Debtors’ Lives Are Open Book in Bankruptcy : Lack of Firm Guidelines Gives Judges Great Power to Mandate Life Styles

NEW YORK —  The legal questions that arise in the federal courthouse of Fargo, N.D., do not normally cover such grand issues as redemption and salvation. But one day last year Bankruptcy Judge William H. Hill found himself confronted with these ultimate matters.

Before him was the case of David and Kathleen Gaukler, who by most measures would have to be judged destitute.

The Gauklers had annual expenditures of $28,470 on their annual income of $21,700. They were supporting four children. Mrs. Gaukler had lost her job. They had lost their home, and their car had been repossessed. They were spending $280 a month on food for their family of six, an amount that Judge Hill considered adequate “to purchase little more than subsistence provisions.”

Where was the money going? To the Worldwide Church of God, the fundamentalist church known for its luxuriant Pasadena campus and the sweep of its television ministry. Of their monthly income of $1,800, the Gauklers were contributing more than $672 per month to the church.

Hill took the opportunity to question the church’s credo. “It seems a quite stern and uncaring religion that would require faithful adherence to such a level of giving,” he complained. Of the Gauklers he wrote: “Apparently they are willing, on the basis of church dictates, to sacrifice the financial well-being of themselves and their children in order to make contributions they obviously cannot afford.”

But he could not bring himself to step between them and their God, and, with a figurative sigh, he approved their petition of bankruptcy. “This wasn’t a case of their setting themselves up as a religious corporation and donating money to themselves to buy a Mercedes,” he said later. “These people were very sincere.”

Lives Under Scrutiny

It has not been long that bankruptcy judges have had the power to weigh people’s religious faith against their family welfare. But since Congress revised the rules of consumer bankruptcy in 1984, few corners of a debtor’s life can escape the judges’ scrutiny.

The new rules gave bankruptcy judges almost unchecked authority to examine debtors’ personal life styles before ruling on their bankruptcy plans. The judges are permitted to make judgments about such private affairs as where debtors may send their children to school, how much they may spend on a haircut, how many cigarettes they can smoke in a day, what cars they may drive and where they may live.

The rules have raised the hackles of legal scholars, who argued that they represented a greater invasion of debtor privacy than in any U.S. bankruptcy law going as far back as the 19th Century.

“This is not the sort of authority I’d give a judge in anything short of a criminal proceeding, and I’m not even sure about then,” said Philip Schuchman, a professor of law at Rutgers University Law School and the author of several studies on the financial condition of typical consumer debtors.

But the provisions stand, the subject of rather persistent confusion among the nation’s more than 230 bankruptcy judges. They represent only one of several areas in which--three years after the 1984 amendments and nearly 10 years after a comprehensive reform of bankruptcy law in 1978--consumer bankruptcy rules have become mired in inconsistency.

Judges have little or no guidance over which of a debtor’s proposed expenditures they should reject and which should be permitted.

At about the time that Judge Hill was approving the Gauklers’ religious contribution of $672 a month, an Ohio judge was rejecting another family’s plan to maintain donations of $25 monthly to their church. His grounds: “This court does not favor, during the course of its Chapter 13 (bankruptcy) cases, the contribution of funds to nonprofit institutions.”

Perhaps the chief reason for such inconsistency is that the 1984 revisions strongly reflected the program of the consumer credit industry, which mounted a well-financed lobbying campaign in Washington to persuade Congress that the original 1978 reform invited affluent consumers to skip out on legitimate debts with irresponsible abandon.

The credit industry, which includes banks, credit card issuers, finance companies and retail stores, argued that wealthy consumers had found it too easy to shed debts they could actually afford to pay. The creditors supported their campaign with an industry-financed study from Purdue University purporting to demonstrate that most bankrupt debtors after 1978 actually could have paid their debts.

“We all felt abused by the 1978 code and horrified by the sharp increase in bankruptcies filed, especially after 1980,” said Alvin O. Wiese, a Los Angeles creditors attorney who helped draft portions of the 1984 revision. “The essence of the 1978 code was to popularize bankruptcy.”

Survey Challenged

But the Purdue survey’s methodology and findings have since come under vigorous academic fire. And many bankruptcy professionals find that the creditor-oriented revisions of 1984 conflict not only with consumer bankruptcy rules as designed in 1978, but with America’s century-old tradition of humane treatment of distressed individual debtors.

Consumer groups say the 1978 reform act enabled a broad spectrum of debtors for the first time to exercise their right, long since made implicit in bankruptcy law, to responsibly shed onerous debts, many of which may have been imposed by overly aggressive or even unscrupulous credit issuers.

