedented 1.3 million consumer bankruptcies.
The Constitution granted Congress the power to establish “uniform Laws on the subject of Bankruptcies” to facilitate the free flow of interstate commerce. However, bankruptcy law has evolved from facilitating debt collection to facilitating debt evasion. Prerequisites to filing are few, but the relief available to consumers is extraordinary. A discharge, which releases a debtor from the obligation to repay debts, offers the debtor a “fresh start.” A consumer can even file bankruptcy more than once.
A filer is also able to choose the most attractive filing option. Chapter 7 allows consumers to walk away from their debts within a few months. There is no requirement that future income be committed to paying creditors, only that the debtor offer up assets not protected under law. A debtor choosing the alternative option, Chapter 13, 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.
One would expect that when economic times are bad, filings would rise; when economic times are good, filings would fall. But over the last two economic expansions, four to five years into recovery, filings have increased dramatically—ultimately to record levels. This phenomenon suggests that bankruptcy now has little to do with bailing people out when the economy goes sour; it has almost everything to do with letting people out of their debts during good economic times.
The current system of bankruptcy laws actually hurts consumers. Contrary to the claims of so-called consumer groups, the recent increase in filings has made lenders more hesitant to extend credit to marginal credit risks because bankruptcy is such an easy option.
A recent report by the Consumer Federation of America, a self-appointed consumer advocacy group, blames 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 to prevent credit card companies from offering households credit lines of more than 20 percent of their income. This legislative approach would let the government dictate credit decisions to consumers. This kind of one-size-fits-all formula would not take into account the individual circumstances of consumers.
Surveys show that roughly half of filers learn of the bankruptcy option from friends or family. Attorneys are also a factor in the decision to file: the recent increase in bankruptcy rates came after a 1977 Supreme Court case that protected advertising by attorneys as commercial speech under the First Amendment. Before then, many states forbade most types of lawyer advertising.
A clear culprit in the rise in bankruptcies is the Bankruptcy Reform Act of 1978, which moved bankruptcy law in a decidedly pro-debtor direction. In the 20 years before the implementation of the 1978 act, bankruptcies increased less than 5 percent per year. In the nearly 20 years after its implementation, they have increased at nearly 12 percent per year.
The Bankruptcy Reform Act of 1994 established the National Bankruptcy Review Commission, which submitted its report in October 1997. Unfortunately, some of the report’s recommendations would actually increase filings. There is currently an exception to debt discharge for government-guaranteed student loans: why allow people to borrow tuition money from a federal program, file bankruptcy and discharge their debts, thus forcing taxpayers to pick up the tab? Amazingly, the commission recommends eliminating this exception. It takes little imagination to predict the likely consequence: lawyers placing ads that ask, “Student loans got you down? We can make them go away!”
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 current system of bankruptcy laws actually hurts consumers. Contrary to the claims of so-called consumer groups, the recent increase in filings has made lenders more hesitant to extend credit to marginal credit risks because bankruptcy is such an easy option. Furthermore, a share of the costs of bankruptcy is passed along to other credit card users. To restore the bankruptcy system to its constitutional purpose of facilitating interstate commerce, all consumer debtors should commit to a plan under which at least some future income and some assets are committed to repaying creditors. Discharge should be limited to once in a lifetime.