Bankruptcy: A Vision For Reform

In last November’s SCOLAG Legal Journal Alan McIntosh criticised the Scottish Law Commission’s consultation on consolidating bankruptcy law as premature (2011 SCOLAG 250).

It now appears the Accountant in Bankruptcy is no longer intending to proceed with those plans and instead is looking afresh at this area of law. This article looks at the case for reform and considers the options.  For many, the Accountant in Bankruptcy’s (AIB) announcement that a “new vision and ambition” is required to overhaul Scotland’s Bankruptcy laws will be a surprise, particularly as only 5 years ago, with the Bankruptcy and Diligence Etc (Scotland) Act 2007, Scotland saw a major piece of legislation concerning this area of law pass through the Scottish Parliament.  

Rosemary Winter-Scott, the Accountant in Bankruptcy, has, however, announced there is a need to rebalance Scottish bankruptcy laws to recognise the importance of creditors.

The Case for Reform 

So the question is: does Scotland’s bankruptcy law need to be rebalanced to reemphasise the importance of creditors? Some have argued yes, as creditors no longer feel part of the process and are unable to engage in it.

The system of bankruptcy we have in this country is in principle the same one we have had for approximately 100 years, albeit there have been significant reforms over those years. Over, that time, creditors have had an important role to play in the system and despite significant reforms, the purpose of bankruptcy has remained consistent: to allow the competing claims of creditors to be decided and for the estate of a debtor to be ingathered to pay those claims.

This remains the case today. Creditors are still able to attend meetings and ask questions regarding the affairs of the debtor and can also in sequestrations appoint the trustee who will administer the bankrupt’s estate. They also have the option of appointing commissioners who can provide advice to the trustee and oversee the administration of the estate. In the other forms of personal insolvency, Protected Trust Deeds, they can vote against or in favour of the actual proposals that a debtor makes to them.

Few creditors utilise these rights. There has been some improvement in relation to voting in Trust Deeds, but this is largely as a result of increased involvement by creditor agents. The problem is, however, some feel they have become disenfranchise from the process and the system is overly friendly to debtors. What is meant by this is not clear. The principle that those that can pay, should pay, still underpins the system.

The most significant changes to bankruptcy in recent years have been the shortening of the sequestration period itself from three years to one year (mirroring changes that had already been introduced south of the border with the Enterprise Act 2002) and the widening of the gateways into sequestration, making it easier for debtors to access the remedy. 

The first of these changes, the one year automatic discharge, however, has not altered the principle that when someone is sequestrated, the majority of their estate vests with the trustee and where a debtor is believed to be in a position to make a contribution, they are expected to do so for three years. The increased accessibility for debtors into bankruptcy has had more significant effects and has in the last 25 years resulted in more fundamental changes in relation to the number of people using personal insolvency and their reasons for doing so. This
has changed the character of the remedy and if anything affected the behaviour of creditors towards it.

The Recent Historical Background

Prior to 1985, bankruptcy in Scotland was difficult to access with less than 300 people going bankrupt each year. Primarily, those who went bankrupt were businessmen or people with some means or assets. They were also probably debtors who knew their creditors or their creditor’s employers (such as bank managers) and it was a more personal affair. Historically, this is one of the reasons why there was such a stigma attached to the remedy.

Prior to 1985, personal insolvency in Scotland was not a consumer friendly remedy: there were no public funds available to pay for the administration of bankruptcy and that meant no-one was willing to make you bankrupt unless you had money or assets. And if you wanted to do it yourself, you wouldn’t have been able to unless you could afford the costs of a trustee in winding up your estate. For these reasons, prior to 1985, bankruptcy was primarily a remedy utilised by creditors to recover debts from those that could afford to pay something and not generally as a means for debtors to obtain relief.

In 1985, this began to change with the Bankruptcy (Scotland) Act and the availability of public funding. Contrast, for example the years 1986/87 with 1992/93. In the first of those years, there were only 560 sequestrations in Scotland and of these, 423 (75%) were the result
of creditor petitions. Six years later, there were 11,970 sequestrations and of these, 1,538 (13%) were as a result of creditor petitions. This was a significant change: an explosion in the numbers going bankrupt, but also a dramatic change in the reasons why they were going bankrupt. More applications were being made by debtors themselves, seeking relief from their debts, than by creditors seeking to recover them.

These changes were possible as a result of the 1985 Act, but also occurred against a backdrop of a changing society: home ownership (as a result of the right to buy scheme) was on the increase, financial services were being deregulated and cheap credit was becoming available to those who traditionally had not been able to access it. They also occurred at a time when the traditional relationship between bank manager and customer began to break down and the depersonalisation of consumer credit began with the emergence of it as a high volume driven business.

