photo by CafeCredit

The ironic feature of the bankruptcy system is that a debtor must come up with a lot of money to file a case.  Indeed, it costs a lot of money to go broke!

According to bankruptcy law professors  Pamela Foohey, Robert M. Lawless, Katherine Porter (now Congresswomen Katie Porter), and sociology professor  Deborah Thorne in their 2017 article No Money Down Bankruptcy, the high cost of filing chapter 7 bankruptcy is causing many debtors to file even more expensive, but less successful, chapter 13 cases that can be filed for “no money down.”

Attorneys charge an average of $1,229 to file and represent a debtor in a chapter 7 case and an average of $3,217 to file and represent a debtor in a chapter 13 case.

The study reveals that while 95% of Chapter 7 debtors receive a discharge of their debts, only one-third of chapter 13 debtors obtain a discharge.

Why is this happening? Why are lower-income debtors filing expensive chapter 13 cases instead of the cheaper and more successful chapter 7 cases?

You can fault the drafters of the bankruptcy code and the Bankruptcy Reform Act of 2005 for this mess.

When a debtor files a chapter 7 case, all debts–including fees owed to their bankruptcy attorney–are wiped out.  The debtor’s attorney may not accept payment for services performed prior to filing the bankruptcy petition.

That’s a big problem. Attorneys cannot accept payments for their services after the case is filed, so attorneys typically charge ALL their fees up front.  And lower-income debtors just can’t afford to come up with the money so they wind up filing chapter 13 for no money down.

So why can’t debtors just save up to file chapter 7?  Well, they can and most attorneys will accept payments before a case is filed.  In fact, most debtors break the chapter 7 fee into installments.

The problem is that debtors usually hire a bankruptcy attorney after they have been sued and wage garnishments are imminent. They have run out of time to save up to file the less expensive chapter 7 option. So even though they are a better fit for a chapter 7 case, they opt to file the “no money down” chapter 13 case to stop garnishments, repossessions and foreclosures.

Geography & Race Factors:

A very disturbing fact of bankruptcy cases is that the filing of a chapter 13 case has more to do with a person’s location and race than it does with anything else.  Debtors in Southern states and African American debtors filed a disproportionate number of chapter 13 cases, suggesting that the decision of which chapter to file has more to due to with the attorney they hire than what is best for a particular debtor.

In some districts as many as 80% of the cases are filed as chapter 13, whereas in 2015 in the Northern District of Iowa only 6.7% of the cases were chapter 13.  That difference cannot be explained by determining what was best for the debtor.  Rather, the authors suggest that attorneys are doing what is best for their bottom line at the expense of lower income Americans.

Correct observations but wrong conclusions.

Although the authors correctly point out the problems with No Money Down cases, they reach the wrong conclusions much of the time.

The basic problem here is compensation. Attorneys are more than happy to file chapter 7 cases if they can be compensated. The only reason attorneys are pushing chapter 13 cases is so they can get paid. The solution is to figure out how to compensate chapter 7 attorneys.

The professors make the following statements in their report:

  • “Given that attorneys facilitate “no money down” bankruptcy, the best way to ensure that all debtors have equal access to bankruptcy is to cabin attorneys’ incentives and role in chapter choice, while still allowing debtors access to this filing option if they so choose.”
  • “One solution to combat the effects of the “no money down” bankruptcy is to allow debtors to pay bankruptcy attorneys’ fees in installments during their chapter 7 cases.”
  • “Standing orders could provide that only if the debtor has paid twenty-five percent (or some other percentage) or more in attorneys’ fees prior to filing will the “no look” fee apply.”
  • “A similar solution would be to revise the requirements for confirmation of chapter 13 plans to include a condition that the plan must contemplate making a substantial repayment to creditors.”

So, the professors suggest that attorneys who steer their low income clients into chapter 13 cases should be denied their fees unless a substantial amount of the creditor claims are paid.  Well, that would DRASTICALLY reduce the number of chapter 13 cases filed.  But is that a good result?

That is actually a horrible idea. How does this help low income debtors? They can’t afford to file chapter 7 so chapter 13 is their only option. Their paychecks are being garnished so they must do something, but these professors just focus on the low success rate of chapter 13 cases instead of the debtor’s immediate need for relief.  Filing chapter 13 does offer IMMEDIATE relief from garnishments, repossessions and foreclosures.

There are two real problems here.  First, we have a chapter 7 compensation problem. Second, we have a chapter 13 success rate problem.

How can we compensate chapter 7 attorneys so they will file cases now and not make a debtor wait to file?  Well, as the professors suggest, legislative changes to allow that would be great, but when is that supposed to happen?

The Bifurcation Solution:

A current option to help allow debtors to file chapter 7 cases for a small retainer fee is to open up the doors to a bifurcated case.  That is, allow attorneys to charge a small payment down to file an incomplete case consisting of nothing more than a debtor’s name and a list of creditors and then allow attorneys to charge monthly payments after the case is filed for completing the remaining schedules.

This solution is available now, but the US Trustee has been extremely hostile to allowing this process even though court decisions say it is allowable.  The problem is, those firms attempting this approach have gone too far and have charged high fees and interest rates making the cost similar to chapter 13. But if courts develop Local Rules creating Safe Harbor zones for reasonable fees and payment schedules, this solution could be implemented right now with no Congressional action.

Chapter 13 Success Rate Solution:

The fact that only one-third of chapter 13 cases nationwide result in a discharge is outrageous. In Nebraska the success rate is about 60% and our firm has normally trended towards 70%. If the success rate of chapter 13 were higher nationally I doubt the authors would be complaining about no money down bankruptcies.

Why do some states have such low success rates for chapter 13? That is the key question not addressed by this article–a glaring omission. Success rates depend on cooperation between the courts, the trustees that supervise the case, and the attorneys who file them.  Chapter 13 cases require fertile soil created by sensible Local Rules that give the system flexibility.

Sometimes debtors cannot make the monthly payment. They lose jobs or file divorce or suffer health problems. Local rules must allow debtors to suspend payments easily.  Attorneys must be properly compensated for keeping the case alive when a debtor encounters trouble, and that means allowing for supplemental fees when amendments to plans or motions to suspend payments are filed.  And courts need simple rules that are easy to enforce. Combine all those ingredients and chapter 13 success rates soar.

The professors also fail to mention many of the benefits of those more expensive chapter 13 cases.  For example, car loans can be paid off for what a vehicle is worth instead of what is owed and at lower interest rates.  That savings can more than offset the higher cost of chapter 13. In addition, new debts incurred after the case is filed–especially ongoing medical bills–may be discharged if the case is converted to chapter 7 later.  Income tax debts may be paid off at lower interest rates as well. No mention of these cost savings is mentioned in the article.

Yes, we need reforms to help lower-income debtors file successful bankruptcies. But attacking attorneys–the gatekeepers to the justice system–or attacking debtors by making it more expensive to file chapter 13 is not the answer to the problem.

Image courtesy of Flickr and