Morally bankrupt?

Apr 15th 2005
From The Economist Global Agenda

America's Congress has passed a new, creditor-friendly bankruptcy bill. As consumer advocates and credit-card companies both try to stake out the moral high ground in the debate, there are some reasons to be concerned about the change

AMERICA leads the world in many fields, but perhaps most commandingly in bankruptcy. Last year, in Britain, which enjoys Europe’s most debtor-friendly bankruptcy laws, 35,898 people filed for bankruptcy protection. In the United States that figure was 1.6m—around nine times higher per capita. Bankruptcy in America has long been easier—and thus more prevalent—than in other parts of the world, but the past 20-odd years have seen an explosion. Five times as many Americans went bust last year as did in 1981.

American legislators are looking to change that with a reform bill aimed at making bankruptcy less attractive. On Thursday April 14th, this was passed by the House of Representatives, having already made it through the Senate. In the run-up to the vote, the debate had turned into a sort of morality play, with advocates for financial firms and consumers each seeking to cast the other as the sole villain behind the increase in bankruptcy filings.

Neither side has a monopoly on blame. Though credit-card companies like to claim that the real problem is the easy bankruptcy ushered in by the last major reform, in 1978, David Skeel, a law professor at the University of Pennsylvania, argues that those changes alone did not cause the spike in filings that followed. He points out that a Supreme Court decision around the same time weakened usury laws and ushered in the era of widespread unsecured consumer borrowing—the kind that bankruptcy makes it easy to shrug off. This is not necessarily a bad thing: before credit cards, consumers often resorted to less salubrious lenders, such as pawn shops or loan sharks. But it does suggest that easy credit is part of the problem.

Nonetheless, it is not by itself a sufficient explanation. While consumers do carry more debt than they used to, the amount of income devoted to servicing that debt has not gone up that much, thanks to falling interest rates and longer maturities. Other factors must be at work; plausible candidates include greater income volatility, legalised gambling, bigger medical bills, increased advertising by lawyers offering to help people in debt, and a cultural shift that has destigmatised bankruptcy.

But Congress clearly blames the debtor, not his financial enabler. The new bill will make it harder for individuals to declare Chapter 7, the most common form of bankruptcy, which allows debtors to walk away from their debts, often while shielding exempt assets like cars and homes. Those whose income is above the median in their state, and who are able to pay at least $100 a month after allowed expenses, will be forced to enter Chapter 13, where they must repay at least part of their debt over five years. Debtors will have to document their income more extensively and go for credit counselling. Serial Chapter 13 filings, which are often used to stave off foreclosure or eviction, will be blocked.

The bill’s reform of corporate bankruptcy, known as Chapter 11, shows a similar suspicion of filers’ motives. Among the main changes are the curtailment of bonus schemes used by bust firms to keep employees they deem valuable during reorganisation; various enhancements of creditors’ rights; and a new mechanism for bankruptcy trustees to take control if there is evidence that existing management engaged in fraud and such like.

Outside of America, this would still seem generous. European managers who take their company into bankruptcy can generally expect to be sacked. In Britain, they can be held liable for the firm’s debts if they continue operations while it is technically insolvent. In continental Europe, courts lean more towards liquidation than reorganisation. Individual bankruptcy, meanwhile, is a rarity, and those who enter it are generally expected to cut their budgets to the bone to make at least partial repayment. In many places, judges can refuse to grant bankruptcy protection if they think the money borrowed was spent frivolously, or if the borrower’s record during repayment is less than perfect.

But while Europeans might be bemused at all the moral outrage in America over the latest reforms, they might also wonder why Americans are so eager to move their bankruptcy law closer to Europe’s—especially since Europe is busily trying to emulate America. Until around 20 years ago, consumer bankruptcy didn’t even exist in many European countries, and corporate bankruptcy was a draconian process too dreadful for all but the most desperate managers to contemplate. Since then, these nations have relaxed their laws precisely because they see the economic benefits this has brought America.

A cure worse than the disease?

Making bankruptcy harder tends to make borrowers more willing to lend, but consumers less willing to take on debt. The result is that interest rates—the price of credit—fall. At first blush, this would make it seem that Europe had the right idea in the first place; the vast majority of people and companies that never declare bankruptcy get better terms on their loans, while the few profligates are forced to watch their step.

But making bankruptcy more difficult has other, less attractive economic effects. Forced repayment plans can discourage people from working harder (or at all), since extra income simply goes to pay creditors. Making bankruptcy more unpleasant can also deter entrepreneurship; people starting businesses are often required to personally guarantee loans to their firm—and those without assets are often forced to rely on MasterCard and Visa for their seed capital. Tougher corporate-bankruptcy rules seem to make companies more risk-averse. America’s current permissive system does let many (possibly undeserving) managers keep their jobs, but it also saves workers and suppliers from a sudden loss of income.

A number of the new bill’s non-economic aspects are also troubling. Some, such as documentation requirements, seem a reasonable way to weed out fraud, which the FBI estimates to be some 10% of cases. But many others, such as forcing those whose incomes qualify for Chapter 7 to fill out detailed budgets, will discourage deserving debtors. The new treatment of secured car loans could put child-support and alimony payments behind GM’s finance arm in the queue. In a sense, the bill's critics fear, it moves America away from Europe in the wrong direction, stripping autonomy from judges and turning the bankruptcy process into a mechanical monster which is all too likely to crush innocents under its wheels.

The bill does at least contain one feature that has everyone pleased: a new Chapter 15, which adopts the UN’s model code on cross-border bankruptcy. This will make multinational bankruptcies, a growing issue, much easier to handle. Still, only time will tell whether America’s steps in Europe’s direction are one forward, or two back.

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