How Bankruptcy Changes Play in Creditor-Friendly South

By CONSTANCE MITCHELL FORD, Staff Reporter, The Wall Street Journal



(March 10) -- The Senate moved closer yesterday to passage of a bankruptcy bill that has been characterized as landmark legislation mapping out a new creditor-friendly environment, yet much of the South has long operated under a system that resembles what the bill aims to establish nationwide.



Senators completed the final hours of debate on the legislation, paving the way for its approval by the chamber today. The Republican-controlled House Judiciary Committee is tentatively scheduled to approve the Senate version of the bill next Wednesday. The full House probably will vote to approve the measure in the first week of April after a day or two of debate following the two-week spring recess. It would then be signed into law by President Bush, who has said he supports the overhaul.



A key feature of the bankruptcy law is that it aims to compel more debtors to file under Chapter 13 of the federal bankruptcy law, which requires filers to repay at least some of their unsecured debts with regular payments over five years. Currently, more than two-thirds of bankruptcy filers across the country use Chapter 7, which wipes out all unsecured debt and allows consumers to start fresh.



But in many Southern states, bankruptcy judges have long steered debtors to file under Chapter 13. "People here want to pay back their debts," says Max C. Pope, an attorney and bankruptcy trustee in Birmingham, Ala., where Chapter 13 was first created during the Depression to help workers make ends meet. At the time, Mr. Pope says, coal and iron workers who couldn't pay all their bills would send their paychecks to a state bankruptcy judge, who would distribute payments to the employee's landlord, banker and other creditors each month.



That system continues to exist today and has spread from Alabama to Tennessee and other parts of the South. "People in the South essentially use the bankruptcy court as a publicly funded consumer-credit counseling service," say Samuel Gerdano, executive director of the American Bankruptcy Institute in Washington, whose members include bankruptcy judges, as well as accountants and lawyers who represent both creditors and debtors.



Some economists and consumer advocates are concerned that Southern states have relatively higher rates of bankruptcy filings and that this could stem from the creditor-friendly system.



According to the American Bankruptcy Institute, one of every 72.8 households in the U.S. filed for bankruptcy protection during the 12-month period that ended in March 2004, but the rates varied sharply by region. Tennessee had the second-highest rate, with one household in every 38.7 filing for bankruptcy, and Georgia had one in every 42.4 households filing. Utah, with one in 36.5 households, has the highest bankruptcy rate of any state.



In contrast, filings are low in the Northeast and parts of the West and Midwest. One in 156.2 households filed for bankruptcy in Vermont, one in 144.3 in Massachusetts. Alaska had the lowest bankruptcy rate, at one filing for every 171.2 households.



There are several reasons for the large regional differences in bankruptcies. Economists say that a major reason is that incomes are generally lower and more volatile in the Southeast than in other parts of the country. Less income leaves families with smaller financial cushions to fall back on when problems arise. But income differences can't explain all of the gap.



Some bankruptcy economists theorize that there's an inverse relationship between strong consumer-protection laws and bankruptcy filings. In states where it's harder for lenders to get judgments against consumers, bankruptcies might be lower because lenders are pickier about who gets credit. In states that make it easy for creditors to repossess property, bankruptcies might be higher because more consumers are extended credit.



That, the economists say, might explain why many Southern states -- known for the creditor-friendly laws -- have higher bankruptcy rates. Alabama, Georgia and Tennessee provide a wide range of prejudgments, creditor remedies, attachments, garnishments and wage assignments with limited or no litigation, Mr. Gerdano says.



Some economists argue that because creditors in many Southern states tend to have more power to repossess goods, debtors in the region tend to file for bankruptcy quickly as an end run around the repo man. Once a debtor has filed for bankruptcy he usually is protected against repossession.



"In those states, bankruptcy filings are a way to stave off creditors," says Mr. Gerdano. In contrast, he says, in states with strong consumer-protection laws, a company has to go to court and get a judgment before it can take property.



The bankruptcy bill is backed by a business coalition called the Coalition for Responsible Bankruptcy Laws and led by the U.S. Chamber of Commerce. Members include the National Retail Association and several financial-services firms including Bank of America Corp., Capital One Financial Corp., the Ford Motor Credit unit of Ford Motor Co., MasterCard InternationalInc., MBNA Corp. and Morgan Stanley. The major credit-card-issuing banks are among the biggest winners, since they represent the bulk of unsecured creditors.



When credit-card companies and banks started pushing for an overhaul to curb perceived mounting abuse of the bankruptcy system, personal bankruptcy filings had jumped more than 70% to 1.35 million in 1997 from 780,500 three years earlier. Although filings have leveled off, the creditors still complain that they are too high. The American Bankers Association estimates that personal bankruptcies totaled about $60 billion last year and they cite research that estimates between 8% and 17% of that amount could be recovered if the bankruptcy bill were passed.



Whether the bill will actually reduce the number of Americans who file for bankruptcy is the subject of debate among economists and bankruptcy lawyers. While it's clear that the bill will impose a strict "means test" to ensure that middle-income Americans with assets pay back some of their debts, it's less clear what happens to lower-income consumers. Currently, many low-income consumers in the South file via Chapter 13 and pay back their debts over a three-year period.



But Elizabeth Warren, a professor at Harvard University, says under the new bill, many lower-income consumers won't pass the means test and would be eligible for Chapter 7, which is the opposite effect from what Congress and creditors intended. Moreover, she says, the bill "does not change the underlying economic realities for American families," many of whom resort to bankruptcy due to financial emergencies, such as sudden medical expenses or unemployment. "It's hard to say whether bankruptcies will go down," she says.



Andre Toffel, a bankruptcy lawyer in Birmingham, says his case load has doubled in the past 10 years; he has a docket of 180 cases in a five-hour period today. Most of the credit problems he sees are related to credit-card debt, and he partly blames the credit-card issuers for rising bankruptcies. "Most people are living paycheck to paycheck, so when the credit-card solicitation comes in the mail, they think this will ease their problems, but it doesn't," says Mr. Toffel.



Indeed, Mark Zandi, an economist, looks at the experience in places like Alabama and concludes that the unintended consequence of the bankruptcy bill could be that more people -- not fewer -- end up in financial trouble that they can't handle. Because creditors feel they have more protection, they will begin to lend more aggressively, which could lead to more consumer-credit problems.



"We'll have more-aggressive small consumer companies lending to lower-middle-class householders," Mr. Zandi says. "So in the end we will have more bankruptcies because creditors will end up extending more credit."



Philip Corwin, an outside attorney for the American Bankers Association, says he disagrees that the bill could encourage credit-card issuers to be profligate. "Most credit-card issuers are owned by banks which are governed by strong safety and soundness standards," Mr. Corwin says. "If a bank was found to have unsound practices, the regulators would come down hard and even prevent them from offering more credit for a period."



--Michael Schroeder contributed to this article.