By Cassandra Erler Clements, Esq.

Consumer bankruptcy is a last resort, but sometimes it is the best option. It is not something to be avoided at any cost just because there is a potential alternative. Any potential alternative must provide the client survival relief in order to be a better option than bankruptcy.

That said, there are circumstances in which bankruptcy creates more problems than it solves.

Each client’s case has to be evaluated by reviewing all the facts and financial circumstances, after which the attorney should advise the client as to what option, whether it is bankruptcy or an alternative, would solve their problems and provide the greatest relief.

This article is a general overview about what the attorney and the client should consider in determining whether bankruptcy is the right answer. It is not intended to be comprehensive, but it touches on a number of common realities that this financial situation can present, and which the client may have difficulty accepting.

Part I — Red Flags

In assessing and advising a client on whether bankruptcy or an alternative is the best course option, red flags to uncover and discuss with clients are listed below. This list is not exhaustive but does contain ones that trend across different groups of clients.

Debt Payments Issues

Issues with debt payments may seem like an obvious early warning sign of possible bankruptcy. But keep in mind the mental toll that financial insecurity can have on the client. A client in “survival mode” — who is spending all their energies trying to avoid falling deeper into debt — may not be able to step back and take an objective look at their own financial reality. The attorney must uncover these issues and explain their implications to the client. 

• Secured debts (e.g., home, vehicle)

It is important to discuss whether a client can realistically catch up on missed mortgage and car loan payments. It is equally important that the attorney and client have this discussion before repossession or foreclosure becomes an irreversible reality.

• Minimum credit card payments

A client may not realize the severity of missing minimum credit card payments. To the client, the issue may not seem “that bad” while they are still able to use the credit card. This misconception can be especially dangerous when the client is using the credit card  (or cards) for essential items or priority bills. In such cases, once that credit card is maxed out, it is likely to drastically worsen the client’s financial situation. Committing to bankruptcy before that happens may be the best path.

• Utility payments

Similarly, it may be hard for a client to appreciate the need to commit to a bankruptcy filing if they are still managing to keep their lights on and the water running. But the attorney doesn’t want clients waiting to file until they’re at risk of living somewhere that isn’t habitable due to lack of water and electricity.

• Falling victim to scams

The client needs to be warned about their own financial vulnerabilities. There are a lot of sham debt counseling companies that prey on people with financial difficulties. Clients need to be advised that they are vulnerable to these bad actors, and should be very mindful to only use reputable debt counseling agencies. At Maryland Legal Aid’s Midwestern Office, we refer individuals to Consumer Credit Counseling.

• Debt management

It’s also important to discuss with a client whether a debt counseling agency or debt management organization would even be a viable option.. If the client doesn’t have enough income to cover reduced payments of their debts, then credit counseling or negotiating for lower monthly payments is not going to be helpful. If a client feels the need to hire a debt management company or settlement company, then they should probably be speaking with a bankruptcy attorney instead.

Homeownership and Bankruptcy

Right now, the US has a homeownership rate of around 66%. Of individuals aged 65 and over 79.5% are reported to own their home. Meanwhile, only 39.3% of individuals under the age of 35 are reported to be homeowners. The unfortunate truth is that, while one may see a lot of renters in no-asset Chapter 7 bankruptcies, many people filing for Chapter 7 or Chapter 13 bankruptcy own homes, often with mortgages exceeding their home’s value.

For homeowners who find themselves in situations where the home is severely over-encumbered and the mortgage is no longer manageable, this may mean it’s time to seek advice from a competent bankruptcy attorney and discuss their options. For example, a client might be able to strip off a wholly unsecured second mortgage via bankruptcy discharge. This lets them walk away with their home ownership still intact, and a less encumbered asset. On the other hand, a house which is severely over-encumbered and in which the facts don’t support stripping off a second mortgage, may mean the client needs to evaluate the feasibility of trying to save the house. 

Family Assistance and High-Cost Loans

Oftentimes, clients without home equity, or any equity, may turn to family for assistance, or resort to high-cost loans. Unfortunately, not every family member who lends a client money is necessarily able. Another thing to consider is that payments to family members or insiders have an extended look-back period. This means that a bankruptcy trustee can usually claw back any funds repaid to a family member within a three-year period.

A debtor trying to play catch-up may also turn to high cost loans such as payday loans or vehicle title loans. While these high-cost loans can be tempting, clients should be aware that they come with risks. For example, a client using their vehicle as collateral for a title loan means that the lender can repossess the vehicle if the debt is unpaid. Interest rates for these loans can skyrocket to 300% in some instances and these loans are also often capped at around 25% of a vehicle’s equity, so clients with older or less valuable vehicles run the risk of having their car repossessed over a few hundred dollars.

Part II — Debt Resolution Booby Traps 

There are a number of debt repayment arrangements and instruments that clients might misapprehend as good solutions but are in fact not. In assessing the client’s situation, the attorney should discuss any and all debts whether or not the client thinks they are resolved. Following are debt resolution solutions that may in fact be debt resolution booby traps. 

