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Banks and credit card companies lobbied Congress for several years to amend the Bankruptcy Code because of an increasing number of bankruptcy filings1 and evidence that debtors were abusing the existing code. On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act into law. The act makes the most sweeping changes to the Bankruptcy Code since its enactment in 1978, amends the Truth in Lending Act (TILA), and directs the Board of Governors of the Federal Reserve System (the Board) to amend Regulation Z, the Board’s implementing regulation for TILA. The act’s provisions became effective on October 17, 2005, except for the changes to TILA and Regulation Z, which become effective 12 months after the Board publishes its final regulations. This article reviews the Bankruptcy Code changes that affect banks.2
Means Test for Debtors Filing Under Chapter 7
The act’s most significant and controversial provision is the Chapter 7 means test, which limits filings under Chapter 7 to debtors who cannot afford to repay their debts. Debtors can file under Chapter 7 without limitation if their income falls below the median income of their state of residence, as calculated by the Census Bureau.3 But if their income exceeds the state median, they are subject to a means test to determine whether they are abusive filers, a phrase used in the act to identify debtors who seek an immediate discharge of their debts under Chapter 7 when they have the ability to repay a portion of their debt in a Chapter 13 payment plan.
The means test precludes debtors from filing under Chapter 7 if they had at least $166.67 in net monthly income available after allowed deductions (i.e., $10,000 over five years), or if they had between $100 and $166.66 in net monthly income available (i.e., $6,000 to $10,000 over five years) and were able to repay at least 25 percent of their nonpriority unsecured debt over five years. The act also specifies that debtors whose income exceeds the state median for the six months prior to filing will have to file a five-year Chapter 13 plan, instead of the three-year plan selected by most debtors. Lengthening the payment plan period to five years should result in more unsecured debt being repaid. A Chapter 7 debtor who is flagged as an abusive filer can avoid dismissal or conversion to Chapter 13 only by documenting special circumstances, such as a serious medical condition, that would either decrease their income or increase their expenses, thereby causing their net monthly income to fall within the above guidelines. These provisions will likely decrease the number of Chapter 7 filings, where unsecured creditors typically receive nothing, and increase Chapter 13 filings, where unsecured creditors typically are repaid a portion of their debt. Therefore, banks offering unsecured debt to consumers in the form of credit cards and unsecured loans should benefit.
Serial Bankruptcy Filings
Some debtors file serial bankruptcies with the goal of indefinitely postponing a foreclosure sale of their home or automobile. These cases are an enormous frustration for secured creditors, who incur significant costs in attorney’s fees and out-of-pocket expenses and suffer years of delays before they are finally able to foreclose on their security. In Delaware County, Pennsylvania, for example, the sheriff’s office requires a $2,000 deposit for a sale of real property, only a portion of which is refunded if the sale is cancelled. The resulting expenses can easily eliminate any equity cushion remaining in the collateral and ultimately result in a loss for a bank.
The act creates several obstacles to serial filings. If a debtor files a new bankruptcy within one year after the dismissal of an earlier case, the automatic stay terminates in the second case 30 days after filing of the second case, unless the debtor demonstrates the filing was in good faith. Further, if a debtor files a third case within the one-year period, the automatic stay does not apply, though it can be instated if the debtor can establish that the third case was filed in good faith.
The act also provides that the automatic stay does not apply to a creditor’s attempt to enforce a lien or security interest in a bankruptcy in which the debtor was ineligible to file under Section 109(g) of the Bankruptcy Code, which defines who can be a debtor. Serial filers are usually ineligible to file under section 109(g) for six months after the dismissal of their last bankruptcy. Thus, if a debtor files a second bankruptcy within six months of a prior dismissal, the automatic stay would not apply to a foreclosure sale. Lenders foreclosing on an asset should therefore move promptly after the dismissal of a bankruptcy to relist it with the sheriff’s office. For banks that have experienced the exasperation of scheduling foreclosure sales of mortgaged property, only to see them repeatedly cancelled by serial bankruptcy filings, these amendments should provide a welcome benefit.
