4 fixes for a bad bankruptcy law

By Liz Pulliam Weston

We Americans are, for the most part, sensible people. However, we tend to believe things about debt that just aren't true.

Like the myth that the average American owes $9,000 on credit cards. Or that the only folks who file for bankruptcy are spendthrifts and deadbeats, who blithely charge their way to financial ruin.

Or that the bankruptcy-reform law somehow made the system better.

Here's what the law, which went into effect on Oct. 17, 2005, actually did:

• Sent bankruptcy filings to a new record of 2 million in 2005, as consumers rushed to file before the new law took effect.

• Forced lenders to write off hundreds of millions of dollars in unexpected charge-offs.

• Frog-marched filers through mandatory credit counseling sessions that do little good. Credit counselors report what bankruptcy experts told us they would, which is that fewer than 5% of filers have the ability to repay any of their debts.

• Increased basic filing costs by about $200, as well as the time it takes for attorneys to prepare a case, by at least 50%, making the process more expensive for people who already are broke.

• Prohibited at least one couple from giving money to their church. Frank and Patricia Diagostino, longtime church members, wanted to continue donating $100 a month to their parish while they were in a Chapter 13 repayment plan. But federal bankruptcy Judge Robert E. Littlefield Jr. of the Northern District of New York reluctantly concluded that the new law, which critics have blasted as extremely poorly drafted, didn't allow them to make the contributions. In short, the bankruptcy reform act as written requires prioritizing credit card companies ahead of the duties of one's faith.

Here's what the new law did not do:

• Stem the tide of bankruptcy filings. After hitting lows in the first quarter of this year that hadn't been seen since the 1980s, filings sharply rebounded in the second quarter of 2006 and continue to rise. Some bankruptcy attorneys predict we'll have pre-reform levels of filings by the law's second anniversary in October 2007.

• Prevent anybody from going broke. The law didn't dry up the ocean of easy credit that can get people in over their heads, and certainly didn't address the three triggers that account for most bankruptcies: job loss, divorce or illness.

We're still unclear whether the new law is achieving its stated aim: making sure higher-income debtors who can afford to pay some of their bills actually do.

Means test may be required

If your income is above the median for your area and you file for bankruptcy, the law requires you be subjected to a means test to see if you might have the spare cash for a repayment plan. If you don't, you get to file for Chapter 7 liquidation, which erases most of your unsecured debt, such as credit card and medical bills.

If the means test says you can afford to pay some of your debts, though, you're shunted into a Chapter 13 repayment plan.

After the reform took effect, Chapter 13 filings plunged along with Chapter 7 filings. But the proportion of Chapter 13s to Chapter 7s was substantially higher, perhaps a sign that more people are being forced into repayment plans. Yet less than a third of the 714 lawyers recently polled by the National Association of Consumer Bankruptcy Attorneys said they were seeing any increase in such forced filings in their practices, and only about one in 20 reported a "major" increase. Other possible explanations for the increase in Chapter 13 repayment plans:

• The Chapter 13 cases would have been filed anyway. The numbers of Chapter 13 cases didn't fall off as sharply as Chapter 7s under the new law. While Chapter 7 liquidations in the second quarter of 2006 were fewer than half the 1994-2004 median, Chapter 13s stood at 94% of their historical rate. People typically opt for Chapter 13s when they're trying to protect assets that would otherwise be sold off to pay their creditors, when they have a strong desire to repay their creditors or when they're trying to prevent foreclosure.

• Foreclosures are on the rise. Chapter 13 filings can be used to temporarily halt foreclosure proceedings and give consumers time to catch up on their payments.

• Higher attorney fees may be shunting more filers into Chapter 13s. Chapter 7 filings typically require the consumer to pay attorney fees upfront, while Chapter 13s allow consumers to add the fees to their repayment plans so they can pay their attorneys over time. Consumers who don't have the cash to pay the higher cost of bankruptcy filings may be opting for Chapter 13 as the only way they can afford to file.

'A complete piece of garbage'

Bankruptcy judges, trustees and attorneys from both sides of the political aisle warned us loudly before the law's passage that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was a complete mess.

The law was crafted largely by credit lobbyists; attempts by some of the nation's most seasoned experts in bankruptcy law to provide guidance were soundly rejected. The act, these experts say, is filled with the kind of poorly drafted provisions and internal inconsistencies that led to the Littlefield decision. Bankruptcy judges across the country have denounced the law as inane and unjust. Longtime Tennessee judge Keith Lundin called it "a complete piece of garbage."

Congress would be wisest to simply trashcan the whole thing and start over. Congress isn't often wise, though, but at the very least it should:

Fix the charitable contribution mess. People should be allowed to honor their long-standing commitments to their places of worship, even if it has to be at a reduced level.

Scrap the credit counseling requirement. Forcing consumers through a 90-minute credit counseling session before they're allowed to file bankruptcy is simply too little, too late. The post-filing sessions, where bankrupts are given instruction in financial management, make some sense, but the pre-filing sessions are a waste of time and money for all concerned.

Reduce the paperwork required for lower-income filers. If your income is below the median, you won't be subjected to the means test, but attorneys complain that they still have to comply with burdensome paperwork requirements that substantially increase the time they spend on each filing (and thus the cost to filers).

Provide more resources for cash-strapped filers. The law allows the courts to waive filing fees for filers in the most-dire straits, but the larger cost for consumers is attorney's fees. There need to be more low-cost options for consumers besides bankruptcy mills and potentially disastrous do-it-yourself filings (read "Beware cut-rate bankruptcy advice" for details). More money needs to be funneled to legal aid societies and others who provide the poor with sound legal advice.

And here's a thought: The banks, credit card companies and other lenders who paid for the passage of the bankruptcy reform act can write the check for this as well.

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.