Credit Unions: are they a special case in personal insolvency?

Credit Unions: are they a special case in personal insolvency?

One of the most controversial issues in the Scottish Government’s consultation on bankruptcy law reform is the issue of extending the type of debts that should be excluded from bankruptcies and protected trust deeds.

Two specific examples are suggested: debts owed to credit unions and child maintenance arrears.

The problem with excluding debts, however, is it dilutes the protections that personal insolvency offers and can be a slippery slope.

However, is there a case for extending the list?

Child Maintenance Arrears

There are clearly strongly moral reasons why child maintenance arrears should be excluded: others may suffer as a result and there are possibly few more deserving cases than innocent children who are the dependents of their parents.

However, life is rarely simple and often child maintenance isn’t paid because estranged parents are raising other families or relationships have broken down to the extent that access to children is being denied and maintenance is not paid.

Also it doesn’t take long for arrears to accrue to the extent where they cannot be repaid.

There is also no evidence from England, where they are excluded, to suggest giving them special status improves recovery rates.

It is also has to be borne in mind that other children in new families can also suffer where there are no effective methods of relief.

Credit Unions

In relation to Credit Unions, however, there may be a stronger case for special treatment. Other than a few large industrial and city wide credit unions, the vast majority of these organisations are small and particularly vulnerable to debts owed to them being included in insolvencies.

Few debtors will actually become personally insolvent because of a credit union debt and the amounts loaned are normally small. In actual fact, many debtors may prefer not to include credit union debts, feeling a strong responsibility to the other members, who may be neighbours or work colleagues.

Another reason for credit unions to be given special treatment is that, unlike other creditors, they are restricted in how much interest they can charge (which is effectively limited to 2% per month, although in reality most charge 1%). They are, therefore, restricted in what they can do, unlike other consumer creditors, who can just increase interest rates when they suffer significant losses due to insolvencies.

For example, if a Credit union suffers a bad debt of £7,000 they would have to lend £350,000 at 2% within a year to recover the loss.  For many small community and workplace based credit unions this is just not feasible.

However, other involuntary creditors, such as HMRC or local authorities can make similar arguments, especially when they use the summary warrant procedure to constitute debts and can only charge a 10% surcharge on the debt, instead of charging the judicial rate of interest at 8% per annum.

That is the slippery slope of excluding debts.

There are other arguments in favour of excluding credit unions, however. They could continue to offer small amounts of credit to debtors during their insolvencies for small emergencies, such as broken washing machines etc. This would remove the risk of debtors failing to make contributions to their bankruptcies and protected trust deeds.

They could also provide a vehicle for debtors to continue having modest savings, although this would possibly require legislative change, but most trustees do permit allowances in debtor’s financial statements for costs that have to be set aside; so logically should we not encourage debtors to set these aside for the purposes intended?

Education

The Accountant in Bankruptcy office is also keen to incorporate some form of education for debtors in Scotland’s debt relief and management remedies and generally support for this principle is supported across the board.

Credit unions could play a pivotal role in this education, by not just making any education a classroom exercise at the end of an insolvency, but by encouraging good practice, such as saving with and borrowing from socially responsible lenders during the operation of the bankruptcy or protected trust deed.

Arguably there is a case for allowing credit unions to have priority during a debt payment plan under the debt arrangement scheme if this approach is taken as most debtors in an 8 year DAS will require some form of credit during that programme.

Alternatives

Even if we don’t accept credit unions deserve to be excluded from bankruptcies and protected trust deeds, this does not mean we cannot give them some form of special treatment.

Changes could be made to the way claims are settled in personal insolvencies. Currently many involuntary and socially responsible lenders are disadvantaged with the current scheme of division, where dividends are paid to ordinary creditors on the basis of what is owed at the time of the insolvency, including interest.

This means the pay day lenders that might charge say 3000% APR and front load interest onto loans, proportionately  can claim more in relation to what they loaned than a credit union or a local authority can.

This could be avoided by introducing a system where dividends are initially paid on the original debt, with interest having a deferred ranking. This would mean our bankruptcy system would still treat all creditors equally but also more fairly. It would also mean we don’t reward predatory lending and would remove the requirement for trustees to challenge extortionate credit agreements, which rarely occurs anyway.

Conclusion

There is no clear answer to the question of what debts should be excluded and what should be included. Many creditors have strong cases, but the argument for excluding credit unions is particularly strong, especially in a society where we see the growing scourge of payday lenders.

They also have a strong case as institutions we would wish to encourage Debtors to use.

They are also arguably part of the solution for dealing with the recurring issue of over indebtedness amongst some of the poorest in Society and could help prevent Debtors repeatedly becoming insolvent.

