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America's new bankruptcy law

By Jared Stamell.

In a few days, a new bankruptcy law will go into effect in the United States. 

The new law is principally aimed at making it harder and more expensive for individuals, and particularly moderate income individuals, to file a bankruptcy and avoid paying their debts. 

In doing this, the law reflects a sharp change in American attitudes about individual responsibility for life's misfortunes.

As the self-proclaimed land of opportunity, America encourages borrowing as a way to grab those opportunities. Debt to buy houses, clothes, food, automobiles, vacations – you name it and you can borrow to buy it. Credit cards had an essential place in American wallets long before the rest of the world thought much about them. 

Although some people, usually those who already have a lot of money, intone solemnly about the moral hazards of too much debt, no one took them seriously.

Borrowing is encouraged not just by banks, credit card companies or other businesses that profit from it. The US government does its part by keeping interest rates low, funding home mortgages and bailing out any really large financial institution that gets into trouble. 

Also, to show that debt is really good, the government has become a spectacular credit junkie, borrowing as if there is no tomorrow, from Japan, China and anyone else that will lend a billion. And, an important government policy that encouraged borrowing has been bankruptcy law that let people walk away from their debts, giving them a fresh start.

The idea of the fresh start is that life's misfortunes, financial or otherwise, are more often than not no one's fault.  Job loss, illness, accident or some other mishap can happen to anyone. 

Since everyone is exposed to these risks, if things go wrong for you, you are entitled to a fresh start, at least financially, to discharge your debts and begin again. That is what bankruptcy law allowed.

Under the old law, when debts were crushing, as long as you were willing to walk away from your house and most of any other property that you owned, anyone could file what is called a "Chapter 7" bankruptcy. 

You lost all your assets to creditors, but all debts were discharged with those assets and you could start over. Since this is America, you could of course keep your gun, a bible and some cash (depending on the state you lived in). 

By freeing people from debts that they could never pay, the belief was that they had a strong incentive to go back to work and build a new life.

The debts that bankruptcy left unpaid were absorbed by society as a whole in the cost of credit. The misfortunes of a family deeply in debt because of a hurricane, catastrophic illness, unemployment or some other factor became a cost of doing business of the lenders shared by everyone who borrowed. 

It was the lenders' responsibility to include this cost in interest rates. As this system became more sophisticated, credit ratings were assigned to each individual measuring the risk of lending.

This system seems to have worked just fine. 

People could borrow to start a business or buy a home and so forth and credit was available to almost everyone at a price. Sudden reversals of fortune could not be undone, but at least the financial effects were limited by the fresh start offered by bankruptcy. 

Bankruptcy was not without penalty. Credit could be re-established, but that took years.

The new law has the opposite philosophy – no more fresh starts. It pushes all but the most destitute (who probably have too little money to even access the legal system) into what is called a Chapter 13 bankruptcy under which you keep your assets, but devote almost all your income for five years to repaying creditors.

Over this period, it severely limits what an individual can spend on rent, food and other basic needs. Although you get a discharge from your debts if you manage to survive five years under this severe regimen, in essence a debtor's prison where you provide your own walls, this greatly reduces the benefit of a bankruptcy.

Also, detailed financial filings are required and lawyers must guarantee their accuracy. This adds substantial additional costs that may make bankruptcy too expensive for most people.

The new law reflects an emergent American belief that people are responsible for their misfortunes.  For instance, everyone feels really bad about the tens of thousands of families displaced in the Gulf Coast by recent hurricanes.

Their homes were destroyed; they have almost nothing but the clothes on their backs, and they lost their jobs. But they have not lost their debts.

Suggestions that the new bankruptcy law be delayed or modified so that the hurricane victims can obtain debt relief were quickly rejected. That victims of a natural disaster would be expected to pay their mortgages and credit card debt would have been unthinkable only a few years ago.

Although there really were no problems with the old law, the fact that people could walk away from debts they had promised to repay bothered some people, particularly well off Americans. 

They complained about perceived abuses and bad faith filings in Chapter 7 by people who, after discharging their debts, earned substantial income – even though that was what they were supposed to do after their debts were discharged. 

As the country became wealthier (or at least borrowed more to appear wealthier), the haves, whose ancestors most likely were have-nots who emigrated to America for that very reason, became convinced that the misfortunes of the have-nots were their own fault and that they should be responsible for their debts no matter what happens. 

There is no small irony in the seemingly popular groundswell of sympathy for creditors.

The irony, of course, is that well off Americans, the haves, do everything they can to avoid personal responsibility for their own debts. 

Recognizing the normal risks and misfortunes of life, they insulate themselves from personal liability through non-recourse loans, limited liability companies, off-shore trusts, and a host of other mechanisms designed to avoid personal responsibility. 

As far as the haves are concerned, for instance, in a business failure, it is OK for employees to lose their jobs and incomes (and still have to pay their debts), as long as the haves are able to limit their own liability.

Even when faced with debts they have the responsibility to repay but cannot, the haves still have an out, the same out that corporations have - the Chapter 11 bankruptcy. 

A Chapter 11 is costly and requires sophisticated legal services unavailable even for middle class individuals.  In a Chapter 11, the debtor, for the most part, controls the bankruptcy and can negotiate with creditors on how much to replay. An agile debtor with a team of attorneys may not even have to file a Chapter 11 to reach an advantageous settlement with his creditors.

Hypocrisy about personal responsibility is not the sin of a few. The new bankruptcy law would not have been enacted unless its basic premise was widely accepted. 

In America, just about anyone with a college degree and a few years of secure employment seems to think that they are in the have group and immune from the misfortunes of the have nots. 

Law has never been particularly adept at legislating morality, but that is precisely what has happened, and badly. 

What once served as a necessary social safety valve has been erased in favor of a puritanical insistence on moral blame for misfortune, leading America away from the land of opportunity to the land of the mean-spirited.

Jared Stamell is a New York-based Attorney. He has been an attorney in the DoJ Antitrust Division and counsel to the US House Judiciary Monopolies Subcommittee. A graduate of Harvard Law School, he also holds a M.Sc. in economics from the London School of Economics.    

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