Henry Sommer is a Philadelphia legal aid lawyer who is the country’s acknowledged master of using bankruptcy as a defense mechanism. He has employed it to fight poverty-level debtors’ evictions from public housing, forestall the revocations of their drivers’ licenses, block the government’s attempt to recover from them overpayments in welfare and Social Security and restore their utility services.

“Ninety percent of this we couldn’t do before the bankruptcy law was reformed in 1978. It was probably the most important piece of consumer protection legislation ever passed in this country,” Sommer said.

Disagreement over the consumer bankruptcy law goes to as fundamental a question as its effect on the volume of bankruptcy cases. No one disputes that the number of filings exploded after the law’s implementation in October, 1979. Personal bankruptcy filings rose an estimated 43% to 312,914 in 1981 over the previous year. In 1986, the figure was 448,989.

But it would be wrong to blame the new law alone for the increase. For one thing, its effective date coincided with one of the most severe nationwide recessions since the Great Depression. Once that eased, depression-scale economic slumps continued to afflict pockets of the country, including the Oil Patch of Texas and Louisiana.

“Any time there’s a depressed part of the country, bankruptcy will go up” in that region, said Karen Gross, an associate professor at New York Law School who has conducted a study of attitudes toward bankruptcy among lawyers, trustees and judges. “People shouldn’t be surprised.”

At the same time, the U.S. Supreme Court’s overruling of sanctions against lawyer advertising allowed attorneys to introduce potential clients en masse to the benefits of the new law.

Still, since 1978, Congress has scarcely ceased tinkering with the bankruptcy law’s inherent conflict between what the public idealizes as the moral imperative to pay one’s debts and the harsh reality that in the modern economy people will unexpectedly lose their jobs, overreach their income, incur unanticipated or imprudent debts and need a way to make a fresh start without facing a lifetime of servitude to creditors.

Bankruptcy Made Palatable

The reform act made bankruptcy more palatable and useful to consumers in several ways. One important element was the establishment of a federal scale governing how much personal property a debtor could retain in a Chapter 7 bankruptcy, in which a consumer liquidates his or her assets to pay creditors whatever he or she can.

In most cases, the federal scale replaced outdated state rules that had become impossibly parsimonious in today’s world. As late as 1977, for instance, Connecticut still required a debtor to surrender to creditors all assets except “two cords of wood, two tons of hay, five bushels each of potatoes and turnips, (and) 10 bushels each of Indian corn and rye.”

The federal rules, in contrast, were designed to assure debtors that they could continue to provide shelter and other necessities for their families even after bankruptcy. They were permitted to keep $7,500 worth of equity in a home and any number of personal items valued at $200 or less. For married couples, each figure was doubled, meaning the home exemption for a family was $15,000, effectively covering most homeowners.

In 1984, Congress attempted to refine the balance between debtors’ and creditors’ rights by requiring debtors to contribute more of their post-bankruptcy wage income to satisfy pre-bankruptcy debts. The $200-per-item exemption was limited to a total of $4,000, for example, and a “pour-over” rule allowing debtors to apply any unused housing exemption to other personal assets was restricted.

The original 1978 reform was built around a principle that had become more deeply cemented in U.S. bankruptcy law with every reform since the first such code in 1800, enacted at a time when debtors’ prisons in many states still housed larger populations than those for common criminals: the concept of the “fresh start” for the debtor.

Aversion to Peonage

The governing idea was that it is preferable to allow an honest individual to permanently shed overwhelming debts by surrendering a portion of his assets than to force him to labor indefinitely on his creditors’ behalf. Society would benefit to the extent that a worker is likely to be more productive if not working exclusively to pay off old debts.

The nation’s bankruptcy laws also tended to reflect their drafters’ aversions to the kinds of involuntary servitude and outright peonage that unchecked rights of creditors would impose and that characterized debtor laws in Europe.

Still, the credit industry argued that the law had shifted the balance of bankruptcy too far in the debtor’s favor. Bank and finance company executives complained that it was allowing people to rack up immense debts for luxury items virtually without obligation. The penalties for declaring bankruptcy, they contended, were so slight as to make it almost irresistible.

Before 1978, Chapter 13 bankruptcy rules allowed debtors to hold creditors at bay while proposing a plan to pay them 100% of their claims over time.

The 1978 law required only that creditors get more than they would if the debtor liquidated most of his or her assets under Chapter 7. One California judge had approved a Chapter 13 plan in which creditors were paid one cent on the dollar--and then suspended the one-cent payment on grounds it was an insult to the creditors.

