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Repay Discharged Bankruptcy Debt?
Debts that had been forgiven by bankruptcy courts are being avidly bought and sold and subsequently are rehaunting consumers. Here's the problem: Although a judge may cancel or discharged a debt, the creditor may continue to report the discharged debt to credit bureaus as a live balance.
The failure of creditors to update credit reports is occuring with relative frequency, and can naturally result in consequences such as being coerced to repay a discharged debt or to prove that it was indeed discharged in order to get approved for new credit. Hence; though difficult to believe, some consumers are actually paying debt they are no longer legally bound to repay, just so they can get new credit such as mortgages.
Since some consumers find it easier to repay discharged debts than to battle creditors to update reports or to get the necessary discharge proof, this action is encouraging firms to buy and sell delinquent consumer obligations. These past due accounts change hands at a steep discount every year. Five of the companies in this business are publicly traded on Nasdaq. Others have large private money backers. B-Line, in Seattle, was acquired last year by the Dallas based hedge fund firm Lone Star Funds. The investment bank Bear Stearns (BSC ) owns two bankruptcy-debt buyers: Max Recovery and eCast Settlement.
Traditionally, discharged debt was seen as not worth the paper it was written on. Once a judge excuses some of a debtor's obligations; part of the bankruptcy system's goal of granting a financial fresh start, that person has no legal duty to pay them. In fact, bankruptcy law prohibits efforts to collect discharged debt.
In the 1990s, businesses adept at tracking and trading consumer debt expanded their reach to dabble in accounts enmeshed in bankruptcy. That dabbling has grown into a robust market. Some of the trade in so-called bankruptcy paper involves debts that remain collectible. What's troubling is that the market now also includes billions in discharged debts, which ought to have no dollar value. Owners of canceled liabilities can revive their value in two main ways: by directly pressuring consumers to cough up cash or by gaming the credit system.
Consumer lawyers and even some longtime players in the bankruptcy paper market say they're worried that the trading of canceled debt encourages unsavory efforts to collect on discharged debt. Some lenders and debt buyers simply hound consumers to pay debts that have been canceled, while others refrain from informing consumer credit bureaus when debts are eliminated. The failure to accurately update credit reporting has allowed unscrupulous activity to prosper.
There aren't any reliable statistics to document this development, however, and the legal parameters remain murky. Since 1986 the staff of the Federal Trade Commission has issued a series of formal "opinion letters" saying that the credit bureaus should report when debts have been discharged. Clarke W. Brinkerhoff, an FTC staff attorney who wrote two of the letters, says that in the view of the commission, creditors must inform credit bureaus that the discharged accounts have a zero balance. But that obligation doesn't appear in any statute.
Ambiguities abound. Bankruptcy judges are divided on whether a lender's failure to update a credit report can be considered an improper attempt to collect. The Fair Credit Reporting Act requires credit bureaus to ensure "maximum possible accuracy" of their reports, but the bureaus are allowed to rely on lenders to provide debt information. "These laws were not written for the way this industry has been transformed," says Ronald J. Mann, a law professor at Columbia University. Nevertheless, Representative Jerrold Nadler (D-N.Y.), a member of the House Judiciary Committee, says the Justice Dept. should investigate whether creditors and debt buyers are trying to collect discharged debts. "Documented abuses have largely gone unpunished," he says.
The market in discharged debt has its roots in the early 1990s, when lenders began to seek at least minimal returns from overdue consumer accounts. The stale debts included those of customers who had filed under Chapter 7, saying they couldn't pay their bills, and those who filed under Chapter 13, a provision allowing individuals with some resources to set up schedules to pay creditors. Creditors are notified by the court when a consumer files bankruptcy, and again when a discharge is granted.
Some lawyers and bankers saw a business opportunity in the bulk acquisition of bankrupt paper. "It was a new niche. Banks didn't understand what it was worth," says Charles Rusbasan, a former executive with Chemical Bank before it acquired Chase and adopted the Chase name. Rusbasan approached Bear Stearns in 1992 to finance a debt-buying operation, and that led to the birth of Max Recovery. Today he is CEO of Max Recovery, which is in London, and its sister, eCast Settlement in New York. He is also a senior managing director at Bear Stearns.
Rusbasan says that sales of Chapter 7 debt are growing. One large bank, which he won't name, is planning a bulk sale of Chapter 7 debt this fall with a face value of $3 billion, he says. He expects similar mass sales later this year and next.
B-Line's former CEO, Weinstein, who started the company in 1997, takes credit for helping build the market for Chapter 7 debt. Even debt initially designated as discharged can bring legitimate returns, he says. In some cases, bankruptcy courts discover that Chapter 7 debtors have additional assets, which are then divided among creditors. Other Chapter 7 cases are moved to Chapter 13 or dismissed altogether, making debts potentially collectible. In a tiny fraction of cases, people repay discharged debts out of a sense of moral duty.
Increased competition recently in the bankruptcy-paper market has driven up the price of discharged debt; from 1/20th of a cent on the dollar to 3/20ths, or higher, and that has helped spur more aggressive collection tactics.
Credit Report Bureaus Sued
Credit bureaus continue to list legally discharged debts as live and collectible.
A pending lawsuit filed by debtors in federal court in Santa Ana, Calif., alleges that two of the three major credit bureaus (TransUnion and Equifax), fail to update credit reports to show a debt has been discharged. Such action is a violation, the plaintiffs contend, of state and federal credit laws. Federal law requires the bureaus to assure the "maximum possible accuracy" of their reports.
On Mar. 6, U.S. Bankruptcy Judge David Carter rejected a preliminary settlement in the case. He wrote that a December, 2006, declaration from a former Equifax employee, John Ulzheimer, serving as an expert witness for the plaintiffs, along with other information, suggests that "a jury could reasonably conclude" that TransUnion and Equifax "acted knowingly" in not updating bankrupt accounts.
Equifax and TransUnion have denied the plaintiffs' allegations in the case and declined to comment.
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