These changes have continued since then and with the further widening of the gateway into sequestration the numbers have continued to increase, particularly since the introduction of Low Income, Low Asset bankruptcies in 2008. Bankruptcy has also changed in that Accountant in Bankruptcy statistics show the top ten creditors in bankruptcies are now all High Street banks and finance companies, whilst other academic studies have shown that in excess of 90% of all debts included are now consumer debts. The idea of creditors in bankruptcies being small traders and businesses is as realistic these days as George Orwell’s vision of Britain as a “country of long shadows on cricket grounds…and old maids bicycling to Holy Communion through the morning mist.”

Creditor Disengagement

It should not surprise, therefore, if creditors no longer feel as involved in the process as they once did, but this should be seen as a reflection of the fact that creditors no longer have the relationships they once had with borrowers. That relationship has changed: between lender and borrower and also between creditor and debtor.

Another possible reason for creditor alienation from the process, however, could be what many perceive as the diminishing returns available. For many, this has got so bad that once a debt is included in a personal insolvency it is now automatically sold on to a debt purchaser. Some of the largest creditors in Scottish bankruptcies are now debt purchasers who specialise in and make profits from this type of debt: exposing the myth that insolvency is about paying back what you can to those from whom you borrowed.

Looking at both types of personal insolvency in Scotland – sequestrations and protected trust deeds – evidence that dividends have unreasonably decreased over time is not strong. In relation to sequestrations, available statistics of average dividends are not easy to access, but it has to be conceded they will have dropped significantly. First in the period 1985-93 as sequestratio became a consumer remedy and its use was no longer primarily as a means of debt recovery, but also since 2008, with the introduction of Low Income, Low Asset bankruptcy and the real development of bankruptcy as a social safety net for the poorest. This has to be considered, however, in the
context a growing consumer credit industry which it could be argued for many of the companies involved, the financial benefits of that growth, outweigh the disadvantages of over indebtedness amongst a higher level of their clients.

In relation to Protected Trust Deeds, the average dividend statistics are easier to access and show in 1996-7 the average dividend was 16.9p in the pound. In 2010-11 this had fallen only to 16.2p in the pound. Dividends for protected trust deeds, however, do fluctuate, as they do for bankruptcy and did peak in 1999-2000 with an average dividend of 34.1p in the pound and as recently as 2007-8 the average dividend was as high as 27.01p, which again suggests the performance of the remedy to recover debts has not significantly declined over time.

In the last 3 years the average dividend has decreased by over a third, but again this has to be considered in the context of the worst recession in 60 years (caused largely by many of the top ten creditors in Protected Trust Deeds themselves) and a housing bubble which has deflated. It is now very difficult for debtors to remortgage and release equity during a protected trust deed as they once did.

Diminishing bankruptcy dividends also have to be considered in the context of the new Debt Arrangement Scheme, which allows many debtors to repay their debts in full. Many higher earners are now using this remedy, where before they would have gone bankrupt. This again has to be considered in the context of the last ten years, where personal indebtedness has grown exponentially and rises in earnings have not kept pace. Realistically, in an economic environment where there is less money available, it is not unreasonable to expect a decline in
the level of debts that are being repaid to creditors.

But if there is a reduction in returns to creditors does this matter? Until recently, the top ten creditors in bankruptcy were profitable organisations and most still are, even with rising numbers of personal insolvencies. It is also clear that bankruptcy levels in Scotland are not dangerously high with only 0.38% of those eligible using it. These figures are higher than those in other parts of the UK, where the figure is only 0.22%, but significantly lower than those in the USA, where the number is 1%.

A Vision of Reform

This is not to say that the bankruptcy laws of Scotland should not be overhauled and rebalanced, but if they are to be reformed what should they aim to achieve? Over the last 25 years we, our society and economy have changed and so has our use of bankruptcy. We live in a modern credit based society and healthy consumerism and use of financial services is important as are small and medium sized businesses, which support the wider Scottish economy.

But we also have to accept that people’s attitude to credit have also changed and not being able to repay your debts no longer carries the same sense of personal failure or humiliation as before. Loans, credit cards and other forms of personal finance are now vital parts of most household budgets.

The role bankruptcy laws play in such a society is more complex than traditional views allow for, so we should guard against those driven by personal morality or outdated notions that no longer apply. We should aim to create bankruptcy laws that create a system that offers fairness to all, whilst offering a safety net to the poorest and most vulnerable in society. It should also be a system which strives to create an environment that will encourage entrepreneurship and is based on a business survivorship culture.

To these ends we need to refocus the debate on bankruptcy away from the narrow notion of debtor and creditor interests and begin thinking about society’s interests. We have to weigh up the economic and social damage of debtors not repaying their debts with the economic and social impact of large numbers of people struggling to cope with unmanageable levels of personal debt. We have to decide when one outweighs the other in terms of benefits for society and use our bankruptcy laws as economic and social levers that can drive the type of changeswe want to introduce.

