Partners, Volume 15, Number 2, 2005

Bankruptcy Reform Legislation

Designed to curb abuses of the current U.S. Bankruptcy Code, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the Act) establishes a needs-based system of qualifying for protection under the law.

The Act was signed by President Bush in April 2005, and most of its provisions become effective in October of this year.

Currently individuals file for either Chapter 7 liquidation or Chapter 13 reorganization bankruptcy relief. Chapter 7, the most common bankruptcy filing, allows debtors a fresh start by requiring them to relinquish all of their nonexempt assets, which are liquidated to pay creditors. Any debt in excess of the amount collected from asset liquidation is then forgiven. Chapter 13 filings allow debtors to repay specified debts over a three-year period, and forgive any debts not included in the repayment plan.

Under current standards most individuals opt to file under Chapter 7. According to U.S. Bankruptcy Statistics 1.1 million filed for Chapter 7 relief in 2004, while nearly 450,000 filed for relief under Chapter 13.

Qualifying for bankruptcy protection
The new guidelines include a “means test” to determine if debtors with annual income above the state median income level qualify for protection under Chapter 7. Debtors who can pay unsecured creditors, such as credit card companies, at least $6,000 ($100 per month) over a five-year period, provided that amount is sufficient to pay 25 percent of the outstanding debt, will be redirected to a Chapter 13 repayment plan.

Debtors capable of paying creditors more than $10,000 ($166.66 per month) over a five-year period are assumed to be abusing the system and will automatically be denied Chapter 7 relief.

Debtors whose income is below the state median income level are exempt from the “means test” and will automatically qualify for Chapter 7 protection. These debtors, however, can still be redirected to a Chapter 13 repayment plan if they are able to pay a minimum of 25 percent of their outstanding unsecured debt over a three-year period, as opposed to the five-year period specified for other filers.

The Act continues to provide protection for individuals who face extenuating circumstances such as a serious medical condition or other hardships. These cases, however, must be supported by documentation detailing expenses or deductions from income.

Income and expense calculation
The new law includes an interesting twist: calculations of income, expenses, and disposable income used to determine a debtor’s ability to repay and the rate of repayment for bankruptcy filings will no longer be based on actual income and expenses, but rather on specified calculations and Internal Revenue Service (IRS) guidelines for reasonable living expenses. When calculating a debtor’s income to determine his or her ability to repay, the court will use the average income for the six months preceding the filing of the case instead of following the former guidelines, which were based on current monthly income. The new method of calculation could pose problems for recently unemployed debtors or those whose expenses are higher than the IRS norm.

Dischargeable debts
The Act will significantly reduce the dollar amount of pre-filing accumulated “goods or services not reasonably necessary for the support or maintenance of the debtor or the debtor’s dependents” that can be discharged. In addition it will increase the time period over which these luxury debts can be accumulated, thus allowing creditors to recover larger amounts of outstanding debt.

Credit card debt in excess of $500 accumulated within 90 days of filing will not be discharged. Currently the law states that amounts in excess of $1,225 accumulated 60 days prior to the filing cannot be discharged. The dischargeable limit for cash advances accumulated within 70 days (currently 60 days) of filing will be reduced from $1,225 to $750. Furthermore the cash advance limitations apply to any items purchased, not just luxury goods.

The new law requires that debtors receive credit counseling prior to filing for bankruptcy, and it mandates financial management training prior to discharges for bankruptcy. This credit counseling can be provided by a nonprofit budget and credit counseling agency approved by the U.S. trustee or bankruptcy administrator as published by the clerk of the court. Approved agencies are required to provide these services without regard to the debtor’s ability to pay enrollment fees. The court makes exceptions when it determines that adequate counseling services are not available, as well as for debtors who are incapacitated, disabled, or on active military duty in a combat zone.

Homestead Exemptions
The Act significantly curbs abuses that occur when debtors attempt to shelter equity in real estate assets from creditors by establishing residency in a state with generous or unlimited homestead exemptions. While Congress did not explicitly pre-empt state law with regard to homestead and other state exemptions, it did impose restrictions on a debtor’s ability to relocate assets to states such as Florida, Iowa, Kansas, South Dakota, and Texas that have unlimited homestead protections.