Debt Reaffirmation Agreements
The act requires additional disclosures for debt reaffirmation agreements, including a summary of the reaffirmation agreement, disclosure of the amount reaffirmed, the annual percentage rate, the security, and the repayment schedule. The act also requires additional disclosures to debtors, including their right to cancel the reaffirmation agreement any time up until the discharge order is entered. A bankruptcy judge can reject a reaffirmation agreement if it appears a debtor lacks sufficient funds to make the agreed-upon payments.4
Limits on Lien Stripping in Chapter 13
Under current law, when the value of a secured creditor’s claim exceeds the value of the collateral, a debtor can strip down the secured claim to the value of the collateral and treat the remainder as unsecured, on which the lender will likely incur a loss. This procedure, known as a cram down, is frequently a problem with car loans because cars rapidly depreciate in value.
The act prohibits a debtor from stripping down a lien on consumer goods purchased within one year preceding the bankruptcy and on cars purchased within two and a half years preceding the bankruptcy. A debtor would have to repay the full value of the claim if the loan were made within the lookback period, regardless of the vehicle’s actual value. These provisions will significantly benefit banks with car loan operations.
Tightening Discharge Rules
The act provides additional reasons for denying discharge of a claim and strengthens existing ones. Of particular interest to banks with credit card operations, the act lowers the threshold for presuming a denial of discharge for luxury goods and cash advances. The amount for the “luxury goods” threshold is lowered to $500 from $1,225, and the cash advances threshold is lowered to $750 from $1,225. The lookback period for these items is lengthened from 60 to 90 days for luxury goods and from 60 to 70 days for cash advances. Thus, if a debtor purchases luxury goods of $500 or more within 90 days of filing bankruptcy or obtains a cash advance of $750 or more within 70 days of filing bankruptcy, the debt will not be discharged. These provisions will help reduce losses on these items.
Prohibition Against Ride-Through
Under current law in some circuits, including the Third Circuit, a debtor can retain secured property in a Chapter 7 filing, after discharge, without filing a reaffirmation agreement by continuing to make installment payments on the debt. This practice is known as “installment redemption” or “ride-through.” The act prohibits this practice and instead requires a debtor to file a statement of intention for the property when the petition is filed.
Mystery Notice Problem Addressed
Creditors frequently receive bankruptcy notices that lack an account number or other information that would enable them to identify the account. To address this problem, notices must now be sent to the address specified by the creditor for correspondence and must include the last four digits of the debtor’s tax identification number and the debtor’s account number. If a debtor fails to give proper notice, the debt is not discharged. Furthermore, as an additional means of ensuring that creditors are notified when their customers file for bankruptcy, the act permits a creditor to file a notice of address with any bankruptcy court. If the notice is filed, the bankruptcy court notifies the creditor whenever debtors list the creditors in their bankruptcy petitions. Thus, if a debtor listed the incorrect address for the creditor, the creditor would still receive notice.
In contrast with existing law, the act requires debtors to perform certain duties or suffer dismissal or other serious consequences.
Statement of intention regarding property. Debtors with property secured by a lien must file a statement of intention before the first meeting with their creditors. The statement must specify whether the debtor intends to surrender, reaffirm, or redeem the debt. If a debtor fails to comply, the automatic stay is lifted for the property without the filing of a motion.
Mandatory credit counseling and financial management courses. The act requires a debtor to complete a consumer credit counseling course from an approved nonprofit agency and to file a certificate of completion within 180 days before filing for bankruptcy. In addition, debtors must complete an education course in personal financial management approved by the U.S. Trustee before they receive a discharge of debts. Debtors are ineligible for discharge unless they complete both the credit counseling and financial management courses.
