Bankruptcy filings surged to surpass 1.4 million in 1998 despite a robust economy, the longest expansion in post-WW2 history and the lowest unemployment in three decades. Annual bankruptcy filings now more than double the number which occurred during the entire decade of the Great Depression. The national bankruptcy rate has been growing eight times as fast as population, amounting to a fifty-fold increase in five decades. Last year there was one bankruptcy for every 68 US households. Bankruptcy has become epidemic in some states. In Nevada, with one filing for every 39 households last year, it may have become a way of life.

Ninety-seven percent of bankruptcies are consumer filings. Consumer filings increased more than seven-fold over the last two decades. Why the surge? Debtor distress can not be blamed on the prosperous economy. Have consumers become inept in their personal financial management? Are moral scruples about repaying debt on the decline? Perhaps a growing number of debtors are utilizing an overly generous legal system as a form of shrewd financial management.

The total amount of consumer debt has increased steadily along with the personal bankruptcy rate. But disposable income has increased too. The debt service burden - the percentage of disposable personal income used to pay interest and principal - now around 17%, is about the same as a decade ago while bankruptcy filings have doubled. The burden of debt has not increased, but since more debt is owed, more is dischargeable and the benefit of eliminating it via bankruptcy has increased.

The composition of consumer debt has changed with growing credit card usage. About 43% of non-mortgage consumer debt is unsecured revolving credit compared to 14% in 1978. A 1978 Supreme Court ruling allowing banks to lend across state lines unaffected by state usury laws coupled with a general deregulation of state interest rate ceilings gave birth to a quickly growing consumer credit card industry and such unsecured consumer debt is easily dischargeable in bankruptcy.

It's difficult to measure changing moral attitudes. Many believe that bankruptcy's stigma and embarrassment has faded. Judge Edith Jones of the National Bankruptcy Review Commission noted in congressional testimony that, "The current system of bankruptcy law permits any person to seek relief without demonstrating financial necessity. At one time in our history, filing bankruptcy was regarded as shameful, and filers suffered social stigma and permanently ruined credit. The shame and stigma are no longer compelling. .. [M]any filers now commence cases without ever having been in default on their debts. This suggests that bankruptcy is, to them, not a last resort but a first resort. Many debtors are well-off and continue to be fully employed before and after filing bankruptcy. Lawyer advertising, do-it-yourself kits, and bankruptcy mills expand the pool of potential filers. Well-publicized celebrity bankruptcies, plus "water cooler" gossip about increasing filings, have tended to reduce bankruptcy to an acceptable alternative for personal financial management."

Legally discharging unpaid debts in bankruptcy is now regarded more as a tool of smart financial management and less of an embarrassment. Oddly, some mortgage lenders recommend bankruptcy to remove high debt loads enabling potential home buyers to qualify for loans.

Economists do not question why the bankruptcy rate is so high, but rather why it's so low. University of Michigan Professor Michelle White estimates that 15.4% of US households could financially benefit from bankruptcy. Less than a tenth of those households actually file. Even more could benefit through strategic behavior prior to bankruptcy. If debtors convert nonexempt assets to exempt property legally retained by the debtor and not part of the estate used to pay creditors, e.g. using cash to contribute to IRAs or paying off home mortgages, the percent who could benefit rises to 17.5%, and to 22.6% if debtors move to states which allow higher exemptions. Last minute borrowing and spending sprees on the eve of filing could increase it even further. The mass of potential filings waits to be tested in the next economic downturn.

One reason filings are not higher is the moral cost or stigma, yet some say this may be declining. However, it's hard to rationalize some debtors valuing that more than the financial windfall. A sense of justice in voluntarily repayment may not outweigh possibly erasing $20,000 in debt. The best explanation for why the bankruptcy rate is not higher is informational. Simply, many debtors are unaware of the sweetheart deal until they become distressed, seek legal advice, respond to ads, or speak with the growing number of friends and relatives who have used bankruptcy to remove debts. It's a relatively painless maneuver - as easy as a doctor can remove a cyst, a lawyer can remove unwanted debts.

Many debtors find out about the good deal from legal advertizing. After the US Supreme Court ruled in 1977 that state laws banning legal advertizing violated free speech rights, legal advertizing quickly grew from $5 million in TV ads in 1980 to $129 million in 1994. Bankruptcy filings began to accelerate around the same time and are closely correlated with legal advertizing according to a recent FDIC study.

