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Jury still out on bankruptcy reforms

By Manav Tanneeru
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(CNN) -- The number of bankruptcy filings dropped significantly in 2006, a year after reforms were passed to amend U.S. bankruptcy law in hopes of curtailing fraud and abuse in the system.

Critics of the reforms, however, said the drop in filings is a temporary phenomenon and expect a return to previous levels because the underlying causes of bankruptcy have not been addressed.

The reforms, passed by a bipartisan congressional majority in early 2005, went into effect October 17, 2005.

During the federal fiscal year ending September 30, 2006, the number of bankruptcy filings fell nearly 38 percent from the previous 12-month period, according to the Administrative Office of the U.S. Courts. The filings in the 2006 fiscal year include a surge of bankruptcies filed in the first half of October 2005, just before the reforms went into effect.

For the three-month period ending September 30, 2006, the number of filings totaled slightly more than 171,000. In contrast, during the same period in 2005, filings numbered more than 542,000 -- a 68 percent drop.

The 2005 law, a set of amendments to bankruptcy law passed in 1978, was precipitated by a concern among lawmakers that the bankruptcy system was too lenient and was being abused, observers say.

"[During] the last 10 or 20 years, we saw a rapid rise in consumer bankruptcy filings, and it was a period of prosperity," said Todd Zywicki, a law professor at George Mason University, who worked at the Federal Trade Commission in 2003-04.

"There was a perception that that was out of whack, that bankruptcy filings should not have been rising so rapidly when the economy was in good shape.

"There was also a widespread impression that fraud and abuse in the bankruptcy system had been rising over time," he said, with people taking advantage of loopholes and sometimes walking away from debts they could afford to pay.

"There was an erosion of the stigma associated with filing bankruptcy, so more people were willing to file bankruptcy as a first resort rather than a second or third resort," he said.

Legislative wrangling over reforms began in 1998, four years after Republicans took control of Congress. The law was finally passed seven years later, implementing a new set of guidelines for bankruptcy filings and safeguards to cut down on potential fraud and abuse.

The law applied a "means test" to determine whether a person qualifies for Chapter 7 bankruptcy, which erases debts, or Chapter 13, which establishes a payment system. The goal was to force more people to repay what they could.

Other changes included mandatory credit counseling prior to filing for bankruptcy, requiring pay stubs and tax returns to verify income, and extending the period between when a person can again file for bankruptcy.

Critics of the legislation contend that it was a boon to the consumer credit industry and that it did not address the root causes of bankruptcy.

The most common reasons behind bankruptcy filings are health care costs, divorce and periods of unemployment, according to Robert Lawless, a professor at the University of Illinois at Urbana-Champaign, who was critical of the law in testimony before the Senate.

As long as those causes of financial distress are not addressed, bankruptcy filings will continue, he said.

Katherine Porter, a law professor at the University of Iowa, said many experts, bankruptcy lawyers and judges she has spoken to expect the number of filings to return to previous levels.

"We haven't changed the economic structure of American families. We still have a lot of families in financial trouble," she said. "[This law] just makes it more expensive and more of a hassle to file."


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