The Bankruptcy Lawyers Blog

The U.S. District Court for the Northern District of Texas ruled today that section 526(a)(4)'s restriction on legal advise violates the attorney's First Amendment Rights.

In Hersch v. United States of America, et al., the court rejected the attorney plaintiff's contention that the debt relief agency provisions of BAPCPA were not applicable to attorneys, stating that the plain language of the statute and the legislative history, combined with Congress's failure to include attorneys in the explicitly listed exceptions, outweighed any minor inconsistencies within the statute.

However, the court went on to state that section 526(a)(4) was not sufficiently narrow. The court pointed out that there are situations in which it may be both lawful and advisable for a client to incur additional debt in "contemplation" of bankruptcy, and that section 526(a)(4) thus "prevents lawyers from giving clients their best advice."

The court dismissed the plaintiff's other claims, finding that section 527 did not unconstitutionally compel speech because, although the attorney's first amendment rights were implicated, the government had advanced a sufficiently compelling interest and the provision did not unduly burden either the attorney-client relationship or the ability of a client to seek bankruptcy.

Finally, the court dismissed the 5th amendment right to counsel claim for lack of standing.

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As foreclosure rates across the country rise and the number of new bankruptcy petitions is steadily climbing back toward pre-BAPCPA rates, local media blame everything from rising gas prices to mass layoffs to a leveling off of property values. Each of those factors likely impacts the foreclosure and bankruptcy rates we're seeing, but the proliferation of subprime lending, and in particular Adjustable Rate Mortgages (ARMs) in the early 2000s is surely a critical factor.

In 1995, fewer than 100,000 subprime mortgage loans originated, with only 21,000 ARMs among them. Over the next few years, however, those numbers escalated rapidly. From the early 1990s to the late 1990s, subprime mortgage lending grew from .74 % of the overall mortgage market to more than 8%. At their peak in the early 2000s, more than 1.5 million subprime mortgage loans were generated in a single year, including 866,000 ARMs.

Subprime loans provide access to home ownership to people whose credit would otherwise not support a mortgage, but there are heavy risks associated. ARMs typically carry a fixed interest rate for 3 or 5 years, and are then subject to adjustment. Many of these loans are "interest only" during the fixed period, creating an even more significant shock when the rate changes and principal payments commence simultaneously. Unfortunately, many ARMs-about 80% of those generated between 2000 and 2002-carry prepayment penalties that make refinancing difficult or prohibitive.

Consumer bankruptcy attorney O. Max Gardner III analyzed the impact of ARMs on consumer finances. Assuming a 3 year fixed rate with an adjustment up or down of no more than one point, originated in 2004 for a $300,000 home with a loan-to-value ratio of 95%, Gardner calculated that interest only payments for the first three years (2004, 2005, and 2006) would be approximately $1551. In 2007, however, when the principal payments and adjusted rate took effect, payments would jump to $2,482-a 61% increase. By 2009, the increase would be nearly 100%, for a monthly payment nearly double the initial monthly payments.

Many consumers are simply unable to absorb the increase, particularly since subprime lenders most often work with borrowers who have lower credit scores or down payments and may not qualify for traditional mortgages.

The ARM "boom" of the early 2000s is coming back to haunt us, as literally millions of ARMs originated during 2001-2003 are reaching their "shock" points simultaneously. The Mortgage Bankers Association reportedly estimates that approximately $330 billion in ARMs have adjusted or will adjust in 2006, with an addition $660 billion or more by the end of 2007. That $1 trillion in ARMs, at an average loan value of $300,000, represents more than three million homeowners nationwide now facing dramatically increased mortgage payments.

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The Chicago Tribune this week announced "Personal Bankruptcy Filings Plunge". Whether through mischaracterization or misunderstanding, mainstream media across the country are reporting on the dramatic drop in bankruptcy filings over a similar period in the previous year: it happened when the fourth quarter 2005 stats were released, and it's happening now, in the wake of the first quarter 2006 stats.

It's certainly true that far fewer personal Chapter 7 cases were filed in the first quarter of 2006 (65,397) than in the first quarter of 2005 (289,239). But in reporting consistently on the dramatic decline, the press persistently ignores the clear trend in filings since the law change.

Breaking down the statistics by month since the law change paints a much more realistic picture:

November, 2005: 5,460 (7); 8,298 (13)
December, 2005: 9,274 (7); 12,362 (13)
January, 2006: 13,033 (7); 14,202 (13)
February, 2006: 19,591 (7); 15,761 (13)
March, 2006: 30,626 (7); 19,351 (13)

In addition to the steady increase in filings each month since the law change, the proportion of Chapter 7 cases is working its way back toward the norm. Although both mainstream media and industry sources like Lundquist Consulting point to the increase in percentage of Chapter 13 filings versus prior years, that ratio is dropping monthly, with Chapter 7 filings far outstripping 13s during March, 2006.