Currently, unlimited state homestead exemptions are available to the debtor 180 days after establishing residency in a state. Under the new guidelines, if the debtor files for bankruptcy within two years of moving to another state, he will have to claim the homestead exemption of his previous state of residency. Once residency has been established for a minimum of two years, he can claim only $125,000 of the state’s maximum homestead allowance. After three years of residency the debtor is eligible for the state’s full exemption.

For example, suppose John Doe relocates from Georgia to Florida and purchases a $300,000 home. Within a year of moving, John falls upon hard times and must file for bankruptcy protection. Because John has lived in Florida for less than two years, he must use Georgia’s homestead exemption allowance of $5,000. John would have been eligible for a $125,000 exemption if he had filed for protection two years or more after moving to Florida. Further, if John had filed for protection after more than three years, he would have been able to claim the unlimited exemption allowed in Florida or the full value of his home.

While some states offer unlimited homestead exemptions, others offer limited exemptions or none at all. Homestead exemption limitations for Sixth District States are as follows: $5,000 for Georgia, Alabama, and Tennessee; $15,000 for Louisiana; $75,000 for Mississippi; and unlimited exemption for Florida. Alabama, Georgia, and Mississippi allow exemptions to be doubled for couples filing jointly. Tennessee allows a $7,500 exemption for joint filers. Louisiana does not increase homestead exemption for joint filers.

In lieu of state exemptions, debtors may have the option of claiming the federal homestead exemption of $18,450, but state law must authorize their right to do so.

An additional limitation placed on homestead exemptions is an absolute $125,000 maximum imposed on debtors who have been convicted of certain fraudulent crimes or criminal acts that caused serious injury or death.

Unlike other provisions of the law that go into effect in October, the homestead exemption limitation rules were declared effective upon enactment of the law on April 20, 2005.

Bankruptcy discharges
To cut down on the number of serial filings, the Act lengthens the amount of time stipulated between Chapter 7 filings from six years to eight years. Chapter 13 discharges are not allowed within two years of a previous Chapter 13 filing or within four years of a Chapter 7, 11, or 12 filing.

Small business provisions
The new law has specific requirements and reporting guidelines for small business debtors who apply for Chapter 11 reorganization. A small business debtor is defined as a business (other than owning or operating real estate) having less than $2 million in debt. Some estimates indicate that this definition covers over 80 percent of all Chapter 11 filings. Filing status as a small business, which was previously optional, now appears mandatory to meet eligibility guidelines.

Another new requirement states that within seven days of filing for the order of relief, the small business debtor must submit a recent balance sheet, statement of operations, records of cash-flow, and federal income tax information. On a periodic basis small business debtors must also file reports on profitability, projections of future cash receipts and disbursements, comparisons of actual receipts and disbursements to earlier projections, payment of taxes, and a statement of compliance with bankruptcy rules, tax, and other governmental filing obligations. Reporting requirements will not be mandatory until official forms for such information have been developed.

Under the new law the small business debtor has 180 days to file a reorganization plan. After that time any individual that has a stake in the bankruptcy case may file a plan up to the 300-day deadline. The previous time frames for these events were 100 and 160 days, respectively. Currently Chapter 11 plans can drag on for years because of repeated filings for extensions. Extensions are significantly restricted under the new law.

The new regulatory and reporting requirements for small businesses are more onerous than in the past to ensure that reorganization plans are filed in a timely manner and that the businesses are performing according to the plans. If, upon inspection of the business and review of reports, the U.S. Trustee assigned to a particular case determines that the reorganization will not work, the business can be directed more quickly into liquidation to allow more timely repayment of creditors.

Other significant provisions
The law will also require changes to Regulation Z, Truth in Lending Act, to be implemented by the Board of Governors. The amendments will focus on minimum payment disclosures and information; requirements for high loan-to-value credit extensions using the home as collateral; and disclosures for special rates, Internet-based credit card solicitations, and late payment deadlines and penalties.

Revisions to the U.S. Bankruptcy Code by the 2005 Act accomplish the goal of curbing abuses by limiting the possibilities for manipulating the system to protect large amounts of amassed wealth while charging off carelessly accrued debt. The Act also protects individuals who, based on financial or other hardships, truly qualify for and need bankruptcy protection.

However, while the new legislation provides creditors with increased ability to collect on debt obligations owed by consumers, it does nothing to constrain abuses by creditors who use mass marketing and lax credit underwriting to lure consumers further and further into debt without consideration for the likely negative consequences.

This article was written by Lisa Easterwood, financial analyst in the Supervision and Regulation division at the Atlanta Fed.

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