If we want to avoid laissez faire lending practices which have resulted recently in dangerous levels of over indebtedness, then increased debtor protection may result in increased responsible lending by creditors. This could take the form of increased protection for debtors homes, as currently exist in the United States. These homestead protection laws are also believed to encourage greater risk taking and, therefore, higher levels of entrepreneurship.

Alternatively, if we wish to encourage debtor responsibility, we may wish to make bankruptcy and the protection it provides less available. This can be done by creating obstacles for anyone considering the remedy, either by stipulating strict legal criteria that have to be satisfied or increasing the cost involved. We have to recognise the disadvantages of this type of approach, however, when you examine its use in Ireland where it takes 12 years to receive a discharge from your debts.

This has resulted in a booming bankruptcy tourism industry which results in many seeking relief in Northern Ireland or in the UK mainland. In the long term, many may not return. Also, given that approximately 20,000 people become insolvent each year in Scotland, we have to consider what benefit it has for local economies and for attempts to reduce fuel and child poverty when people and their families are left with little or no disposable income for three years. Could making people pay more exacerbate their problems?

We also have to consider the social and economic effects of leaving people stigmatised with bankruptcy for longer than necessary, especially when there is little benefit for creditors.

We could also encourage more personal responsibility from borrowers by ensuring it’s a requirement that everyone who wishes to become bankrupt must first seek advice. Debtors could also be denied discharges from their debts unless they attend a financial education course.
In relation to sole traders and partnerships, we could create a culture focused on business survivorship rather than liquidation. Some advisers are already doing this using the Debt Arrangement Scheme, but this remedy is not ideal as it was primarily intended for consumer debts. A similar remedy could be created, however, allowing sole traders and partners to remain in control of their businesses but receive protection from their creditors as they try and reorganise and pay down debts. They could be required to submit business recovery plans as part of the process, obtaining help from professionals. This could save jobs and increase returns for creditors.

We also have to recognise in drafting such laws that there is a need to fund this new system with increasingly less public funding available. Currently 40% of bankruptcies in Scotland are Low Income Low Asset bankruptcies. Most of which involve debtors solely or largely dependent on social security benefits, who have no or little assets. They are administered at a cost to the public purse by the AIB. This is despite the fact that when these debtors are made bankrupt, creditors are not invited to submit a claim for their debts, as in most cases no
dividend is paid. We could consider allowing a discretionary early discharge after 4-6 months in such cases in addition to the one year automatic discharge that currently exists. This would free the AIB from the cost of having to administer such cases and remove from the poorest the stigma of bankruptcy that may affect their ability to obtain future employment.

In addition, are there any reasons why we should not increase private sector involvement in personal insolvency, removing the risk from the public purse? Some have argued that costs in the private sector are too high and greater returns for creditors can be realised through public sector provision of insolvency services. That, however, places the risk of dealing with bad lending decisions onto the public purse and arguably, even if the private sector is more expensive, the cost and risk should be borne by the private sector. As noted above, the consumer credit industry is a volume driven business, so like most volume businesses although the number of bad debts may be higher, the costs of the services are lower and overall companies are making more, not less, profit. The recent credit crunch does nothing to change this realityin that most of the bank failures had less to do with the retail, consumer lending side of businesses than with their investment banking arms.

In conclusion

The plans to overhaul Scotland’s bankruptcy’s laws should be welcomed and they are necessary, but we need real vision and ambition in drawing up replacement laws. This article does not allow sufficient space to consider all the ideas, but hopefully during the AIB’s consultation process, an opportunity to  so will be available.

Bankruptcy laws need to recognise the importance of creditors, but they also need to recognise the risks they can pose to our economy and society as a whole. Retail and consumer lending in this country is still a hugely profitable business and one argument is poor creditor participation in personal insolvency is not because they have been excluded, alienated or disenfranchised.

The argument is that with the onset of the current consumer credit industry, they disengaged from the process and continue to do so. Even as recently as this year, the Scottish Government’s Protected Trust Deed consultation concluded and although seventeen credit unions and one creditor representative submitted a response, only one consumer creditor bothered.

For most finance companies the failure rate for debtors is still within acceptable levels and whilst this continues to be so, hopes for increased engagement from them is overly optimistic.

In actual fact, changing our laws to place more responsibility on debtors and society as a whole at this time is arguably undesirable,
considering the other damaging social and economic effects of over indebtedness.

This doesn’t mean we should not look at finding different ways to encourage their engagement. In actual fact it should be a requirement to ensure they take more responsibility for their poor lending decisions and play a role in helping remove the toxic debt they have flooded onto society.

What is paramount, however, is the need refocus the debate on bankruptcy away from creditor and debtor interests and onto society’s interests.