Additionally, the Tribune reports that June personal bankruptcy filings averaged 2,272 per day. Although the paper compared that to the "typical" 5,000-6,000 filings per day before the law change. The more significant comparison, however, seems to be with current numbers: if the reported average is accurate, then June filings--significantly outdistancing March filings--show that the trend back toward pre-BAPCPA numbers continues.

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Back in May, we reported that the National Association of Consumer Bankruptcy Attorneys (NACBA) and the Connecticut Bar Assocation (CBA) had filed suit in federal court alleging that the "debt relief agency" provisions of BAPCPA prohibited attorneys from providing complete and accurate information to their clients, making it impossible to fulfill their ethical obligations.

NACBA/CBA requested a preliminary injunction prohibiting application of those provisions to NACBA/CBA members until the issue had been decided.

Yesterday, the District Court heard arguments on the preliminary injunction. Eugene S. Melchionne, Esq. kindly provided an "eyewitness account" of the hearing. NACBA was represented by Peter Rubin and Henry Sommer, and CBA by Tom Gugliotti and Barry Fiegenbaum. There were also several NACBA members in attendance, including Eugene, Charlie Maglieri, Jed Berliner and Susan Williams.

Peter Rubin, by Eugene's account, presented an excellent case and ably answered the judge's many questions. In contrast, the government's argument reportedly relied heavily on the idea that where the law was written overbroadly, the government wouldn't think of enforcing it "that way."

No indication of the direction the judge might be leaning, but all indications were that he'd educated himself on the issues and asked a number of pertinent questions. We'll post information about the ruling as soon as it is available.

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Nathan Udell filed a Chapter 7 bankruptcy petition in 2002, and sought to discharge a debt of $123,692 to the United States government. The bankruptcy court discharged the debt, but the U.S. District Court for the Eastern District of Pennsylvania reversed that order and held that the debt was not dischargeable. The 3rd Circuit affirmed the reversal.

The debt stemmed from Udell's completion of three years at the Air Force Academy. Upon enrollment, Udell had signed a "Record of Acceptance, Obligation, Reimbursement, and Oath of Allegiance," agreeing to complete his education and serve on active duty for a period of eight years.

However, after three years at the Academy, Udell voluntarily separated from the service in the wake of misconduct that could otherwise have led to dishonorable discharge.

The Record of Acceptance signed by Udell specifically referenced 10 U.S.C. s. 2005(d) of the Armed Forces Code. The relevant provision imposes an obligation to reimburse the government for educational costs, and specifies:

(d) a discharge in bankruptcy under Title 11 shall not release a person from an obligation to reimburse the United States required under the terms of an agreement described in subsection (a) if the final decree of the discharge in bankruptcy was issued within a period of five years after the last day of a period in which such person had agreed to serve on active duty...

The facts are undisputed in that Udell incurred a reimbursement obligation under his agreement with the Air Force, and that more than five years had elapsed at the time his debt was discharged by the bankruptcy court.

Udell argued that the above provision of the Armed Forces Code authorized discharge of the debt after five years, and that as a more specific statute and one explicitly referenced by his agreement with the Air Force, it should control.

However, the District Court found, and the Appellate Court affirmed, that there was no conflict between the Armed Service Code and the U.S. Bankruptcy Code. Rather, the Armed Forces Code created a further restriction on the ability to discharge such a debt in bankruptcy. Within the initial five year period, even a debt that would have been dischargeable in bankruptcy based on a finding of undue hardship would not be dischargeable. However, once that five year period had elapsed, the debt would simply be subject to the regular provisions of the Bankruptcy Code.

The Bankruptcy Code provides in relevant part that there shall be no discharge

"for an educational benefit overpayment or loan made, insured, or guaranteed by a government unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution, or for an obligation to repay funds received as an educational benefit, scholarship or stipend, unless excepting such debt from discharge under this paragraph will impose an undue hardship on the debtor and the debtor's dependents"

Thus, the debt could have been discharged only on a finding of undue hardship--an issue Udell did not raise in his bankruptcy proceeding.

The Circuit Court distinguished the case from those, such as In re Borrero, 208 B.R. 792 (Bankr. D. Conn. 1997), concerning discharge of a Health Education Assistance Loan, since the Public Health Services Act not only prohibits discharge for seven years, but also specifies the terms under which the debt may be dischargeable thereafter.

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The Federal Reserve-yes, that same institution that reassured us all last month in its Report to Congress on the Practices of the Consumer Credit Industry in Soliciting and Extending Credit and their Effects on Consumer Debt and Insolvency that "the aggregate growth of consumer debt has not entailed a threat to the household sector of the economy-released statistics this week indicating that outstanding non-mortgage consumer credit had increased by $4.4 billion in May. That $4.4 billion is the latest in a string of increases-seven consecutive months-and the largest single-month increase since October of 2004. The net increase since the end of 2005 if more than $64 billion, with no indication that the pace is slowing.

