Bankruptcy “reform” calls for a “Means Test” to determine, based on the law and not necessarily on actual fact, whether you can “afford” to pay any part of your unsecured debts, and if so, how much you can “afford.”

As you would expect, to do a Means Test, you need to define “Income” and “Expenses.” This post will concentrate on the definition of income and the problems the new law, if passed, will pose.

S.256 as passed by the Senate (warning: very large HTML file) defines income as:

…”the average monthly income from all sources that the debtor receives (or in a joint case the debtor and the debtor’s spouse receive) without regard to whether such income is taxable income, derived during the (previous) 6-month period…”

That’s it (with the sole exception of Social Security income, which is excluded). After doing a complete search (on the word “income”) of the bill as passed by the Senate and The Bankruptcy Code as it would be revised if the bill passes, I don’t find any other exceptions to this definition in the bill, nor do I find any ability on the part of judges, trustees, or administrators to modify this definition in any way (if you know of any exceptions or can show that the parties involved have any flexibility I haven’t discovered, e-mail me and point to specific examples).

It appears not to matter if you just got fired or laid off, were injured on the job, or became medically disabled–the monthly average of what you earned during the past six months is used, PERIOD. It assumes that you will continue to earn what you have been earning regardless of any changes in circumstances that would affect what you can realistically hope to earn in the future. Even if you have suffered a sharp income reduction that would logically qualify you for the “automatic Chapter 7″ supposedly accessible to those with incomes below their state’s median, as long as you earned above the median during the past 6 months, there is a good chance you will be forced into a Chapter 13 repayment plan. If you are, the plan will be based on an assumed level of income that will doom the plan to failure from the start.

Now, why in the world would the bill be written this way? Simple: to discourage the very people who would be the most logical candidates for bankruptcy from filing, so supporters can claim “victory” when the bankruptcy stats go down (never mind the misery heaped on people already condemned to extended financial trauma by events beyond their control).

A person or family whose income has gone down sharply would need to wait six months for the new average-income reality to be properly reflected in a bankruptcy filing. In the meantime, finance charges, penalty charges, and penalty fees pile up, meaning that the train wreck that occurs when the delayed filing is made will almost inevitably be much worse than it would have been if a filing based on a realistic estimate of future income had been allowed six months earlier.

Bill proponents complain that many people play games with the current system by quiting work in advance of a filing so they will qualify for Chapter 7. I would like the stats proving that it happens often; I doubt that it does.

The bill’s six-month lookback requirement will also be tough on seasonal workers in industries like construction who are laid off or injured near the end of a seasonal peak time. In these cases, the income definition will ignore those periods of the year, such as winter for outside workers in northern climates, where income earned is much lower, and will generate an arbitrarily high average income. Since it’s required anyway, why not look at the tax return to see what a typical annual income would be for such a person, and divide by 12? Answer: see above–to discourage filings.

Despite the obvious flaws in the bill’s definition of income, B-”R”’s supporters comically claim that:

It will not prevent any innocent, good-faith filers from filing bankruptcy and getting a discharge. It preserves the fresh start for those who need it.

Unless I am missing something, and I don’t think I am, the above shows that this claim is a bald-faced, Grade-A lie. (Or could it be that the bill’s supporters believe the unemployed, laid-off, injured and disabled DON’T “need” a fresh start? Hmmm.)

So what should be done?–

Essentially, the courts should just keep on doing what have been doing for years. Simply come up with a realistic estimate of the debtor’s projected future monthly income based on current facts and circumstances. Is that difficult? No, it generally hasn’t been.

Is such a projection subject to manipulation? A little, but I sense that trustees, administrators, and judges often ferret out the more obvious instances of deception, and that very few truly egregious cases escape prosecution (see Point 4 in my previous post on the FBI’s failure to proscute more than a small number of bankruptcy fraud cases each year, despite a task force devoted to the “huge problem”).

Would it be nice to give judges, trustees, and administrators a little more ability to audit debtor statements about current and future income, perhaps to compel presentation of copies of bank statements and other documents if they suspect something is amiss? Sure–Just don’t expect to find billions of dollars worth of lies.

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Anyone with a good argument against the content of this post, or with a better idea of how to define “income,” is welcome to respond. I will post good responses that I receive in a later post.

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UPDATE: Moderate Mainstream usefully reminds me in an e-mail that “on average, most people don’t consider bankruptcy when they lose a job; it happens months after the unemployment runs out. People just don’t believe they will be off work for a long period. Yes, there are exceptions but generally speaking, the event that leads to bankruptcy happens YEARS in the past, usually 2-3 years. People really do consider bankruptcy a last resort…sometimes (often) to their detriment.”

Points well-taken. OTOH, I have spoken with Employee Assistance Plan counselors in some of the “exception” situations who have recommended immediate bankruptcy filing to just-laid-off or fired workers who are financially in over their heads, especially middle-manager white-collar types who might not find another comparable job for at least 3-6 months. These people would be intensely shafted by the new law’s forced 6-month lookback, especially since unconstrained lenders have all the time in the world to pile on penalty rates and fees.

A copy of the Democratic House Judiciary Staff’s dissenting views on the bankruptcy bill was “leaked” (oh sure, but that’s OK) to an “alternative news nexus” called RAW STORY earlier this week.

Sure, there are predictably liberal arguments in it, including the somewhat (but not totally) “discredited” study that assigned 50% of the blame for bankruptcy filings on high medical costs, but there are plenty of valid points that conservatives can agree with:

- “S. 256’s Means Testing is Arbitrary and Unworkable in Practice.” Since when do we add a resource-sapping bureaucracy on top of an existing one?

- “(changes in) the IRS collection standards can change the manner in which the bankruptcy laws are applied.” The adminstration of bankruptcy filings would be or will be largely and absurdly controlled by items determined by someone else not in the court’s control. Since when do we want to give the IRS control over ANY courts?

- “…making chapter 13 the only avenue for bankruptcy relief for some individuals and imposing the bill’s strict income and expense tests will undoubtedly result in an even smaller proportion of successful chapter 13 plans.” Since when do we feel good about setting a program up so that it will fail even more often than it does now?

- “the National Conference of Bankruptcy Judges that at least 16 potential sources of litigation are contained in the means testing provisions alone, and that another 42 litigation points have been identified in the other consumer provisions.” (This dovetails with an “archair quarterback” impression I have picked up throughout the course of my study of the bill) Since when do we create a lot of new work for an activist judiciary? Do we want give them the chance to do to bankruptcy what they did, for example, to campaign finance law?

- “In the eight years since the credit industry first came to Congress seeking relief from the rising rate of personal bankruptcy filings, the extension of credit has not been curtailed nor have the industry’s profits been diminished due to bankruptcy filings.” Since when do we reward an industry for its poor decisions?