Americans have had a nice safety net in the personal-bankruptcy laws, which allowed debtors to wipe away much or even all of their outstanding obligations. What's more, the process is fairly easy and inexpensive. More than a million people pursue this option every year in the United States. And it's even losing its stigma. After all, many celebrities -- Burt Reynolds, Wayne Newton, Kim Basinger, MC Hammer -- have filed for bankruptcy, as have a lot of well-known companies. For several decades, in fact, bankruptcy appeared to be the standard operating practice among U.S. steel companies.
Of course, this is all bad news for lenders -- especially credit card companies, which have to write off much, if not all, of their bankrupt customers' debt. As a result, the financial industry has lobbied hard over the past seven years to make the bankruptcy process more onerous.
It worked. Effective today, there will be a new federal bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This law is a clear signal that the pendulum has swung toward the interests of lenders. And it marks the most momentous change in U.S. bankruptcy laws since Jimmy Carter was president.
Traditionally, when a person filed for personal bankruptcy, Chapter 7 was the preferred method. Since the purpose of bankruptcy was not to punish but to provide a "fresh start," debtors would have certain types of assets that were exempt from liquidation (in some cases, no assets would be liquidated) and could cancel all debts remaining after liquidation. True, this is harmful to a person's credit rating. But over time, credit can be re-established.
Under the new law, Chapter 7 will be much harder for people to elect. Debtors will be subject to a means test and will not qualify if they exceed the median income for the state they live in and have the ability to pay $6,000 of unsecured debt over five years. The most common form of unsecured debt is credit card obligations.
"The means test will mean a massive increase in the number of Chapter 13 filings," said Aaron Malo, a partner at the law firm Sheppard Mullin. Under Chapter 13, debtors must agree to a repayment plan that lasts five years. After deducting for minimum living expenses, the remaining income most go to pay creditors.
The new law also makes the bankruptcy process much more cumbersome. Debtors must provide much more disclosure, bankruptcy attorneys most vouch for the disclosures, and any false disclosures will result in fines and sanctions. Thus, it should be no surprise that bankruptcy attorneys will increase their fees.
Moreover, expect financial institutions to significantly increase their collection and recovery efforts in the expectation that there will be many more Chapter 13 filings. In fact, financial institutions may start taking legal actions against debtors. Once a judgment is obtained, financial institutions can normally get an interest-bearing stake against the credit card borrower for up to 10 years, with the right to renew it for another 10.
The new law also requires that a debtor undergo credit counseling six months before filing for bankruptcy.
OK, suppose you have a major life event, such as a disability or death of a spouse. Well, there are no hardship provisions. Unfortunately, the new law is quite strict. People might've taken note in some way, shape, or form -- bankruptcy filings are up nearly 14% compared with last year, according to a recent Wall Street Journal article.
On the brighter side, qualified service providers, like Financial Solutions LLC, can help people renegotiate their debt to avoid a bankruptcy filing. "We do everything possible to get the client to avoid filing a chapter 7 or 13," said Lief Fiel, the firm's co-founder. "In most instances, credit card debt, judgments, and liens can be negotiated."
The changes in bankruptcy laws have made it more important that debtors take actions now to improve their financial situations. For example, look at insurance -- such as disability and life policies -- and make sure you have about three months' worth of living expenses in the bank. And, of course, The Motley Fool has many resources on debt management and budgeting -- including the Credit Center, our how-to guide on getting out of debt, and our community discussion boards -- that can be a great help in tough situations.
See John Reeves' story for more on the new bankruptcy law.
Fool contributor Tom Taulli can be reached at [email protected].