Is the surge attributable to the generosity of the law? Most consumer filings occur under Chapter 7 Liquidation where debtors retain exempt property allowed under state or federal law with the rest of their estate used to pay off debts pro rata discharging the remaining unpaid balances. Future income is not required to be used to pay off debts. A person earning a million dollars a year is entitled to a discharge. Exemptions can be generous. In some states, homestead exemptions are set by area as opposed to value. Florida's 160 acre exemption allowed Paul Bilzerian to retain a $6 million, four story, 11 bedroom, and 20 bath mansion near Tampa. In a Virginia case, the owner of a failed mortgage company was allowed under state law to keep his "one horse" - an $800,000 racehorse purchased just prior to filing. Courts have permitted debtors to keep mink coats, Rolex watches and expensive jewelry as "clothing," plus valuable antiques as household furnishings. Bankruptcy law not only protects O.J. Simpson's $4.1 million in pension assets against the $33.5 million civil damage award for the wrongful deaths of Nicole Simpson and Ronald Goldman, but even allows the judgement to be fully discharged. Chapter 7's title, "Liquidation," is a misnomer since in 96 percent of cases there is no estate to liquidate and creditors receive nothing. The "liquidation" in practice is merely a few pages of paper filed with the court removing unwanted debts.

Alternatively, debtors can choose Chapter 13 where they keep all assets and attempt to pay back some debts with disposable income leftover after living expenses under a plan lasting three to five years. "Expenses" in some cases have included tithing to churches, gifts, vacations, and private school tuition costs for dependents when public school is available.

Discharges are generally limited to one every six years. But once the forbidden fruit is bitten, many bankrupts come back again to discharge debts. Some plan their bankruptcies, incur debts and spend monies without the intent to repay. Approximately 8.6 percent of filers have declared bankruptcy once before, 2.5 percent have declared three or more times.

The ease of obtaining a discharge has lead to reckless spending and abuse of law. For example, Doctor Hashemi took his family on a six week, $60,000 European vacation charged to his American Express card, and upon return promptly declared bankruptcy seeking a discharge. Mr. Uddin, an unemployed New York waiter, amassed $170,500 in debts over six months for airline tickets, consumer electronics, perfume, cosmetics, and gambling trips to Atlantic City. He obtained $50,000 in cash advances on his credit cards, claimed he lent it to a friend who defaulted and disappeared, and asked the court to absolve him of his debts. Judge Newsome in his Congressional testimony noted a case where one couple ran up $177,000 on 34 credit cards.
 

HOW DID WE GET HERE?

The genealogy of bankruptcy law is a fascinating story of transformation in jurisprudence. At the time the US Constitution was framed, bankruptcy was a criminal act of debtor fraud, a felony punishable by death in English Courts. In stark contrast under modern law, it's considered a social welfare program for debtor relief.

Modern bankruptcy statutes are directly traceable to ancient Roman law. In a publically condoned form of self-help, unpaid creditors could seize the debtor's property and person. The debtor and family were then sold into slavery to satisfy debts. No "personal" exemption existed., the debtor's body was part of the estate. The most notorious part of Roman Law, de debitore in partes secando, empowered creditors to divide the debtor's body proportionately among them. Despite the seeming cruelty, debtors freely posted their bodies as mortgage collateral aware of the implications of default. Such bonds were later immortalized in Shakespeare's Merchant of Venice, where the banker Shylock tried to collect his pound of flesh from bankrupt Antonio.

Modified Roman law was revived in the Medieval France and Italy and first adopted by England in 1542. Bankrupts were defendants accused by plaintiff creditors of committing bankruptcy. Acts of bankruptcy were forms of debtor fraud, typically absconding with property to avoid legal processes and paying debts.

Etymological roots arise from "banqueroute" in French and "banca rotta" in Italian. Banqueroute signified being on the 'route' or the lam, the debtor a fugitive from creditors, often recklessly spending and living extravagantly on the run. 'Banca' refers to the table or board from which traders sold their wares and money changers bought and sold foreign coins in Medieval town squares - giving rise to the word bank. 'Rotta' means broken, rotted or ruptured. Banca rotta literally means broken board as it was custom to break the bankrupt's work bench, often over his head.

The main purpose of bankruptcy law was to recover property from absconding debtors for the collective benefit of creditors who equally shared from the estate. Otherwise, first-come first-served rules under common law unfairly favored those who first arrived to the courthouse with latecomers receiving nothing.

The discharge of indebtedness was forbidden until the early eighteenth century. It was introduced under English law to reward honest debtors who showed up for court and revealed property instead of fleeing. It was also a temporary relief measure after a very large fraudulent bankruptcy caused the insolvency of many defrauded merchants and a financial panic. A discharge could only be obtained if creditors approved by a four-fifths, an extension of their voting rights over trustees who liquidated the estate.

