On October 17, 2005, the Bankruptcy Abuse and Consumer Protection Act became law. The legislation was the culmination of a bipartisan effort in Congress to change a legal system that seemed to encourage bankruptcy filings during a time of prosperity.
It is fashionable now to compare the low unemployment of the late 1990s with the current, tepid economy. Yet, during the 1990s, personal bankruptcies spiked dramatically, and Congress responded by drafting legislation to reduce the misuse of the bankruptcy system. Congressional supporters of the legislation worried that abuse of the bankruptcy laws would unfairly increase costs for non-bankrupt consumers. The reform was supported by large bipartisan majorities (including support from then-Senator Joe Biden). As President Bush noted when he signed the law, "If someone does not pay his or her debts, the rest of society ends up paying them."
It is reasonable to ask, 10 years out, whether the reform law achieved its goals. As a former counsel to the Senate Judiciary Committee who helped to draft the legislation, I believe the law has worked well, though not perfectly. As intended, the number of bankruptcy filings has declined dramatically since 2005, from almost 1.7 million to 920 thousand in 2104. This decline occurred despite the Great Recession of 2008.
The so-called "means test" — which measures a prospective bankruptcy filer's ability to pay and channels those with higher incomes into repayment plans — has worked very well. Despite criticism, the "means test" assures repayment but permits the truly distressed to avoid hardship. In fact, according to testimony from the Obama Justice Department in early 2015, the "means test" implements bankruptcy reform "without creating unfair results for those with special circumstances." It is worth noting that this conclusion comes from an administration whose leader was once highly critical of the reform law. Then-Senator Obama spoke against the legislation.
The requirement that prospective debtors undergo credit counseling prior to filing bankruptcy has also worked well. Again according to the Department of Justice, there are at least 140 nonprofit agencies approved by the government to provide pre-bankruptcy counseling. There are an additional 220 nonprofit entities approved to provide education for consumers in the midst of a bankruptcy. These agencies are screened to ensure that consumers receive only valuable advice, free from scammers that prey on the unwary under the guise of providing financial "counseling."
This evidence strongly supports the conclusion that bankruptcy reform has reduced opportunistic bankruptcy filings, to the benefit of consumers and the economy.
The reform has been less successful at incentivizing more responsible behavior by attorneys who represent bankruptcy filers. One egregious example involves fees charged by bankruptcy attorneys. These fees rose dramatically after 2005, according to a GAO report. Some in the legal profession chose to jack up prices for those consumers who were in such poor financial condition that they qualified for bankruptcy under the tighter, post-2005 rules. And this increase in fees occurred despite the fact that the reform waived court fees for low-income filers, reflecting Congress' desire to ensure that Americans genuinely deserving of a fresh start not be blocked by fees. Looking back, I believe Congress should have limited the ability of attorneys to assess fees against financially struggling consumers.
Another example involves "material misstatements" in bankruptcy court documents. These documents are filed under penalty of perjury, and attorneys must certify to their accuracy. The 2005 law required audits of court papers in a bankruptcy case to ensure that there are not hidden assets or income. In 2014, these audits found that there were "material misstatements" in 23% of bankruptcy filings. Nationally, over 2,000 bankruptcy cases were referred for criminal prosecution last year. It is a sad commentary that almost a quarter of bankruptcies contain such errors even with the potential for steep penalties. In retrospect, I believe Congress should have made much tougher penalties for failing to disclose information because the temptation to hide assets is apparently so strong.
The law also reformed the rules for businesses that file bankruptcy. The policy goal of these changes was to ensure that businesses — big or small — not use bankruptcy to escape the forces of the free market. For instance, the 2005 law makes it more difficult to pay bonuses to top executives of bankrupt companies and forces bankrupt businesses to honor the terms of contracts and leases. Importantly, the law also restricts the period of time for "old" management to continue running a business that files for bankruptcy. If management missteps force a company to use bankruptcy, why reward the executives whose poor judgment caused the fortunes of a business to suffer?
The 2008 recession highlighted one provision of the law that was intended to isolate failing financial firms. Following the near collapse of hedge fund Long Term Capital Management in 1998, the Clinton Treasury Department and the Federal Reserve urged Congress to permit non-bankrupt parties to derivatives to limit their losses. The fall of Lehman Brothers in 2008 demonstrates the value of these reforms. Had Lehman's creditors not been able to mitigate their losses, one can only imagine the possible cascade of additional business failures that might have followed.
The changes made 10 years ago reduced abusive bankruptcies and made our nation's economy more resilient. If Congress had gone further by regulating attorney fees and increasing penalties for fraud, the economy would be that much stronger.
From 1995-2001, John McMickle was a Counsel to the Senate Judiciary Committee, where he was the bankruptcy counsel and one of the primary drafters of reform legislation.