Bankruptcy Proposal Could Be Tough on Consumers

A sweeping bankruptcy measure -- pushed by credit card companies that have been stuck with much of the bill for the vast rise in personal bankruptcy filings over the last decade -- is wending its way through Congress and considered highly likely to become law.

Already passed by the Senate and supported by President Bush, the bill is expected to be debated in the House of Representatives early next month.

Banks and credit card companies say the measure will curtail abusive filings by people who can afford to pay their debts but refuse to do so. But consumer groups say the bill goes too far, subjecting legitimate debtors to a rising paperwork burden and onerous tests of their ability to repay.

“This is going to erect barriers to bankruptcy for people who have suffered serious financial hardships,” said Travis Plunkett, legislative director for the Consumer Federation of America. “The very limited amount of abuse does not justify putting the remaining 96% of the population, who use bankruptcy for the right reasons, through these additional requirements.”

Countered Lynne Strang, spokeswoman for the American Financial Services Assn.: “We think this is a well-crafted bill, where both sides have been given the opportunity to weigh in. Is it perfect? No. But the positives far outweigh the negatives.”

If the law does pass, it would usher in significant changes for indebted consumers who hope to eliminate their financial obligations through bankruptcy, both sides agree.

Just what would the measure do and when? Here are a few answers.

Question: How would bankruptcy law change under the proposed legislation?

Answer: For individual debtors, the most significant change would be an income “means test” on those wishing to file Chapter 7 bankruptcy, or liquidation. Essentially, people in higher income ranges may be forced into Chapter 13 bankruptcy, or an “adjustment of debts” bankruptcy.

Q: What are the differences between Chapter 7 and Chapter 13?

A: Under Chapter 7, debtors turn over most of their assets to their creditors to pay off as much of their debts as they can, and the rest of their obligations are largely wiped away.

Chapter 7 is the most common type of consumer bankruptcy, accounting for about two-thirds of bankruptcies, according to the Administrative Office of the U.S. Courts in Washington, D.C.

Under Chapter 13, the debtor works out a payment plan and continues to pay creditors for three to five years. Although creditors rarely receive everything they are owed, they generally get more with a successful Chapter 13 than a Chapter 7, said J. Scott Bovitz, a Los Angeles bankruptcy attorney. Chapter 13 also can allow consumers to maintain certain nonexempt assets, such as automobiles.

Still, Chapter 13 is less popular because most consumers who file for bankruptcy don’t have much in the way of nonexempt assets to protect, Bovitz said. And Chapter 13 filings require them to live under court-ordered spending limitations for three to five years.

Q: How would the means test work?

A: The means test is based on the median income in the state in which the filer lives -- that is, the level at which half the households make more and half less. In California, the median household income was about $49,300 in 2003, the most recent year for which figures are available.

Those under the median income level for their state would be able to file for Chapter 7 bankruptcy, as under current law. But those who earn more would be subject to a second test to determine their ability to repay under the proposed law.

That second test would look at the debtor’s income and spending to determine whether he or she could pay off at least 25% of “nonpriority, unsecured debts”-- usually credit card charges -- over five years. A debtor who could make these payments, based on a formula set up in the bankruptcy law, would be forced to file Chapter 13, rather than Chapter 7.

Q: Would Chapter 13 rules change too?

A: Yes. They also are being tightened to restrict what the debtors can spend on discretionary expenses, and to require somewhat larger payments to creditors.

Q: How would the proposal restrict expenses?

A: Under current law, U.S. Bankruptcy Court judges determine how much the debtor can spend on food, clothing, housing, transportation and entertainment before paying down debts. Because those determinations are all individual, critics contend, the process can be arbitrary and, sometimes, give debtors too much leeway.

The proposal calls for national budgetary standards, to be based on collection financial standards set by the Internal Revenue Service guidelines.

These guidelines, which vary based on family size and income, specify how much can be spent on groceries, transportation and education, among other expenses. The standards can be found by going to the IRS website at www.irs.gov and searching for “collection financial standards.”

Critics of the new standard, such as Plunkett of the Consumer Federation of America, say the IRS guidelines are far too onerous. Strang disagrees, saying they provide a reasonable balance between the interest of the debtor and the interests of the creditors.

Q: How would the proposal require an increase in payments to creditors?

A: Current rules for Chapter 13 bankruptcies allow something dubbed “cram-downs,” which reduce the debt owed on certain secured loans, such as car loans. In a cram-down, if the loan amount is greater than the current value, the loan amount will automatically be reduced to the current market value of the car, for example.

Cram-downs wouldn’t be eliminated, but they would be curtailed under the proposed law, Strang said.

Q: When would the law go into effect?

A: It’s expected to go into effect six months after passage to give consumers time to react to it before being subject to the new rules.

Q: Should consumers contemplating bankruptcy take any steps in anticipation that the bill will pass?

A: Some bankruptcy attorneys suggest that people on the brink of filing do so quickly to get in under the old rules. Bankruptcy filings besmirch credit scores for a decade, however, so it’s not something consumers should do without careful thought, Strang said.

Those not yet on the brink of filing should be careful about running up debts, Plunkett said. Although divorces, job losses and medical bills are often the events that push consumers into bankruptcy, those without significant debts can often weather these events without resorting to Chapter 7 or Chapter 13.

Experts agree on one thing: People who have difficulty budgeting or frequently find themselves in economic hot water should consider sitting down with a budget counselor to get help before the situation gets desperate.

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes.com/kristof.