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Bankruptcy reforms aimed at curbing filings may wind up increasing them

Mark Reutter, Business & Law Editor


CHAMPAIGN, Ill. — If history is any guide, last year’s changes to the bankruptcy law aimed at reducing individual bankruptcy filings may have the opposite effect – a long-term surge in personal filings, according to a study by a University of Illinois expert.

In an upcoming paper in the University of Illinois Law Review, Robert M. Lawless, a professor at the Illinois College of Law, examines the relationship between changes in federal bankruptcy law and the filing rates by consumer debtors.

He concludes that the liberalization of the bankruptcy law in 1979 did not lead to a significant rise in bankruptcy filings, but the subsequent tightening of provisions in 1984 did.

More stringent bankruptcy laws, he wrote, can have the “perverse effect” of creating expectations of higher recovery rates from debtors by banks and other lenders, which then encourage the lenders to expand consumer credit, which can lead to more future bankruptcies.

Calling this the “paradox of consumer credit,” Lawless also noted that the widely accepted idea among experts that bankruptcy filings are directly linked to outstanding consumer debt might be misplaced.

Instead, growth in consumer debt appears to be linked to short-term decreases in bankruptcy filing rates, followed by a rash of petitions.

“Desperate borrowing by financially strapped consumers postpones the day of reckoning,” Lawless explained, but “mounting consumer debt catches up with consumers, and eventually leads to higher long-term filing rates.”

Lawless cited research showing that the number of bankruptcies increased with the increase in consumer credit – mainly from the widespread distribution of credit cards to low creditworthy households  – in the 1980s and 1990s.

These findings, the Illinois scholar said, have implications for banking and credit card regulation as well as the effectiveness of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act.

The law, which went into effect last October, was enacted by Congress to reduce the number of bankruptcy cases termed “abusive,” or filed by consumers in order to escape unsecured debt through the discharge of the debt by the bankruptcy court.

Among other changes, the new law requires “means testing” for households that file for bankruptcy and requires those with sufficient funds to repay unsecured debts.

“Despite the fixation by Congress and financial lenders on the effect of legal regulation, it is reasonable to question whether legal regulation affects bankruptcy filing rates,” Lawless noted.

In fact, government data going back to 1898, when the first bankruptcy law was enacted, “suggest that the 2005 amendments may lead to an expansion of consumer credit and a long-term increase in the bankruptcy filing rate.”

His forthcoming paper is titled, “The Paradox of Consumer Credit.”