Rich Families, Poor Families, And Chapter 13 Bankruptcy

When someone contemplates filing for bankruptcy, one of the first choices that an individual or a family must make is this: “Do we want to file for a Chapter 7 or Chapter 13 bankruptcy?” In a nutshell, the difference is this: If you file for a Chapter 7, you are going to lose almost all of your possessions and personal property, but the principal advantage is that you get almost all of your debts wiped clean (with the exception of things like student loans, costs related to a DWI, child support payments, and things like that) so that you can start your life mostly anew a few months after filing you file for Chapter 7 bankruptcy.

Chapter 13 bankruptcy, is a little different. If you’re behind on your mortgage payments, you get a chance to catch up, and you get a chance to keep most of your possessions (like your car) provided that you stick to a payment plan for three to five years. If you’re unfamiliar with how these payment plans work, it tends to go like this: to successfully file a Chapter 13 claim, you have to demonstrate the capacity to pay off all of your secured creditors within either a three-year or five-year time frame.

The critical distinction in such a plan is between secured and unsecured creditors. To be eligible for Chapter 13 bankruptcy, you have to show a likelihood to pay off all of your secured creditors within that three-year or five-year term (if you’re unfamiliar with the jargon, “secured creditors” refers to money you borrow that is linked to collateral that can get repossessed like a car, whereas “unsecured creditors” refers to money you borrow that is linked to your reputation and name alone, like a credit card). When you file for a Chapter 13 bankruptcy, the rules are as follows: you must pay off all of your secured creditors (and one of the perks of bankruptcy is that you are allowed to perform a “strip-down” on your debts to pay the value of the item’s current worth rather than the amount of debt you owe on it, so if your $10,000 car debt is for a vehicle that is currently worth $4,500, you only have to pay off the $4,500 under the bankruptcy plan).

Here is where I get interested in the philosophy behind Chapter 13 bankruptcy law: You are required to pay off your secured creditors in full, and you must contribute all of your disposable income to paying off your creditors for three to five years, but there is no requirement that your unsecured creditors must get paid off. My interest begins when courts try to define what constitutes a necessary living expense, and what legally constitutes your “disposable income” that must go towards creditors. The incentive structure that exists under the present bankruptcy law is that individuals want to come up with a plan that will pay off the mandatory secured creditors, and beyond that, they want to maximize the amount of living expense claims because there is no incentive to pay off unsecured creditors because those debts will get discharged automatically at the end of the post-bankruptcy payment plan if they’re not paid off.

It sounds easy in the abstract to define what is a necessary expense—housing, transportation, food, and clothes costs—but the question becomes much tougher when you try to define necessary expenses over a three to five year time frame, especially when children are involved. Is paying for private school a necessary expense? Texas courts say no, Florida courts say yes, and Illinois courts say “maybe” depending on whether that the student has been attending private school for a “considerable” amount of time.

Are braces for your thirteen-year old a necessary expense? California says absolutely, Delaware performs a measuring test to see whether they could be put off for a few years until after the post-bankruptcy period without being a “significant detriment” to the health of the child.

What if your kid wants to play on a sports team? The state of Nebraska’s rulings on this topic has caught my attention, because they consider cable and internet bills to be necessary living expenses, but soccer camp and sporting lessons to be luxuries. I wonder what it says about American society that enabling a child to watch TV falls into the category of necessary, but a physical activity is a luxury. Where things get even more interesting are the bankruptcy filings in Colorado where they measure how good your kid is at the sport in question—Johnny has a bright future as a soccer star? Boom, necessary expense. Teddy the kind of kid who could strike out on two pitches? Sorry, letting him play baseball is a luxury.

And it’s not just kids that make things more complicated than you’d guess. You could be a single guy filing a Chapter 13 bankruptcy, and the question of whether you get to contribute to a 401(k) plan during your payoff period is intriguing. On one hand, you do have an obligation to contribute your disposable income in excess of secured creditors to your credit card bill for a few years before getting a discharge. Should you be allowed to stiff people you borrowed from in the name of improving your own financial position? On the other hand, the bankruptcy process is designed to help get a fresh start and get back on their feet, and is it sound public policy to prevent folks from having two nickels to rub together even as they work their way through clearing significant debts? Does it matter whether the employer matches the potential contribution? I suppose Visa shareholders and families in the first month of a Chapter 13 plan payoff would answer these questions differently.

What catches my attention the most is the different treatment based on your earnings power and economic/social class at the time you file for bankruptcy. When you earn $2,500 per month and file for bankruptcy, those braces and soccer lessons seem to get extra scrutiny in the judicial process compared to those making $10,000 per month. As a matter of public policy, is it desirable to enable bankrupt households earning a good salary to maintain higher necessary expenses than a bankrupt family earning minimum wage?

As you can tell by my paragraphs written in the form of questions, I don’t have an opinion of which way to define necessary expenses in Chapter 13 bankruptcy filings would be best. I can respect the argument of a family making $20,000 per year feeling just as entitled to soccer lessons for their kids as a bankrupt household making $150,000 per year, while also respecting the argument that you want to motivate bankruptees to file Chapter 13’s rather than Chapter 7’s so that creditors receive more compensation from people earnestly trying to pay off their debts for a few years, and I fear that you would destroy this payback incentive if you forced a household of two doctors to live in a hovel and make do with ramen noodles.