“It was very hard to justify the law as it stood then,” said John D. Ayer, a former bankruptcy judge in Los Angeles who now teaches law at the University of California at Davis.

Some cases cited by creditors in testimony before Congress challenged the notion of “honest” bankruptcy to an almost baroque degree.

One cherished yarn concerned a young doctor with an annual income of $120,000 who took advantage of a few months’ unemployment to extinguish $45,000 in debts in bankruptcy, just before taking a job at a second hospital at his old salary.

The credit industry backed up its stories with money. Between 1981 and July, 1983, bankers, finance companies, credit unions and large retail merchants contributed $1.1 million to the 200 congressmen who co-sponsored the 1984 amendments.

The largest individual contributors were three companies that are among the largest purveyors of high interest rate credit to lower-income consumers: Household Finance Corp., which spent $46,325; Beneficial Finance Co., which spent $93,275, and Sears, Roebuck & Co., which spent $69,250.

With a $300,000 grant, the industry financed a widely cited survey by the Purdue University Credit Research Center that characterized the typical individual in bankruptcy as “relatively well-to-do,” “more affluent,” and “high income.”

This survey suggested that as many as half of all individuals liquidating their debts forever under Chapter 7 could actually afford to have paid those debts off with discretionary income over three to five years--meaning they would theoretically still have enough left over to pay for housing, food, clothing and other necessities.

The survey acknowledged, however, that its figures were conditioned on reducing the debtor and his or her family to the poverty level in the interim. This was a goal that was not universally considered acceptable by bankruptcy professionals.

A team of University of Texas law professors observed, following their own study of bankrupt debtors in five Midwest and Southern states, that the vast majority of bankruptcies involved the unfortunate and the undisciplined, many of whom had been lured into debt by the easy credit terms of credit card issuers and retail stores.

“The unfortunate deserve a discharge (of debts), a hope for tomorrow for themselves and their families,” they wrote. “The undisciplined are not admirable, but neither are they criminal. We should not permit purveyors of high-risk credit to lure the undisciplined further into debt and then to use the great, expensive engine of the law to collect their debts by making the undisciplined live for five years at the poverty level.”

The Texas survey was completed after the 1984 amendments were already law. But even during the congressional debate some experts were challenging the credit industry position. One was Professor Vern Countryman of Harvard Law School, the nation’s leading academic expert on bankruptcy.

“True, there are occasional news stories of the movie actor, the singer, the professional athlete who resorts to bankruptcy just before signing a new contract, but there are no more than one or two or three of such cases a year,” he testified, arguing that any law inspired by them would be a disservice to the vast majority of bankrupts. “It seems preferable to me to leave such persons to the judgment of the ultimate arbiter of moral issues.”

Other surveys suggested that Purdue’s “affluent” debtor was largely mythical and pointed out that the Purdue study was based on interviews with debtors, half of whom--demonstrably the less-affluent debtors--had refused to cooperate. That skewed the survey’s findings toward higher-income respondents.

“The creditors tried to magnify the rare cases of abuse into a grand pattern,” said Sommer, who has written extensively on consumer bankruptcy. “But typical debtors are lower-middle-income people with a lot of medical debts and, frequently, unemployment.”

A 1983 Rutgers University survey of bankrupts in nine Eastern states in 1980 found that 62% had family incomes of $14,000 a year or less, and an additional 22% had incomes of less than $21,000. That meant 84% were below the nation’s median family income. Only 3% had income higher than $35,000, and the highest income among all the survey’s 753 subjects was $45,700.

“The typical cases we saw,” said Rutgers’ Schuchman of his studies of debtors in New Jersey and Connecticut, “were people above the poverty level, earning lower-middle-class incomes, blue-collar jobs. There would be a lot of divorced people, because the cost of maintaining two households is so high. Many bankrupt debtors are women living alone with a child or two, and not receiving any support.”

Sloppy Credit Analysis

Other professionals complained that perhaps the principal cause of debtors’ overextended credit was the sloppy credit analysis procedures of the lending industry itself, which was offering people credit cards without adequate background checks.

During marketing promotions in the early 1980s and again after the recession of 1982, banks unwittingly offered pre-approved cards to prison inmates, jobless teen-agers and family dogs. In part because of this intense marketing, consumer debt as a percentage of Americans’ disposable income rose to 19.8% last year from 16.5% in 1979.

Creditors bristle at any suggestion that inadequate credit analysis is responsible for a significant share of consumer bankruptcies. “The business of lending means you’ve lent to get your money back,” said Frank Salinger, general counsel to the American Financial Services Assn. “You make every loan in good faith.”

