Ethics of Bankruptcy

Many of us will face a Financial Crisis at some point in our lives. Catastrophic events such as family illness, the death of the primary breadwinner, the unexpected loss of a job, or a natural disaster like Hurricane Katrina can alter one’s financial solvency in the blink of an eye. In such circumstances one’s very livelihood, once secure, is drastically upended and life becomes a daily struggle to pay bills, evade haranguing phone calls from creditors and protect the family home from foreclosure.

Financial worries take an enormous physical and emotional toll on individuals and relationships alike. Sleep is just one more lost luxury. Self-blame is common and often leads to clinical depression. Friends and peers may become critical and judgmental of one’s choices. Longtime business partnerships and marriages will sometimes falter under the constant pressure to survive financial hardship.

When presented with a financially draining situation beyond one’s control, investigating bankruptcy is not only understandable, but may in fact offer the best hope of debt relief. In these cases, filing bankruptcy serves a morally correct and ideal purpose: to protect otherwise fiscally sound individuals experiencing untoward hardship from monetary ruin by providing a clean financial slate with which to begin life anew.

Consider now the opposite side of this same coin: those individuals experiencing financial hardship resulting from events within their control. These circumstances might include reckless overspending, recreational gambling, racking up additional debt after filing for bankruptcy, mishandling finances (or financial illiteracy), or simply choosing to renege on payments to creditors. At what point should ethics factor into their bankruptcy claims?

Rarely if ever, according to many economists, who point out that lenders and creditors anticipate and negotiate the risk of consumer non-payment into their loan or interest rates, thus protecting themselves should a borrower default. Because of this industry practice, borrowers shouldn’t feel morally irresponsible when they stop paying on a mortgage or credit card debt. Does a ‘no harm, no foul’ approach to bankruptcy render the question of ethics moot?

Not so, says David VanHoose, Herman W. Lay Professor of Private Enterprise at Baylor and a professor of Economics. He supports the view that an individual entering into a contractual agreement has a moral duty to honor their obligation to the second party.

“A borrower has an ethical duty to avoid behaviors that significantly increase the probability of non-repayment of an obligation to a lender,” says Dr. VanHoose. “In an important sense, a borrower is steward of the funds that the lender has made available for the borrower’s use.”

Professor Steve Green, chair and director of the graduate program in economics at Baylor, agrees with his colleague from a moral standpoint, but admits that it’s a complicated issue when viewed from an economic perspective.

“Is it a binding promise to pay when the terms of the loan – the interest rate you pay – factors in the #possibility of default? That is, if the rate you are paying in effect includes a bankruptcy insurance premium?” asks Dr. Green. “Given the widespread use of the bankruptcy provision and the easy access of creditors to borrower information, one could argue that virtually all transactions in our economy are priced this way.”

That said, he concludes, “Bankruptcy imposes costs – mainly the increased difficulty of getting loans in the future, so it should be avoided for practical as well as moral reasons.”

In his book, The Ethics of Bankruptcy, Jukka Kilpi remembers a time in America when items were purchased on a cash-only basis or not at all, and the use of credit was considered to be a disreputable practice by the American majority. Achieving the ‘American Dream,’ he writes, once meant owning a home and an automobile.

What a different picture Americans paint today in this age of easy credit and instant gratification!

According to MSNBC, more than 600,000 claims were filed in America’s federal bankruptcy courts in 2006. This figure actually marked a 70 percent decline from the previous year’s claims of 2.1 million, when proposed changes to the nation’s bankruptcy laws sparked a run on the courts by individuals rushing to file before the reformed law went into effect that October. That drop was just temporary according to industry experts, who indicate that the number of bankruptcy filings is on the rise once more.

In April, CNNMoney.com reported that February 2007 saw a 17 percent increase in bankruptcy claims over the previous month. High gas prices, the recent fallout of the mortgage industry and rising use of credit by consumers are creating an economic condition ripe for bankruptcy. This is great news for bankruptcy lawyers, but what about consumers suffering under the stigma of bankruptcy? Some would tell us that stigma no longer exists.

Timothy Gorman, publisher of Debt-Relief-Solutions.com, believes that the stigma associated with bankruptcy lessens exponentially as the number of claims increases. In an article posted on Bnet.com entitled Bankruptcy as an Option, Gorman states that “bankruptcy has become so common, it is no longer ‘the big ugly monster’ it once was.” He further writes:

“Filing for bankruptcy once scarred you for 10 years. There was no hope of buying houses or cars or getting more credit cards. Often filing for bankruptcy meant you had to give up most of your property. Anymore there are credit card offers in the mail as soon as your bankruptcy is discharged. Buying a car is no problem as long as you can handle the sky-high interest rates. And buying a house, well, you may have to be a little more patient and let your bankruptcy ‘settle’ in the stomachs of mortgage lenders before they will grant you a home loan, but you can certainly get one, bankruptcy or not.”

What are the ethical variables to be considered here? Was it morally right that bankruptcy was once considered a disgrace in the American culture, as Kilpi asserts? Is it morally right that claiming bankruptcy results in little more today than a slap on the consumer’s wrist, as Gorman would have us believe? Should our courts process bankruptcies without assumption of guilt or blame? The answers are as varied as each individual’s ethical compass.

Consider this question: if lenient bankruptcy laws lead to higher levels of consumer credit, isn’t that an economic boost to society? Ideally, yes. Until we begin to abuse those laws.

Enter the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which seeks to prevent consumers from abusing the bankruptcy system by clearing all their debts when they have the ability to repay at least some of them.

The reforms appear to be working. An increasing number of individuals file for bankruptcy under Chapter 13 of the bankruptcy code, in which individuals establish a payment plan with creditors involving a period of seven to 10 years. Before the new bankruptcy law took effect, the majority of Americans filed for Chapter 7 bankruptcy, where all unsecured debts were eliminated.

So who benefits most from bankruptcy – society, creditors, or claimants?

Obviously debt collectors are benefiting under the reformed law, since they are more likely to receive some money from the borrower, no matter how reduced that payment may be. Creditors do not appear to be suffering, if offers of “easy credit” and “flexible financing” to those with shaky credit histories are any indication. Predatory lenders who aggressively market credit cards to college students and extend high-interest loans toindividuals against a pending paycheck or car title appear to be thriving. Since federal law now requires bankruptcy claimants to enroll in debt counseling before they file, ads touting various debt consolidating and counseling services are flooding television, billboards and the print media. While some of these companies are reputable, many are not, so consumers are wise to do their research.

Another plus on the side of bankruptcy (and capitalism): bankruptcy laws protect entrepreneurs when they take risks and fail, allowing them a fresh start on a new idea.

Certainly the immediate benefit filing for bankruptcy offers the claimant is the cessation of hostile calls from collection agencies demanding payment on credit card debt, or creditors threatening to repossess a car. Court-ordered reduced payments on secured debts, such as taxes, a mortgage, or a student loan, also provide tremendous relief. Unsecured debts, such as medical bills, could be discharged completely by the court and may be well worth the price of waiting out a shaky credit rating for up to 10 years.

Even so, bankruptcy remains the last option many financially distressed consumers will choose, and personal ethics may well be the reason. While some individuals see little or no stigma attached to bankruptcy and are unwilling to scale down either their lifestyle or their spending to pay off a debt, others will struggle financially for a lifetime before reneging on an obligation.

Just as ethics are central to giving individuals the right to wipe a financial page clean and enjoy a new start at life, so too should ethics factor into one’s acting responsibly so as to avoid bankruptcy court in the future. With the promise of luxury only a quick swipe away, that is not always going to be the case.

 

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Baylor Business Review, Fall 2007



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