At the same time, McClatchy Newspapers is reporting that last year credit card companies-the ones the Federal Reserve assured us were "carefully pre-screening" those to whom they extended credit offers-sent out more than 6 billion solicitations. And those solicitations aren't just offers of credit, either. According to McClatchy, 58% of those offers included some kind of "rewards" for the use of credit. Those incentives rarely work out to the consumer's benefit, since interest on a purchase not paid off within the grace period will often more than consume the "cash back" associated with the purchase. Such programs would have been very relevant factors for consideration by the Board of Governors of the Federal Reserve in responding to Congress's concern as to whether credit card companies offered credit "in a manner that encourages consumers to accumulate additional debt"-had the Board decided to address that concern at all.

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Congress-no friend to the debtor in the 2005 bankruptcy reform-was nonetheless compelled to acknowledge some apparent culpability on the part of credit-issuing banks. Section 1229 of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) says, in part:

SEC. 1229. ENCOURAGING CREDITWORTHINESS
(A)SENSE OF THE CONGRESS.-It is the sense of the Congress that-
(1)certain lenders may sometimes offer credit to consumers indiscriminately, without taking steps to ensure that consumers are capable of repaying the resulting debt, and in a manner which may encourage certain consumers to accumulate additional debt; and
(2)resulting consumer debt may increasingly be a major contributing factor to consumer insolvency.

In short, Congress suggested, right in the bankruptcy statute, that credit issuers might be at least partially to blame for the increase in bankruptcy filings. Congress went on to order the Board of Governors of the Federal Reserve to conduct a study of such practices and their impact on consumer debt and insolvency.

Indiscriminately, without taking steps to ensure that consumers are capable of repaying

On the first two issues-whether lenders were issuing credit "indiscriminately" or "without taking steps to ensure that consumers are capable of repaying the resulting debt", the Board summarily concluded that they were not. Citing the two-step process in which most consumers are "pre-qualified" before receiving credit offers and then individually screened upon application, the Board determined that "lenders analyze consumer financial behavior carefully before offering credit, and they consider consumers' ability and willingness to pay in making decisions about extensions of credit."

Unfortunately, the report fails to take into account a number of critical facts. For instance, those pre-screening processes are just as easily used to target consumers who are in desperate straits and likely to accept egregious credit terms. Many credit card lenders make their fortunes on annual fees, "start-up" fees, and high interest rates that would never be accepted by the truly credit worthy. In fact, the Board's concluding paragraph points out that "risk segmentation enables providers to price for risk...".

Likewise, a lender's assessment is based on profitability of the account, and with fees, high interest rates, late charges, and over-the-limit charges, delinquent accounts can be quite lucrative for credit card issuers. In fact, the borrower who pays at or near his minimum payment level, carries a high balance, and makes occasional late payments is a much bigger moneymaker for the lender than a responsible borrower who pays off his balance in full each month.

In a manner which may encourage certain consumers to accumulate additional debt

The Board dodged the issue of lenders encouraging consumers to accumulate additional debt, concluding that, "the aggregate growth of consumer debt has not entailed a threat to the household sector of the economy." We could argue that the statement itself is inaccurate, but that's hardly relevant here, since Congress didn't ask whether the aggregate growth of consumer debt entailed a threat to anyone-Congress asked whether credit card company practices encouraged consumers to take on additional debt.

In an effort to provide support for the idea that the leap in credit card debt and usage was attributable to other factors, the Board largely contradicted its first two findings, pointing out that "credit cards have become more widely available to all groups, including lower-income consumers and to populations with a wider range of credit risks." Translation: people who are less likely to be able to repay can now obtain credit cards more easily. This statement, at least, is supported by data. Consumers with incomes below the 40th percentile are carrying 21% of the total outstanding credit card balances, and more than 60% of those in that income category who use credit cards are carrying balances from month to month.

The biggest evasion on this issue comes in a single sentence relating to concerns about whether consumers have enough information to make good decisions and avoid unexpected costs: "These concerns are beyond the scope of this report." It's difficult to understand how the Board might have considered understandable disclosures to consumers "beyond the scope" of whether or not credit card issuers encouraged consumers to accumulate additional debt.

Consumer debt as a contributing factor to insolvency

The Board cites a 2002 study to support the startling notion that the best predictor of whether or not a household will file for bankruptcy protection is the financial benefit of doing so. The connection between the financial benefit of bankruptcy and the level of unsecured consumer debt relative to income and assets is glossed over. The Board does concede that consumer debt is one of many factors that may play into insolvency, but concludes, "the decision to file for bankruptcy is complex and tends to be driven by household distress arising from unforeseen adverse events such as job loss, divorce, and uninsured illness."

It's too bad Congress didn't ask this question before making those sweeping changes to the Bankruptcy Code to root out the "deadbeats".

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