In colonial America, the palms of bankrupts were branded with a "T" for thief. Punishment under Pennsylvania's Bankruptcy Act of 1785 borrowed from English custom and included standing the bankrupt in a public place for two hours with an ear nailed to the pillory and then cut off. Besides punishment, the "earmark" served to mark the bankrupt as not being a reputable person with whom to contract debts. Bankrupts in France were subject to public humiliation, paraded naked at the time of their estate's attachment, and forced to wear shameful green berets. Most European bankrupts became legally infamous, could not vote, hold public office, contract new debts, or engage in commercial enterprise, unless they repaid their original debts and thereby legally becamem rehabilitated with their names removed from the official list of bankrupts.

The power to establish uniform laws over bankruptcy was delegated to the federal government since fraudulent debtors could otherwise easily abscond between the states to avoid attachment of property. As James Madison remarked in 1788, "The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be moved into different States." At the US Constitutional Convention, Roger Sherman voted against including bankruptcy as a federal power because it was punishable by death under English law and did not want to grant the government such a power.

At that point, bankruptcy was a means for honest creditors to compel fraudulent debtors to surrender property for a rateable recovery on just debts. Creditors were plaintiffs, debtors defendants. Only merchants and traders were eligible. The discharge of indebtedness was only granted if the prerequisite number of creditors signed a discharge certificate.

This would change in repeated episodes of debtor relief during periodic economic collapses. After the Panic of 1837, then the deepest depression in US history, debtor relief became part of the Whig presidential platform to win the votes of distressed debtors. The 1841 Act allowed debtors to voluntarily petition themselves into bankruptcy and widened eligibility to non-merchants and thus access to the discharge. Widespread fraud and abuse occurred. Friends and family of debtors often would claim fictitious debts, share in the distribution from the estate, and then vote for a discharge. This lead to its repeal after a mere 13 months.

The 1867 Act was to absorb the bad debts from the Civil War. Creditors were restricted to voting over the discharge only in cases where creditors recovered less than 50¢ on the dollar. Meager personal property exemptions prior usually included wearing apparel and tools of trade. The 1867 Act allowed states to set their own property exemptions. States in the South legislated generous homestead exemptions over real property set by acreage and unlimited by value effectively preventing Northern creditors from collecting a dime. After the Panic of 1873, the statute was amended in 1874 for debtor relief again weakening voting creditor rules over the discharge. It was repealed in 1878 with a return to prosperity and again amidst a general distaste for extensive corruption in obtaining discharges.

The 1898 Act occurred during the second worst depression in US history and removed all creditor voting over the discharge in consumer cases. The discharge of debt was no longer discretionary, it became an entitlement. The Great Depression again ratcheted up benefits for debtor relief; introducing three to five year payment plans for wage earners during which secured creditors could not enforce liens, business reorganization as an alternative to liquidation, and municipal bankruptcy whereby government entities could discharge unpaid debts.

Law changed again in 1978. Corporate executives no longer lost their jobs to court appointed trustees under Chapter 11. During proceedings, companies could continue to operate, borrow new money against the estate senior to prebankruptcy debt, and offer creditors who could not enforce claims interim a fraction of what was owed via the plan of reorganization. As a result, many unprofitable small companies which should have shut down continued to operate until the estate withered away. In many large corporate cases, old equityholders retained a portion of the stock in the new company emerging from reorganization despite creditors being paid less than in full. Business bankruptcies surged nearly 50% the first year the act was effective under the more favorable rules.

Consumer debtors also benefitted under the 1978 Act. The amount of personal property retained by debtors while they discharged debts was increased further encouraging bankruptcy filings. It also widened eligibility to Chapter 13 repayment plans to encourage such over Chapter 7 liquidation so debtors could keep their residences, expanded upon the list of dischargeable debts types, and limited the ability of creditors to prevent the discharge for cause.

Supreme Court rulings circa making state usury laws not applicable to intestate lending leading to an explosion of unsecured consumer credit easily dischargeable in bankruptcy, and the legalization of legal advertizing making consumers aware of their ability to rid themselves of unpaid debts in bankruptcy, compounded the debtor friendly 1978 reforms, and resulted in the consumer bankruptcy rate afterwards spiraling upward.

Committing bankruptcy was once criminal, and the purpose of law to compel debtors to pay back their debts. Bankruptcy has now been transformed to the reverse. It has become a way to legally escape paying back debts with Congress's repeated use of it as a social welfare program bestowing creditor funded debtor relief during economic crises.
 

REFORM

Congress established a bipartisan National Bankruptcy Review Commission in 1994 to redraft the nation's bankruptcy laws, yet without any explicit direction to formulate legislation to curb the growing bankruptcy rate. Commission appointees became split into pro-debtor and pro-creditor factions, and never came to a consensus on many issues.

The commission submitted its final recommendations in 1997 after a two year study during which 2.5 million bankruptcies occurred and annual filings grew by over 50%. Proposed amendments were considered lax, a few items actually increasing debtor benefits, and DOA when received by Congress. Alternative legislation was quickly drafted with the purpose of limiting the growing abuse of the statute. The major changes resulting from the new bills would become known as "means testing."

