The Consumer Bankruptcy Landscape

When long-awaited bankruptcy reform legislation was passed in 2005, it came with a promise of lower overall consumer filings going forward and stricter rules for those that did seek protection. While the impact was seen immediately in 2006, the prolonged recession has driven filings back to pre-reform levels, and there is a chance total consumer filings in 2010 could approach all-time records.

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) took effect in October 2005. The law requires a greater percentage of consumers who file for bankruptcy to repay a larger portion of their debts. Under the legislation, many consumers can no longer avoid payments on credit card debt and other unsecured loans by claiming bankruptcy protection under Chapter 7 of the U.S. Code. Instead, these consumers are now subject to a means test that consigns many debtors to Chapter 13 status. Under this classification, cases are reviewed by judges who can order and administer repayment plans that vary with the consumers’ ability to repay financial obligations to creditors.

Historical filing data support some of the intended effects of Act. In the 12 months ended March 31, 2006, there were 1.8 million bankruptcies filed in U.S. Circuit and District courts. By contrast, 700,000 bankruptcies were filed in the 12 months ended March 31, 2007, a 61.2 percent decrease over the same period in the previous year.

Driven largely by a flood of filing activity in the run-up to BAPCPA’s effective date, there were 2 million total bankruptcy filings in the U.S. by the end of calendar year 2005, according to the Administrative Office of the U.S. Courts. This was the first time in U.S. history that bankruptcy filings exceeded the two million mark in a single calendar year. In the first three quarters of 2006, total consumer filings were 429,522, down 69 percent from the same period in 2005. By the end of the 2006 calendar year, only 600,000 personal bankruptcy petitions had been filed.

But the trend has been moving higher ever since, culminating in an eye-popping 1.4 million total consumer bankruptcy petitions filed in 2009. The figure is near the 1.55 million average annual filings from 2001 to 2004, before bankruptcy reform was passed and following a milder recession in the early 2000s.

Most analysts expect total consumer bankruptcies to come in around 1.7 million to 1.8 million in 2010. If they are right, it would be the second-highest annual total ever recorded, behind only the inflated numbers from 2005.

Chapter 7 vs. Chapter 13

While the overall increase in consumer bankruptcy filings is troubling for creditors and ARM organizations, the rise in Chapter 7 filings directly contradicts an intended benefit of the reform effort.

When the stricter bankruptcy rules took effect in 2005, a major goal was to require more consumer filers to rely on Chapter 13, which requires debtors with regular income to repay debts in full, or in part, over several years. The means test imbedded in the new law identifies and validates employment in the bankruptcy process.

The precipitous rise in unemployment over the past 18 months has caused many consumers to fail the means test. This results in a Chapter 7 filing, which allows a court to discharge most unsecured consumer debt, including credit card accounts. Numbers from the American Bankruptcy Institute support the shift back to Chapter 7 filings.

In 2004, Chapter 7 filings accounted for 71.5 percent of all consumer bankruptcy protection petitions. In the rush to file ahead of the new laws, that percentage jumped to 80 percent in 2005. The following year, with the new rules in place, Chapter 7 filings accounted for only 58.4 percent of all consumer bankruptcies. It has steadily increased in each subsequent year.

In 2009, Chapter 7 flings accounted for 71.4 percent of all consumer filings. And the pace of Chapter 7 increases far outpaces the growth in Chapter 13 filings; Chapter 7 filings rose 41 percent in 2009, while Chapter 13 filings were up just 12 percent.

“New Normal” or Economically Driven?

Because of the breadth, depth and complexity of the current downturn, it is difficult to compare current consumer bankruptcy filings against historical readings. It is reasonable to assume that the spike in filings in 2008, 2009 and 2010 is due principally to historically high unemployment and underemployment. We will not get an accurate sense of the impact of the new bankruptcy rules until at least the end of 2011.

Testing of the new law also clouds the picture. There have already been high-profile challenges to the law. In early March, in a minor win for the government, the U.S. Supreme Court upheld a provision of the legislation that said bankruptcy attorneys could not give their clients advice to take on more debt. Last year, there was a popular movement to amend bankruptcy rules to allow for mortgage modification in bankruptcy proceedings. And there is currently a proposal before the United State Courts to require even more documentation on the part of creditors when filing proofs of claim in a bankruptcy proceeding. In other words, the law is currently in a “shake out” phase in its first five years of existence.

Regardless of the outcome of the movements to amend and modify the new bankruptcy law, parties with a particular interest in consumer bankruptcy should expect higher levels of filing in 2010 and 2011, with Chapter 7 filings accounting for an outsized proportion of consumer filings.

This article originally appeared in Know Your Debtor, a free quarterly newsletter focused on the health of the U.S. consumer. To subscribe to Know Your Debtor, please the Member Center. You can see a copy of the latest edition at http://www.insidearm.com/newsletters/know-your-debtor.html.