Providing tax returns and other financial documents. The act requires debtors to file certain financial documents with the bankruptcy court within 45 days of filing the bankruptcy petition, including an itemized statement of net income, a statement disclosing any reasonably anticipated income or expenditures over the 12 months following the filing of the petition, and pay stubs for the 60-day period preceding the bankruptcy. Debtors must also provide the trustee with their most recent tax return, and they have a duty to provide future tax returns throughout the course of the bankruptcy. Failure to file the required documents will result in automatic dismissal of the case on the 46th day. A debtor must also provide proof of insurance to secured creditors on property subject to a security interest.
Establishing IRS Standards
To prevent debtors from exaggerating their living expenses, the act establishes national standards for allowable amounts for various living expenses based on guidelines promulgated by the IRS. This will benefit creditors by increasing the amount of income available for a Chapter 13 plan.
Sanctions Against Debtors’ Counsel
The act places greater responsibility on debtors’ counsel to ensure the accuracy of documents filed with the bankruptcy court. First, attorneys must perform a reasonable investigation into the circumstances of a bankruptcy petition, pleading, or written motion they file with the court. Second, an attorney’s signature on a bankruptcy petition constitutes a certification that, after conducting a reasonable investigation, counsel has no knowledge that the information in the schedules is incorrect. Counsel can be ordered to pay attorney’s fees for any violations.
The act does not define “reasonable investigation,” but attorneys must be able to document their efforts to verify the information in debtors’ schedules before filing. This might include obtaining a credit report; verifying whether debtors have filed prior bankruptcies; reviewing bank statements, tax returns, and pay stubs; and examining property valuations of taxing authorities. The act also contains a specific provision authorizing sanctions against an attorney if a case is converted from Chapter 7 to Chapter 13 and the court determines the attorney did not adequately investigate the debtor’s eligibility to file under Chapter 7. These potential sanctions will place pressure on debtors’ counsel to ensure the accuracy of their filings.
To prevent debtors from forum shopping for the most generous state exemptions, the act permits debtors to use a state’s exemptions only if they resided there two years before filing, in contrast with the current requirement of six months. If debtors have not been domiciled in a single state for the two-year period, the Reform Act uses the state where they resided for the six-month period two years prior to filing bankruptcy. This means that a debtor must wait at least two years after moving to a new state to qualify to use that state’s exemptions.
Homestead exemptions also have changed. Some states, notably Texas and Florida, have unlimited homestead exemptions, which prevent creditors from reaching any portion of a debtor’s principal residence regardless of its value. Under the act, a debtor who resides in a state for less than three years and four months before filing bankruptcy is subject to a maximum homestead exemption of $125,000. If there is evidence of fraud, the homestead equity is always limited to $125,000, regardless of the length of ownership. The act also limits homestead exemptions to $125,000 for debts arising from securities laws violations, fiduciary fraud, or racketeering or for crimes or intentional torts that result in serious bodily injury or death.
Protection for Debtors
A debtor can reduce unsecured creditors’ claims by up to 20 percent in limited circumstances. If a credit counseling agency approved by the United States Trustee Program proposes to a creditor, at least 60 days before filing for bankruptcy, to settle a debt for at least 60 percent of the value of the debt and the creditor unreasonably refuses, a debtor can file a motion to reduce the creditor’s claim by up to 20 percent.
In summary, the act makes substantial changes to consumer bankruptcy law that will make it significantly more difficult for consumers to file bankruptcy and to receive a discharge. It will take some time to see how the changes are implemented and how debtors respond, but it appears that banks should fare better under the new law. Indeed, in the weeks leading up to October 17, 2005, bankruptcy courts around the country experienced a record number of Chapter 7 filings, as debtors raced to file before the new law took effect.
If you have any questions about this article, please contact Consumer Regulations Specialist Kenneth J. Benton or Supervising Examiner John D. Fields through the Regulations Assistance line at (215) 574-6568.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.