1 Corp. & Bus. L.J. 1 (1999)

A NEW PROPOSAL FOR IMPLEMENTING MEANS TESTING IN BANKRUPTCY

By Gregory E. Maggs, Associate Professor of Law, The George Washington University Law School

Last year, banking and corporate interests implored the House and Senate to change the rules governing consumer bankruptcies. They specifically wanted Congress to establish a "means test" that would limit the choices that individuals currently enjoy when they declare bankruptcy. At present, debtors may elect to satisfy their obligations in bankruptcy by giving up either their disposable income for a short period or all of their non-exempt property. The proposed means test, as explained more fully below, would have required bankruptcy debtors to surrender their disposal income whenever this option would have produce more money than turning over their property.

Supporters of the plan argued that means testing would reduce the enormous losses that businesses suffer in consumer bankruptcy proceedings. Opponents, however, challenged this argument. They claimed that mean testing would affect few debtors, would increase debt payments only a small amount, and would impose huge costs on the bankruptcy system.

As a result of the controversy, Congress failed to pass any new legislation before adjourning. The House and Senate, however, already have indicated that they will reconsider means testing legislation in 1999. In this essay, I describe briefly a new proposal that I am preparing in this regard. The proposal would allow Congress to implement means testing in manner that addresses legitimate concerns that the opponents of means testing raised in the fall of 1998.

Background

A stunning paradox produced the recent interest in bankruptcy on Capitol Hill. Although the national economy has never seemed better, a record number of consumers filed bankruptcy petitions last year. More than 1.4 million individuals took the plunge, declaring their insolvency and asking the bankruptcy courts to discharge their debts. The incongruity between the nation's apparent wealth and the deluge of bankruptcy filings has caused many creditors to question whether the consumer bankruptcy system has something wrong with it.

The principal legal rules at issue are not complicated. The Bankruptcy Code offers most consumers the ability to obtain a permanent discharge or cancellation of their outstanding debts. In seeking this discharge, consumer debtors at present generally have two options, which are provided in chapters 7 and 13 of the Code.

If debtors choose chapter 7, they must hand over all of their non-exempt property. For example, they may have to turn over their money in the bank, automobiles, and so forth, but they generally may withhold some possessions that federal or state laws shield from creditors. If consumers elect chapter 13, they can keep all of their property, but they must surrender their non-disposal income for a three-year period. A bankruptcy court ultimately decides what income is disposable and what is necessary for a debtor's subsistence.

Credit card issuers and other typical creditors have come to believe that some debtors are taking advantage of the choice between chapter 7 and chapter 13. In particular, they suspect that debtors who have incomes but few non-exempt assets are electing to proceed in chapter 7. This choice allows these debtors to receive discharges without giving much of anything in exchange. They lose little or no property and can keep their salaries.

In 1998, representatives of the credit card industry hired the national accounting firm of Ernst & Young to conduct a study of the issue. Ernst & Young concluded that approximately 15% of debtors who choose chapter 7 could pay more of their debts in chapter 13. The firm's study further estimated that forcing these debtors into chapter 13 would increase the amount paid to creditors by more than $4 billion a year.

Based on this study (and a least one other which found comparable results), business and banking lobbyists persuaded both the House and Senate to consider legislation that would impose a "means test" in consumer bankruptcy. The House and Senate each approved versions of a bill that would have prevented debtors from using chapter 7 if they could pay more in chapter 13. As noted above, however, Congress ultimately failed to pass the legislation in 1998.

A vocal group of bankruptcy scholars and practitioners opposed the plan to impose means testing. These opponents did not object to the creditors' premise that debtors who can pay more of their debts out of their disposable income should have to do that. Instead, they hotly disputed the contention that means testing would accomplish what the creditors wanted.

Professors Marianne B. Culhane and Michaela M. White of the Creighton University School of Law produced a study contesting Ernst & Young's findings. Their study, which used different assumptions and data, concluded that the means testing proposal under consideration by Congress would force only 3% of debtors into chapter 13 and would produce no more than $800 million in additional payment to creditors.

Other opponents asserted that implementation of means testing would have significant costs. Under the proposal that went before Congress last year, when a debtor filed a chapter 7 petition, the bankruptcy trustee might have to investigate the debtor's finances and then prepare a report about whether the debtor should be in chapter 13. This process, when repeated in numerous cases, might cost hundreds of millions of dollars. This cost would come out of funds available for creditors. In addition, the debtor and creditors might litigate the trustee's findings. This litigation also would diminish the funds distributable to creditors.

Evaluation of the Debate

As a neutral observer, I find it very difficult to dismiss the creditors' belief that means testing will increase their returns in consumer bankruptcy. Their self-interest makes them credible. Retailers, banks, and other businesses would have no reason to spend money lobbying for means testing if they did not truly believe that the proposal would make them better off. In general, they probably know the economics of their business better than any outsiders.