In any event, the creditors’ lobbying bore fruit in 1984 with the enactment of what has become known as the rule of “substantial abuse.”

Under this amendment, a bankruptcy judge may dismiss a debtor’s Chapter 7 filing--that is, one designed to liquidate all debts--if he finds that it represents a “substantial abuse” of the bankruptcy code, generally seen as a case in which a debtor’s future income is high enough to pay off some creditors.

The step generally forces a debtor to file instead under Chapter 13, in which wage-earners must file a plan to pay off a significant portion of their debts from their wages over three to five years.

Analogously, any debtor who files under Chapter 13 is subject to a judge’s opinion on whether his or her repayment plan pays creditors an adequately high portion of their claims, compared to the amount the debtor intends to spend on his or her own life style.

As it happens, the law nowhere defines “substantial abuse” or provides guidelines for judges overseeing Chapter 13 cases. The result is that thing the law abhors: a vacuum, allowing 232 judges in courtrooms across the country to impose on bankrupt people their own impressions of the appropriate life style of a debtor.

By any measure the upshot has been chaos. “The problem with the ‘substantial abuse’ approach is it’s so idiosyncratic,” said Jay Lawrence Westbrook, a University of Texas law professor involved in that school’s debtor study. “Every judge has a different view of what’s abusive or not.”

Some take a relatively liberal view of the life style that can be accommodated in bankruptcy. “You can get a person down to the poverty level and they can do quite nicely spending $100 a month for food for a family of four,” said Judge William Hill, who ruled on the Gauklers’ religious contributions. “But that to me is not what the law requires.”

Other judges take a stern view of any expenditures beyond what is strictly required for family necessities. Case reports issued since 1984 are filled with angry judges’ references to “the life of Riley,” “hot” life styles, and the like--all purportedly led by debtors at their creditors’ expense.

Creditors argue that only the truly abusive will run afoul of the rule: “People caught by the substantial abuse provision are the yuppies trying to get out of their MasterCard bill, people with luxury cars,” said Salinger of the American Financial Services Assn.

It is true that many cases adjudicated under the rule so far involve what most reasonable people would consider unexceptionable judgments about how bankrupts should live. Automobiles appear to be one convenient yardstick; in case after case, judges have objected to the style in which a debtor intends to do his or her driving.

Last October, for instance, a Flint, Mich., judge rejected one debtor’s proposal to pay most of her creditors 17 cents on the dollar but to keep her new red Corvette by paying in full the $17,000 in installment payments still due.

The judge acknowledged that bankruptcy “does not require a debtor to dispose of all of life’s little pleasures,” but he lectured the debtor that he would not allow her to “pamper her own psyche at the expense of her unsecured creditors.”

But other judges have gone well beyond the question of why a debtor should drive a Corvette when a Chevette would do. One Ohio judge painstakingly appraised a debtor’s family expenses for food, newspapers, magazines and so on--objecting to, among other things, the expenditure of “$3.33, on approximately three packs of cigarettes per day.”

Moreover, even if individual judges remain consistent in their own application of the rules, the system itself provides no overall consistency in what one judge may overrule and another permit.

For instance, one Minnesota judge not long ago rejected a Chapter 13 plan filed by a debtor with $50,000 annual income as a lawyer, debts of $66,000 and three children, of whom the oldest was a college freshman of 18. The reason: She was proposing to pay her unsecured creditors 14 cents on the dollar while paying $1,000 a month for private school tuition for two children.

“An expensive private school education is not a basic need,” the judge ruled, “particularly in view of the high-quality public education available in this country at both the collegiate and secondary school levels.” The judge also objected to the debtor’s monthly home payment of $989 as “well above the amount necessary to provide adequate housing for a family of four” (not counting the oldest child, who was away at school).

Around the same time, a New York judge was shying away from making such sweeping determinations, meaning that in some respects a debtor’s prospects of winning approval for liquidation of his or her debts depends largely on the luck of the judicial draw.

In New York, Judge Prudence Abram approved the bankruptcy of Clarence and Michelle Edwards, a couple with annual income of $60,000, debts of $13,500 and three children. The couple were expecting a fourth child, which would necessitate Mrs. Edwards’ leaving her job and reducing their income by nearly $12,000.

“Having a fourth child may be a questionable luxury,” Judge Abram mused before concluding that the decision was not hers to dictate: “At what point such inquiries and decisions by a bankruptcy court would become an affront to society’s sensibilities or the U.S. Constitution remains uncertain.”