Thomas Evans & Paul B. Lewis, an Empirical Economic Analysis of the 2005 Bankruptcy Reforms

• Jurisdiction: United States,Federal
• Publication year: 2011
• Citation: Vol. 24 No. 2

AN EMPIRICAL ECONOMIC ANALYSIS OF THE 2005

BANKRUPTCY REFORMS

Thomas Evans^*

Paul B. Lewis^**

INTRODUCTION

The Bankruptcy Abuse and Consumer Protection Act of 2005 (the "Act")¹was signed into law on April 20, 2005, and took effect on October 20, 2005. The Act represents the most significant change in personal bankruptcy law since the Bankruptcy Code's (the "Code") enactment in 1978.

The Act passed into law following a period of time in which bankruptcy filing rates were increasing,²despite low unemployment, low interest rates, and generally increasing economic prosperity.³Among the stated goals of the Act was to limit access to bankruptcy relief, in part, to ferret out and limit abuse.⁴

The Act generated a large amount of commentary, both from academia and the popular press. Much of the commentary has focused on the addition of the so-called "means test" to be eligible for relief under chapter 7 of the Code.⁵

Many have decried the means test, designed to limit access to chapter 7 bankruptcy for debtors of a certain financial stature, as unfairly altering the balance between debtors and creditors in that it could potentially deny bankruptcy relief to a sizable number of individuals.⁶Others have argued that the means test is an appropriate method to deal with certain perceived bankruptcy abuses.⁷

This Article makes three contributions to the debate. First, in Section I, we describe the two primary bankruptcy routes for which consumer debtors may opt: chapter 7 or chapter 13. We include both the major advantages and disadvantages of the respective choices and the primary changes in bankruptcy law stemming from the Act. Second, in Section II, we present empirical evidence of the effect of the Act on both the number of personal bankruptcies, and on the relative fraction of chapter 7 and chapter 13 filings. The goals of the Act were to reduce the total number of bankruptcies, and to reduce especially the incidence of chapter 7 declarations. Using separately gathered national level, state level, and micro-data from the United States Bankruptcy Court for the Northern District of Illinois, we find that the Act was causal in reducing the total number of personal bankruptcies by approximately 200,000 per quarter (a reduction of approximately 40%), and in reducing the fraction of chapter 7 bankruptcies from 0.7 to 0.6. Third, in Section III, we provide a discussion of the meaning of the fresh start, and put the Act in both historical and international perspective.

I. OVERVIEW OF PRE-ACT BANKRUPTCY LAW AND THE MAJOR

AMENDMENTS

The Code⁸provides for two primary forms of consumer bankruptcy proceedings. The first, known as chapter 7, has in recent years been the overwhelmingly favored option among debtors.⁹The other is known as chapter 13. The preference for chapter 7 rather than chapter 13 among debtors, and the accompanying ability of chapter 7 debtors on average to discharge far greater amounts of debt than their chapter 13 counterparts, was in large part the motivating force for bankruptcy reform in the United States.

Chapter 7 is designed to provide debtors with a simple and relatively inexpensive method of obtaining a bankruptcy discharge. In chapter 7, debtors may obtain a discharge of prepetition debts without incurring future debt payment obligations as long as they relinquish all non-exempt assets owned at the time of bankruptcy for distribution to creditors. Chapter 7 debtors need not pay creditors out of future income.

The amount of available exemptions is, thus, very significant for chapter 7 debtors and their creditors. Debtors may generally opt for either the Code's exemptions¹⁰or for those of their state of domicile. The exemption amounts vary greatly, both across states, and between those available under the Code and those available under individual state law. Most notably, the homestead exemption under existing bankruptcy law has been $15,000.¹¹By contrast, those debtors opting for the exemptions available in their state may have a homestead exemption ranging from nothing to the unlimited homestead exemption long available in Texas and Florida.¹²

Under chapter 13 to obtain a discharge, a debtor must repay a portion of his or her indebtedness from future earnings over what historically had been a standard three-year period. These payments are made pursuant to a court- approved plan. Unlike a chapter 7 debtor, a debtor in chapter 13 is not required to relinquish any non-exempt assets. Rather, payment is made out of postpetition assets, including future earnings, acquired during the duration of the plan. In the event that a trustee or an unsecured creditor objects to confirmation of the debtor's proposed payout plan, the plan must conform to the projected disposable income requirement. This requirement mandates that the plan provide for the debtor's entire projected disposable income for the life of the plan be applied to creditor payments under the plan. The projected disposable income calculation requires a projection of how much the debtor will earn over the plan period and a deduction from that amount of expenses that are reasonably necessary for support of the debtor and his or her dependants. The resulting amount must be used to fund the plan.¹³