In addition, even if Professors Culhane and White used more realistic data and assumptions in their study, the fact remains that they ultimately agreed with Ernst & Young's conclusion that means testing would result in greater payments to creditors. Although their projection of $800 million in savings is less than Ernst & Young's estimate of $4 billion, that difference hardly seems a reason by itself to reject means testing. After all, $800 million a year is still nothing to scoff at.

In my view, however, the costs imposed by means testing present a serious problem. The legislation before Congress seems wasteful because the proponents and opponents agree that the vast majority of chapter 7 filers should stay in chapter 7. Most means testing, accordingly, would not force debtors into chapter 13. In addition, while creditors would bear most of the costs of means testing, it is not clear that all of them want means testing or would benefit evenly from it. For this reason, Congress should not impose means testing in the manner that last year's bills envisioned.

A New Proposal for Means Testing

The question arises whether Congress might implement means testing in a manner that does not raise the legitimate concerns about costs that opponents have raised. I believe that it can. Congress simply has to adopt a reform that makes the creditors who support means testing put their money where their mouths are.

Here is my new proposal. When an individual debtor chooses chapter 7, the bankruptcy trustee would poll the creditors to see whether they wanted means testing. If no creditors said yes, then the debtor could remain in chapter 7. The bankruptcy court would liquidate the debtor's non-exempt assets and use the money to pay the creditors.

If any creditors wanted means testing, the trustee then would investigate the debtor's finances and file a report indicating whether the debtor should move to chapter 13. The debtor would have a limited right to challenge the report's conclusions (as under the legislation considered last year). Upon completion of these tasks, the trustee would calculate the total amount of money expended in preparing the report and litigating its conclusions.

After receiving the trustee's statement of the costs of means testing, the bankruptcy court would divide responsibility for paying this amount among the creditors who asked for means testing. (In the division, the creditors would pay in proportion to the size of their claims against the debtors, unless they agreed on a different arrangement.) The debtor and creditors who opposed means testing would not have to pay any portion of the costs.

If the means testing report predicted that the debtor could not pay more in chapter 13 than chapter 7, then the debtor could remain in chapter 7. The creditors who paid for the means test would recover only the amount of their claims, not what they spent for the test. This rule would give creditors an incentive not to call for means testing indiscriminately.

In contrast, if the means test showed that the debtor could pay more in chapter 13 than in chapter 7, then the bankruptcy court would convert the case to chapter 13. Chapter 13 would operate as it presently does, with one exception. In particular, under my scheme, the creditors who elected not to pay for the means test would be limited in their recovery in the chapter 13 proceedings to the amount that the means test predicted they would recover in chapter 7. The balance of payments would go to the creditors who paid for the means test. These creditors, accordingly, might receive a greater percentage of their claims. This possibility would give creditors an incentive to support means testing when the evidence available to them suggests that the debtor could pay more in chapter 13 than chapter 7.

Advantages of the New Proposal

My proposal has several advantages over the legislation that Congress considered last year:

First, the proposal would reduce the aggregate costs of means testing. Unlike the bills previously before Congress, my scheme would not require means testing in any class of cases. Instead, means testing would occur only in the specific instances when creditors ask for it.

Second, the proposal would distribute the costs of means testing more fairly. Under the proposal, as noted above, only the creditors who want to examine the debtor's finances have to pay for the chapter 7 trustee's means testing report. The proposal does not affect creditors who, for whatever reason, are content with the status quo.

Third, the proposal would distribute the potential benefits of means testing more fairly. The proposal provides that only creditors who take the risk of paying for means testing will enjoy the possibility of greater recovery in chapter 13. By contrast, the creditors who do not want to pay for means testing will get only what they would have gotten in chapter 7 if means testing had not occurred.

Fourth, the proposal has a political benefit. In particular, the proposal frees Congress from the task of estimating how many debtors could pay more in chapter 7 than chapter 13 based on conflicting statistical studies. Instead of requiring Congress to decide whether means testing is a good idea in the aggregate, the new proposal allows creditors to make the judgment on a case by case basis -- and insures that they bear the risks of error.

True, some debtors may not like this proposal because means testing may force them to pay more in chapter 13 than they would have to pay in chapter 7. This possibility, however, should not trouble the opponents of means testing legislation, provided that they have been candid in stating their objections. As explained above, opponents of means testing generally have not objected to the idea that debtors who can pay more in chapter 13 should pay more. On the contrary, the opponents have claimed only that few such debtors exist. This proposal addresses their objection by placing the costs of means testing on the creditors who favor it.

Predictions of What Will Happen

My guess is that, under this new proposal, creditors will pay for means testing in a small percentage of cases. In most instances, however, they will not. Sophisticated creditors one way or another will figure out when to opt for means testing and when not to seek it. After all, as lenders, they are largely in the business of knowing how much disposal income people will have in the future.

Over time means testing under proposal may have the added benefit of revealing new things about bankruptcy economics. If means testing greatly reduces the number of filers, it may help show that abuse previously was occurring. On the other hand, if trustees rarely find that chapter 7 debtors belong in chapter 13, and filings do not diminish, then it may prove the opposite. This information may influence future reforms.