sealPurdue News

December 1997

Purdue study: Bankruptcy laws are part of the problem

WEST LAFAYETTE, Ind. -- The bankruptcy system in the United States functions as unlimited insurance for financially troubled consumers, with the rest of us paying the premiums.

That's the conclusion of a joint study released recently from Purdue University and the Credit Research Center at Georgetown University. Researchers analyzed nearly 4,000 bankruptcy petitions filed in 13 U.S. cities during 1996. The report, part of an ongoing study by the Credit Research Center and Purdue Professor John M. Barron, will be presented at the January meeting of the Allied Social Science Association.

The report says that more bankruptcy petitioners than previously thought have the ability to repay at least a portion of their debt, but choose not to.

"Chapter 7, the most widely used form of bankruptcy, allows the debtor to basically wipe out his or her debt with a signature," says Barron, professor of economics at Purdue's Krannert Graduate School of Management and co-author of the study.

Under Chapter 7, nonhousing, nonexempt assets are sold to repay creditors, and the remaining debt is forgiven. "In that sense it's like insurance that provides a social safety net for borrowers with financial problems, with creditors serving as the insurance companies," Barron says. "But if creditors must play the role of insurers, then the system should adopt policies for loss control just like a private insurer would."

The study found that 44 percent of debtors who filed Chapter 7 bankruptcies could have repaid some of their debt over a five-year period, while maintaining mortgage or rent payments. In fact, 5 percent of the petitioners had the ability to repay all of their debt, and 10 percent could have paid off up to 78 percent.

For petitioners under Chapter 13, an estimated 70 percent of debtors had enough income when they filed to repay two-thirds of their nonhousing debt over five years. Fifty percent could have paid off all debt. Chapter 13 bankruptcy is a reorganization of debt and the commitment to a payment plan of three to five years.

Between 1990 and 1996, the report states, the number of Chapter 7 petitions rose by about 70 percent. That rate of growth, and the assumed loss to creditors, is resulting in an increase in the cost of credit.

"Our results imply that the bankruptcy system itself may be contributing to these rising costs by offering the opportunity to wipe out debt to many borrowers who have the capacity to repay," Barron says.

According to the report, the only "control" in place in the bankruptcy code is the judge's power to deny a bankruptcy discharge if he or she suspects the debtor of "substantial abuse" of the system. But the code does not define what constitutes such abuse. The researchers say the lack of clarification in the code has triggered various proposals for 'means' or 'ability-to-pay' testing for Chapter 7 petitioners. The testing is one issue of debate for members of an advisory commission charged with recommending revisions of the code to Congress.

"The issue will be hotly debated once it reaches Congress," Barron says. "On one side of the issue is the need to provide a fresh start for those in legitimate financial trouble; on the other side is the cost of bankruptcy to creditors and other consumers."

The report says that, of approximately 740,000 Chapter 7 debtors who filed bankruptcy in the United States in 1996, about 185,000 had the capacity to repay more than 30 percent of their debt over a five-year period. Close to 40,000 had the capacity to pay off all of their nonhousing debt over a five-year period.

"Those are significant numbers," Barron says. "Certainly enough to justify looking into some kind of 'means' testing for Chapter 7 petitioners. Our ongoing study will focus on why debtors choose Chapter 7 over Chapter 13 bankruptcy and what factors are influencing the choice of bankruptcy over some type of debt counseling."

Source: John M. Barron, (765) 494-4451; e-mail,
Writer: Kate Walker, (765) 494-2073; e-mail,
Purdue News Service: (765) 494-2096; e-mail,

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