Fundamentals of Personal Bankruptcy Law

Bankruptcy law is a debt-collection law that insures people to some extent against the inability to repay their debts as they fall due. The vast majority of people file for bankruptcy under either Chapter 7 or Chapter 13 of the bankruptcy law (specifically, title 11 of the U.S. Code). (Certain consumers can also file under Chapter 11 or Chapter 12.) Chapter 7 is used by about 70 percent of filers; it provides for "straight bankruptcy," or the liquidation of assets. Chapter 13, entitled "Adjustment of Debts of an Individual with Regular Income," is a court-sponsored debt-refinancing plan.

Debt Collection and Insurance

The procedures by which creditors can collect debts are laid out in state commercial law as well as in bankruptcy law. State commercial law outlines the process for staking a claim to what is owed; it also ranks those claims and details the "remedies" available to creditors to satisfy or collect them. State law for debt collection is a "grab law," based on the notion of first come, first served.

Accordingly, the creditor that first stakes a claim to particular assets of a debtor is entitled to be paid first (Jackson 1986). The legal remedies for creditors, such as foreclosure on and the sale of property, allow them to collect what they are contractually owed, and from the point of view of state law, debtors are required to repay debts in full, regardless of the circumstances. But debtors sometimes default on their debts, and grab law makes no provision for sharing the risk of such defaults--either among creditors or between debtors and creditors. That results in an inefficiency; in other words, society would be better off with provisions for sharing default risk. The inability of borrowers to shift such risk also creates what is known as an adverse selection problem for creditors: risk-averse consumers will shy away from borrowing, leaving creditors with a group of riskier borrowers.

Bankruptcy law can better allocate the risk of default for the economy in comparison with the allocation provided by state commercial law. Most important, bankruptcy law spreads default risk among borrowers and lenders by providing borrowers with some insurance against their inability to repay their debts. The insurance "payoff" for borrowers is the opportunity to receive a discharge (or forgiveness) of their debts and to keep certain assets to start life afresh after bankruptcy. As a result, that insurance gives people an incentive to increase their borrowing because they know they will not be impoverished if they cannot repay their debts. Society benefits from this aspect of greater risk spreading because it allows people to better plan their consumption--they can finance it when they desire it most rather than when they have the cash to pay for it.

In the long run, borrowers pay the cost of the insurance provided by bankruptcy law. To recoup their losses from bankruptcy, creditors will raise the cost of borrowing by using a combination of stricter standards and terms on their loans, such as higher interest rates, larger down payments, and restrictions on the supply of credit. Essentially, the premium borrowers pay for the insurance coverage of bankruptcy is that additional cost of borrowing. In the short run, creditors will share some of the risk of default if their loan losses are greater than expected. Moreover, if the law is tightened, creditors are likely to profit--at least temporarily (see the later discussion).

The strength of the law's incentive to borrow and the cost of borrowing depend on the magnitude of the fresh start. The greater the fresh start, the greater are the incentive to borrow and the cost of borrowing. A larger fresh start also gives people more incentive to use bankruptcy, rather than other means, to solve their financial problems and escape debt repayment. Consequently, a bankruptcy law with a generous fresh start may promote greater risk spreading, but it can also raise the cost of borrowing by expanding the fresh start and making it easier for people to walk away from debts that they could afford to repay.

The difficulty of achieving a desirable trade-off between the benefit of risk sharing and its cost helps explain several changes to bankruptcy law since the late 1970s: The Bankruptcy Reform Act of 1978 (BRA-78) was the first overhaul since 1898 and the first major revision since the Chandler Act of 1938 introduced the wage-earner Chapter XIII plan, precursor to the current Chapter 13. BRA-78 had several goals: to modernize bankruptcy law following the tremendous growth of consumer credit in the post-World War II period, to improve the fresh start for personal filers, and to reform a bankruptcy court system that many people viewed as inefficient and unfair.

The Bankruptcy Amendments and Federal Judgeship Act of 1984 sought in part to curtail alleged abuses of bankruptcy law by reducing bankruptcy's benefit for consumers.

The Bankruptcy Reform Act of 1994 made a host of changes in the bankruptcy code; among other things, it doubled the dollar value of federal asset exemptions (which had not been adjusted for inflation since 1978) and included provisions to curtail bankruptcy fraud.

Basic Provisions of Chapter 7

Under Chapter 7, the administrator of a bankruptcy case, who is known as the trustee, oversees the liquidation, or sale, of a debtor's nonexempt assets and the distribution of the proceeds to creditors. Only creditors with "allowable" claims in the case receive a share of those proceeds, which are distributed after the trustee's expenses, other administrative costs, and priority claims have been paid.(8) Unless the court finds that the debtor was dishonest or engaged in wrongdoing, it discharges (forgives) all allowable claims on the person and his or her assets except for nondischargeable claims (for example, many kinds of taxes) and any debts covered under reaffirmation agreements (in which the person specifically agrees to repay one or more debts). The debtor keeps the value of the assets designated as exempt under the law (the fresh start discussed above) and may not receive another discharge under Chapter 7 for six years.

Although bankruptcy law is federal in scope, provisions designating exempt assets appear in both federal and state law. BRA-78 introduced federal exemptions but allowed states to "opt out" of using the federal limits and continue using their own. Today, 35 states do not use the federal exemptions; in the remaining states, residents may use either the federal or the state exemptions. Both federal and state exemptions cover broad categories of assets including primary residences; motor vehicles; various kinds of personal property, such as household goods and clothing; and the tools of a person's trade. However, the particular types of assets that may be exempt and the dollar values of those exemptions vary widely.

The homestead exemption is a good example of how dollar values for asset exemptions differ among the states. Georgia allows bankrupt consumers to keep only $5,000 of equity in real property used as a residence; Florida, in contrast, allows an unlimited amount of equity in as much as one-half acre in a municipality or 160 contiguous acres elsewhere (King 1998). The federal dollar limit on the homestead exemption is currently $16,150 and is adjusted for inflation every three years.

Basic Provisions of Chapter 13

Chapter 13 helps people avoid liquidation of their assets by requiring them to repay their debt out of future income. To qualify for a Chapter 13 discharge, debtors (with the exception of stockbrokers and commodity brokers, who are covered by separate provisions) must have a regular income, and their unsecured (such as credit card) and secured debts must total less than $269,250 and $807,750, respectively. The debt limits are adjusted for inflation every three years.

Under Chapter 13, the debtor works with the trustee and submits a plan to the court to repay outstanding debts over three (or, in some circumstances, five) years. The plan must satisfy three criteria: First, although the plan may call for less than full repayment of certain debts, creditors must receive at least as much as they would have received if the consumer had filed for bankruptcy under Chapter 7 and liquidated his or her nonexempt assets.

Second, the trustee and all unsecured creditors must agree to the plan. If one of them objects, the debtor must use all of his or her income in excess of reasonably necessary living and business-related expenses for debt repayment.

Third, the court must determine that the plan has been filed in "good faith"; otherwise, the plan may be dismissed.

When the payments are completed, the consumer receives a discharge from all debts that the plan covered. A Chapter 13 filing has three advantages (relative to a Chapter 7 filing) that encourage people to use it: debtors retain all of their property, not just their exempt assets; a greater variety of claims can be discharged; and consumers may be able to repay less than they owe on certain secured debts.

Source: The U.S. Congressional Budget Office