18 August 2005

The New Bankruptcy Law: The Means Test.

Tomorrow, I'll be giving a presentation to the Financial Planners Association regarding the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which is the new bankruptcy law, most of the provisions of which will take effect in October. This is the biggest overhaul of the bankruptcy code since 1976, but to a great extent it doesn't do what the public perceives it to do. Today, I'll address the defining feature of that new law, the means test.

Basically, under the new law, people making more than the median state income in their state who can pay some meaningful portion of their debts have to do a five year payment plan under Chapter 13, rather than a liquidation under Chapter 7 which will immediately discharge most of their debts without drawing upon the debtor's income at all. The most important thing to know about the means test is who it doesn't impact. About 80% of debtors in Chapter 7 have less than the median income in their state, and thus won't have to even consider filing under Chapter 13 (and if they do choose to make a payment plan, may choose a more lenient three year plan). Thus, only about one in seven people who file for bankruptcy today would be moved from Chapter 7 to Chapter 13 by this provision.

This said, the impact of the means test is still significant, both in how it affects the financial backdrop for about half of the population, whether or not they do go bankrupt, and for how it affects the 30% or so of debtors who already file under Chapter 13, a larger proportion of whom are higher income debtors.

The means test is flawed in significant ways. The state median income test makes it much easier to file a Chapter 7 bankruptcy in an affluent state than in a less affluent state. In Massachusetts, the median income is $72,451. In West Virginia, it is $42,290.

The formula used to determine if those making more than the median income can pay a meaningful part of their debts also favors people with large quantities of assets secured by substantial secured debts, over people with few assets and smaller debts, and people who lease their homes. If you rent an apartment, you have to use an IRS set standard to determine your living expenses under the means test -- in Denver for a family of four that is $1,552 for rent and utilities combined (which will get you a modest two bedroom apartment in a decent neighborhood, or a three bedroom house in a shabby neighborhood). If you have a $1,500,000 mini-mansion with a $1,375,000 mortgage and the balance sheltered by a state homestead exemption, the house doesn't count as a bankruptcy asset that must be distributed to general creditors and you can use your $8,000-$10,000 monthly mortgage payment to determine your living expenses under the means test. The same issue is present when it comes to car payments. If you own a car with car payments you may take your actual car payments as an expense when calculating the means test regardless of their size.

There is a backstop of a general "abusive filing" objection, but the basic principle which will apply in the vast majority of cases is actual secured debt payments rather than the IRS standards that apply to people who lease. Debtors with large alimony and child support payments also do well under the means test, and debtors whose debts are not "primarily consumer debts" aren't subject to the means test at all. (Incidentally, running up large unsecured debts has only modest benefits for those trying to get out of the means test, because anyone who can afford to pay $166.66 a month after paying secured debts like mortgages must do a payment plan regardless of how little a dent this makes in their total unsecured debt load).

Another major problem with the means test is that it is also used determine how much of a payment must be made in Chapter 13 for the five year plan period that applies to those who are required by the means test to file under Chapter 13.

Under the new means test, the amount that a Chapter 13 debtor gets to keep for himself is the same regardless of whether he makes $60,000 or $600,000 a year. The secured debt rule mitigates this somewhat. A high income debtor probably has a large mortgage payment and car payment backed by an expensive house and expensive car, while a low income debtor probably doesn't. But, the general rule does have considerable force.

Outside of bankruptcy, the maximum wage garnishment allowed by law for a non-domestic creditor is 25% of the extent to which your income exceeds minimum wage. For a debtor just over the means test threshold, a Chapter 13 plan is usually going to involve a smaller payment than this alternative outside of bankruptcy. For a high income debtor, like a partner in a large law or accounting firm, or medical doctor in a specialty practice, or a senior business executive, the Chapter 13 payment will generally be well in excess of what that person would have had to pay outside of bankruptcy, although the bankruptcy payment will end in five years, while a garnishment supported by a judgment outside of bankruptcy can last for decades.

Before the means test was enacted, the basic rule was that your creditors had to come out at least as well as they would have if you had filed under Chapter 7 (except for "superdischarge" creditors who can have their claims wiped out in Chapter 13 but not in Chapter 7). Often, middle class debtors with lots of unsecured debts who were mortgaged to the hilt would need to make only nominal payments for three years to meet that threshold. This in turn allowed them to discharge debts which couldn't be eliminated in Chapter 7 filings, such as many debts for back taxes. The superdischarge in Chapter 13 has also been greatly limited.

Thus, under the new law, middle class debtors have to pay much more to creditors, over a longer period of time, and get far fewer debts discharged in the process, and for high income debtors, the payments will be crushing (conceivably more than half of a debtor's income for five straight years). Given that two-thirds of attempts to complete a Chapter 13 payment plan under the much more lenient current law fail, the prospects of a debtor successfully completing a payment plan under the new more strict law seem even more bleak, and the incentive to stick it out are weaker, because the amount of debt discharged when the plan is complete will be far smaller in many cases, both because a larger part of that debt will have been paid and because less debt will be discharagable in bankruptcy at all.

The means test rules may make irrelevant flaws in the new law in its limitations on other asset shelters for high income debtors, like homestead exemptions, asset protection trusts and retirement and education accounts. Even if those devices can shelter significant assets from creditors in a bankruptcy, why should a high income person go bankrupt if they have to make crushing payments to creditors for five years in any case if they do go bankrupt? Increasingly, high income debtors will find that their most advantgeous route is to negotiate with creditors completely outside the bankruptcy context. This isn't necessarily a horrible thing, but creating a bankruptcy system that artificially encourages people capable of earning high incomes to depress their earnings so that they can qualify for bankruptcy protection (income is generally determined based on a six month window) isn't a good thing either, and defeats the economic argument for the fresh start in bankruptcy, which is to discourage just that kind of lost initiative.

The flip side of this, of course, is that it makes offering credit to someone with more than the median income in a state much less risky, since the ability of that debtor to file for bankruptcy is greatly restrained. Expect to see credit card companies push large credit lines with high default interest rates on middle class customers everywhere, extremely aggressively, starting in October, if not sooner. Also, ironically for an Act primarily pushed by Republicans, it operates as a kind of "anti-tort reform" by making it significantly harder for professionals and business people to completely discharge unsecured debts like tort debts (i.e. debts based on negligence and malpractice), although the restriction of the means test to cases involving "primarily consumer debts" will mitigate this effect somewhat.

Suffice it to say that while requiring people with significant incomes to apply part of that income to their unsecured debts is a good concept, that the implementation of the principle in the 2005 Act was poor. A law that would have imposed the maximum garnishment allowed under federal law for five years in favor of the bankruptcy trustee on anyone over the median state income who filed under Chapter 7, or the equivalent on any self-employed person, would have been both simpler and more fair.

2 comments:

Kyle said...

Very interesting post.

CreditSmart said...

Yes, this is a very interesting post. Therehas been a lot of talking about how the new bankruptcy law works for creditors rather than for debtors but I really think that nobody forces you to borrow money. If you can not pay back - why borrow?