Under existing law, debtors filing under Chapter 7 Liquidation often can keep virtually all property under generous personal property exemptions and receive a discharge every six years. There is no test to see if bankrupts could otherwise repay debts utilizing future income. For example as reported by CBS News, a month before going bankrupt, Leonard Massie used his credit card to repair his Lexus, charge $670 at restaurants, and purchase $4,600 in airline tickets to Aruba. One week after charging the airfare, Massie and his wife filed bankruptcy under Chapter 7 having amassed $100,000 in credit card debt. The Massies, who live in a $350,000 home, had a joint income of $180,000 a year. Under current law, their debts are dischargeable regardless of their ability to repay.

Under proposed means testing, some debtors would be ineligible for Chapter 7 relief if they had sufficient income to pay back a portion of their debts. These debtors would still be able to file a Chapter 13 plan using disposable income to pay back debts over a three to five year period.

Means testing would not apply to debtors with incomes less than the median American income, about $51,000 for a family of four. A calculation for debtors with incomes over the median would see if they could pay back a portion of debts. If income after deducting living expenses could repay at least $5,000 or 25% of unsecured non-priority debts under a hypothetical five year Chapter 13 repayment plan, that would be grounds to dismiss a Chapter 7 case.

The Bankruptcy Reform Act of 1999 would also extend the minimum period between bankruptcy discharges from six to eight years.

Bankruptcy is the only social welfare program without means testing. Affluent debtors can access the discharge despite the capacity to repay their debts. Judge Edith Jones in congressional hearings on bankruptcy reform, said, "It is not inconsistent to have means testing in bankruptcy the same way that we means test every other part of our social safety net in this society. Welfare, food stamps, social security, disability, medicaid - all are means tested. Bankruptcy is part of the social safety net. It ought to be means tested as well."

Special interests also battled to shape legislation. Attorney groups who were getting rich off the surge in filings, protested the proposed reforms fearing a fall in legal fees. Lawyers earn more than twice as much from the Chapter 7 bankruptcy system than unsecured creditors recover from estates. The credit card industry, hurt by the surge in filings, advocated reform. Over the last decade, credit card charge-offs as a percent of all credit card loans had doubled, mainly due to bankruptcy losses. WEFA, in a study funded by VISA, estimated the financial costs of bankruptcy for 1997 at $44 billion, mostly discharged unsecured debt, noting that such costs passed on to households would amount to $400 per household or 400 basis points in higher interest rates.

Ernst & Young, in a creditor funded study, estimated that proposed means testing would exclude 10% of Chapter 7 filers and result in $4 billion more recovered by creditors annually. Law professors Marianne Culhane and Michaela White, in study a funded by the American Bankruptcy Institute, a nonprofit organization of bankruptcy professionals, found that only 3.6% would be impacted and creditors would collect an additional $930 million from can-pay debtors.

Means testing would attempt to curb bankruptcy abuse by debtors who can repay their debts. However, the median income test excludes 80% of filers, and at most half of those remaining have sufficient income to pay back a fraction of debts under a Chapter 13 plan. The majority of current filers would not be impacted - many of whom are petty debtors responding to legal ads to discharge a few thousand dollars in debt or stop eviction for a $400 legal bill. The legislation is also mute over exemptions which often completely deplete the estate. Overall, the attempt at reform may have little direct impact to stem the growth in filings. But costs to administer the test, borne by US Trustees and debtor attorneys - estimating income, expenditures, and creditor recovery under hypothetical Chapter 13 plans - would add to the cost of bankruptcy. Billboard ads, "Bankruptcy for $400," could rise to "Bankruptcy for $800," and indirectly lead to fewer debtors responding and filing for bankruptcy.

The inalienable right under current law to periodically remove debts without payment regardless of ability to pay invites abuse. A rarely used clause in the Code allows dismissal for "substantial abuse." Senator Charles Grassley (R-Iowa), who sits on the committee with jurisdiction over bankruptcy and has pressed for reform, and remarked that this clause implies, "that it's okay to abuse the bankruptcy system somewhat, so long as you don't abuse it so much that the abuse becomes substantial."

Bankruptcy is not a form of creditor funded debtor relief. Rather, all debtors pay in terms of higher interest rates and more stringent loan qualifications. The benefit of filing for bankruptcy - mainly the ability to discharge debts while retaining property - encourages debtors to utilize the procedure. Prior expansions of debtor benefits lead to an increasing bankruptcy rate. The Bankruptcy Reform Act of 1999's mild attempt to limit abuse is weak and may fail to lower the growing number of filings and fix the broken system of failures.