Bankruptcy Reform, 4 Years On

In 2005, Congress passed, and President Bush signed, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA).

This law was passed with the explicit intent of making it more difficult for individuals to file for bankruptcy, by significantly changing the U.S. Bankruptcy Code for the first time in decades. The changes will be discussed in more detail below.

The law was primarily supported by banks, credit card companies, and other major lenders.

One of the major effects of the new law was to make it far more difficult for individuals to file for Chapter 7 bankruptcy, which allows them to liquidate their nonexempt assets, and use those funds to pay off as much of their debt as possible, after which all eligible debt is discharged. This, in theory, leaves the consumer with far fewer assets, but with a greatly reduced debt burden, allowing them to start over (hopefully with a new appreciation for the consequences of taking out debt that you can’t afford to pay back).

However, the major provision of the new law adds a “means testing” to Chapter 7 filings. Basically, the Bankruptcy court has to look at the debtor’s income, assets, and debt. If the debtor’s income exceeds the median income in their state of residence, they cannot file for Chapter 7, and instead must file for Chapter 13 bankruptcy.

Under Chapter 13, debt is not discharged. Instead, payments are structured in such a way that they will be theoretically manageable for the debtor, and they are made until the debt is at least in part paid off. This usually requires the debtor to spend several years using all or most of their disposable income to pay off their debt. Similar to Chapter 7, once this process is complete, most of the debt is discharged.

While both systems have their advantages and disadvantages, Chapter 7 is typically seen as a better “nuclear option” or course of last resort for debtors who are on the verge of financial ruin. Chapter 13 is generally seen as more appropriate for individuals whose debt has become unmanageable, but still have a steady source of income.

The results of this change in the law are complicated. For starters, in the months before it took effect, Chapter 7 filings spiked, presumably to take advantage of the old system. After it took effect, Chapter 7 filings plummeted. Over the last couple years, however, filings have leveled out.

Predictably, the percentage of filings by type shifted after the law took effect. Immediately before the law took effect, Chapter 13 filings made up around 11% of all consumer bankruptcy filings. After the law took effect, that percentage jumped to 59%. Again, this percentage has been continuously dropping in recent years, and is currently around 25%. A more detailed analysis of the data can be found here.

So, it appears that this law’s intended effects came to pass in spades, at least in the short term. However, as bankruptcy lawyers learned about the new system, the response appears far more measured, and the numbers are not showing the huge peaks and valleys we saw immediately before and after the law took effect.

But has this had the intended effect of reducing bankruptcy abuse? It’s hard to tell. There’s no question that some irresponsible debtors gamed the system before the law was passed. It’s generally assumed, however, that they made up a small minority.

It’s pretty hard to tell if this has actually reduced abusive filings, since, presumably, those who successfully gamed the system don’t get caught. However, the fact that it is now so much more difficult to file for Chapter 7 has made life very difficult for some debtors, who are now paying for the actions of a few bad apples.