• Preference payments

Clients need to understand they cannot pick and choose — or prefer — whom to pay off before filing for bankruptcy. For example, preference payments to creditors made within 90 days of a bankruptcy filing will have to be paid back and added to the estate. Similarly, preference payments to family members made within three years of filing can also be clawed back. For that reason, if bankruptcy seems like a certainty in their near future, clients should not be making payments to creditors outside the ordinary course of business.

• Creditor write-offs

It’s also important to discuss with the client the fact that creditor write offs do not release the client from their obligation to pay the debt back. A write­-off is just a tool for the creditor’s own bookkeeping purposes — it is not forgiveness of the debt, and the creditor or a collection agency can still sue the client to collect written-off debts. Clients often don’t include written-off debts in their mental tally of what they think they owe, and it’s important to ask and inform them about this ongoing obligation.

• Buy-Now-Pay-Later plans

Another debt that clients often fail to take into consideration are buy-now-pay-later plans. Use of these plans saw a huge increase during the pandemic, and by January 2022, one in five adults who had made a purchase using a BNPL loan service missed a payment on that loan. Once a client falls behind on a BNPL, it begins to look much more like a traditional debt — it can accrue late fees and penalties, and the debt balance can be sold to a debt collection agency. In a bankruptcy, any item purchased through a BNPL plan is considered to be the client’s property, whether or not they paid for it in full. This means that the item purchased must be listed as an asset, while the outstanding balance owed will need to be listed as a debt.

• Debt settlement offers 

In some cases, clients may generally be debt-free but for one large debt, such as a foreclosure deficiency from a second mortgage. In these instances a creditor might extend a debt settlement offer where, for example, they offer to forgive a client’s $95,000.00 deficiency if the client can pay them a one­-time $5,000.00 lump sum payment. What a client needs to consider before they jump on this opportunity, and what a bankruptcy attorney should consider advising them about, is that the IRS will consider the forgiven loan amount as taxable income, unless the client qualifies as insolvent. Clients should also be advised that debts discharged in bankruptcy are not counted as taxable income by the IRS, so bankruptcy can be a much more favorable way to discharge a large debt rather than accepting a debt settlement offer.

Part III — Collections and Affirmative Defenses

In addition to discussing red flags and booby traps with the client, it is important also to discuss collections and possible affirmative defenses. 

Collections 

The attorney should work with the client to determine whether the debt is still with the original creditor or has been moved to collections. Oftentimes, once a debt is sold or sent to collections, it can be much harder for a client to try and negotiate. For that reason, it can be very beneficial to a client if they reach out to the original creditor before actually falling behind, in which case the original creditor could be much more amenable to deferments, payment plans, etc. One thing clients should be made aware of is that settling with one collection agency may not prevent the debt from being sold to another. Thus, discharging the debts in full in bankruptcy can be a much more desirable option.

Affirmative Defenses

• Statute of limitations

Regardless of a debt’s age, all debts need to be listed on bankruptcy schedules. In Maryland, a judgment is only valid for twelve years. While it can be renewed for an additional twelve years, if the judgment was not renewed after the twelve year period, then the creditor cannot legally enforce the judgment debt. Clients should be made aware that a statute of limitations argument is an affirmative defense which is waived if not raised. 

• Nondischargeable debts

Certain debts, such as recent taxes, spousal support, child support, alimony, and specific student loans, cannot be discharged in bankruptcy. For clients with debt, the majority of which is nondischargeable, bankruptcy may not be a good option. However a client with child support arrearages might consider filing a Chapter 13 bankruptcy, which can be helpful in managing those types of payments.

• Collection­-Proof clients 

Collection-proof is a term used to describe a person who has no income or assets that can legally be seized for debt repayment. Clients that receive certain benefit payments such as unemployment and social security may be protected when certain conditions are met. For example, a client’s unemployment funds are not protected if those funds are commingled with other funds in an account, and neither social security nor unemployment benefits are protected if they are transferred from one bank account to a different bank account. 

There may be times when a collection-proof client may still want to file bankruptcy, for example to stop the phone calls, court notices, and other daily intrusions into their lives. But it’s important to remember the impact that a bankruptcy will have on a person’s credit report, and their ability to get housing, loans, or other secured debt moving forward. On the other hand, it’s also important to note that a collection-proof client may not be collection-proof forever and collection efforts do not cease just because a client lives solely off their Social Security income. For elderly clients in particular, it’s important to note the effects that constant communications from debt collectors can have on their mental health.

• Garnishment

Clients should also know that if a creditor attempts to garnish their account, the client can exempt funds up to $6,000.00 by filing a motion with the court within thirty days of the date the bank was served with the garnishment. That said, if a client is considering filing bankruptcy to avoid a garnishment, bankruptcy may not be necessary if the client’s assets are less than $6,000.00.

Effectively advising a client on whether to opt for bankruptcy necessarily involves educating the client through a seemingly simple yet highly complex landscape. Complicating the process is the emotional difficulty that financial distress can cause to a client, diminishing their ability to understand or appreciate the consequences of their past or future financial decisions. It is incumbent on the attorney to walk the client through and uncover the red flags, booby traps, collections process, and affirmative defenses outlined here. This article does not provide a comprehensive or exhaustive checklist of items to cover, but instead it is an overview of issues that trend across different groups of clients.

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Cassandra Erler Clements  is a Staff Attorney at Maryland Legal Aid’s Midwestern Office.