As an incentive to choose chapter 13 rather than chapter 7, chapter 13 debtors receive what is often referred to as a "super-discharge." Section 523 of the Code provides for numerous types of debt that are non-dischargeable in a chapter 7 proceeding. Of the eighteen non-dischargeable debts under pre-2005 law, all but three had historically been dischargable in chapter 13.¹⁴

The treatment of secured claims in chapter 13 is noteworthy. Chapter 13 provides two methods by which debtors may deal with an accelerated secured loan. Under the first, known as modification under pre-Act law, if a secured creditor refused to accept a proposed plan and if the debtor refused to voluntarily surrender the encumbered collateral, a plan could still be confirmed so long as it provided for repayment of an amount, as of the effective date of the plan, that is at least equal to the amount of the allowed secured claim.¹⁵If the collateral is worth less than the outstanding debt, the value of the secured claim-and thus the amount of payment-is based on the collateral value, not the debt value. This was the so-called "cramdown" effect of chapter 13. Thus, a chapter 13 debtor could, over the objection of the secured creditor, effectively redeem the collateral by paying off its value in installments over the life of the plan.

The second principle method of treating secured claims in chapter 13 is reinstatement and cure. Unlike modification, this is a return to the initial terms of the loan. The default is deemed cured, and the loan is deemed reinstated.

When this happens, the debtor assumes two obligations. First, any obligation that is overdue must be cured within a reasonable time; and second, any obligation that has not yet become due remains payable on the original due date. Reinstatement and cure tends to be used more frequently than modification because unlike modification, reinstatement and cure may be used for debt secured by a debtor's primary residence.¹⁶

There tend to be a number of factors why individuals choose chapter 13 over chapter 7. Among the most compelling factors are the existence of substantial non-exempt property that would be liquidated in a chapter 7 but which may be retained in chapter 13,¹⁷and the possibility of discharging certain debts in chapter 13 which cannot be discharged in chapter 7.¹⁸

Alternatively, the debtor may believe that chapter 13 involves less stigmatization or may result in a lesser impact on the debtor's credit rating.

Nationally, the Act's goals-to reduce consumer filings and to alter the percentage of chapter 13 filings relative to chapter 7 filings-appear to have initially succeeded. Consumer filings dropped following the Act's enactment from roughly 1.5 million per year over the past few years to an annualized rate of approximately 800,000.¹⁹In addition, the percentage of debtors filing under chapter 13 has initially increased.²⁰

By moving more debtors into chapter 13, the amount of debt repayment creditors can expect to receive when their debtors enter bankruptcy will likely rise. This result comes from two directions. First, chapter 13 debtors on average repay their creditors significantly more than do chapter 7 debtors.²¹

Second, and perhaps more importantly, while virtually all individuals who file under chapter 7 receive a discharge, roughly only one-third of debtors who file in chapter 13 successfully complete the required payment schedule and obtain a discharge.²²Thus, roughly two-thirds of chapter 13 debtors obtain little or no relief from their creditors by virtue of the bankruptcy laws. The Act's attempt to accomplish its goals comes largely through an expansion of the definition of when a chapter 7 filing constitutes an abuse of the bankruptcy process. The new standard used to determine chapter 7 eligibility is commonly referred to as the "means test."

Under the Act, when a debtor whose income is greater than the median income for his or her state of residence²³files a case in chapter 7, the bankruptcy trustee, the court, or any other party in interest²⁴may bring a motion to dismiss a chapter 7 filing for abuse²⁵under Sec. 707(b) of the Code. In such an occurrence, the "means test"²⁶will be employed to determine whether the debtor may remain in chapter 7, whether his or her case will be dismissed, or, with the consent of the debtor, whether the case will be transferred to one under chapter 13. Under the means test, abuse of the bankruptcy process will be presumed²⁷if the debtor's current monthly income,²⁸less payments on secured and priority debt divided by sixty, minus allowed personal expenses,²⁹exceeds one of the Code's two trigger points.³⁰If the debtor will have at least

$6575 over five years, abuse is presumed if that income...