Maybe it’s time to make one last exception.

Bankruptcy Consultation Cancelled

Bankruptcy Consultation Cancelled

A consultation on the reform of bankruptcy law appears to have broken down as reforms opposed by consultees appear to be proceeding regardless. Alan Mcintosh untangles the mess.

Anger has broken out amongst money advisers over the Scottish Governments Bankruptcy Law Reform. Within a day of the first of a number of industry consultations, many advisers have been left furious and angry at what appears to be the contempt the Accountant in Bankruptcy (AIB) is treating the process and those participating in it.

One of the key issues is should the AIB be able to provide advice.

The day after a consultation event organised by Money Advice Scotland, where the proposal was unanimously rejected by the members present, the Accountant in Bankruptcy advertised it was seeking two advisers to be seconded to a pilot project beginning next year.

The Accountant in Bankruptcy has no legal powers to deliver such a service and no bill is presently in front of parliament proposing they have such powers. Even the consultation proposing they should have such power is not complete. Yet despite it being expected that opposition to it will be overwhelming, the AIB appear to have decided the proposal will go ahead.

The issue is an old one and first arose with the passage of the Bankruptcy (Scotland) Act 1993. The then conservative government rejected the idea as there was a conflict of interest. Since then the idea has repeatedly re emerged and has lead to accusations of empire building by the AIB. More recently in the current consultation, the proposal was made with the assurance that the project will be ring fenced in acknowledgement of the conflict of interest.

The AIB claim they regularly receive calls from debtors asking for help or arriving at their office and need to be able to assist them by delivering advice. The Scottish Government, however, already funds the National Debt Line and either North Ayrshire Council or Irvine Citizen Advice Bureau could easily, with funding, serve the AIBs office.

Why then the need for a duplicate service?

In launching the Bankruptcy Law Reform consultation, Rosemary Winter Scott, the Accountant in Bankruptcy called for “vision and ambition” in redrafting Scotland’s bankruptcy laws, but also worryingly indicated this was a good time for the reforms with the majority government. It’s clear now what she meant with such comments: legislation will be driven through parliament and Government dominated committees will be expected to rubber stamp provisions.

Many like me fear the AIB’s vision of rebalancing Scotland’s bankruptcy law is gradually about eroding independent debt advice and replacing it with more pro-creditor advice. This is an erosion of the principles that advice should be non-judgemental and always in the best interest of the client.

What is shocking in relation to the Accountant in Bankruptcy actions, however, is the cynicism of what they have done. No mention was made of the pilot project at the Money Advice Scotland consultation the day before, despite the attendance of a senior AIB staff member. Instead it was only after the extent of feeling became clear it was announced, possibly to instil a sense of defeatism in people or to entice others fearing job cuts.

Equally disturbing is that the announcement was made through Money Advice Scotland, who knowing the strength of its own member’s feelings, circulated the advertisement seeking advisers to apply. This raises questions about the influence the AIB now have, now they control significant portions of their funding and The Chief Executive is a non executive member of the AIB’s Board.

The decision to announce this project is in bad taste and signals contempt towards the consultation process and those involved in it. If this matter is already decided, what others are?

Rosemary Winter Scott said she wanted vision and ambition during this reform, but already it appears cynicism and distrust is creeping in.

You have to wonder if there is any point continuing with the consultation.

Bankruptcy: A Vision For Reform

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.


 

Why Scotland Needs 200,000 Bankrupts!

Why Scotland Needs 200,000 Bankrupts!

A couple of years ago I was speaking at a Credit Today Scotland conference in Edinburgh. The room was filled with creditors, debt collectors, debt management companies and insolvency practitioners. As the token money adviser I was just a tat out of my comfort zone.

I told the story of Donald Trump walking by Tiffany’s one day. He turned to a colleague as they passed a beggar and asked him if he knew the difference between himself and the beggar. The Colleague didn’t know, so Trump gave him the answer: about 900 million dollars. The irony was that whereas the beggar was probably solvent, trump wasn’t with his assets hugely outweighed by his liabilities. I was making the point to them they should be careful as many of their clients were effectively bankrupt.

It’s a sobering thought that if someone like Donald Trump could be effectively bankrupt, how many more of us could be as well. Last year in Scotland there was nearly 23,000 personal insolvencies in total, that’s approximately 0.5% of Scotland population over the age of 18.That means in the next two year, one in one hundred people in Scotland will be declared insolvent.

At another conference I was at last week, Citizen Advice Scotland, the Accountant in Bankruptcy office was there and said the figure was only about 0.3% of the population per year, which was an acceptable figure. However, the Accountant in Bankruptcy were not counting those who went into protected trust deeds, another type of personal insolvency in Scotland. Total personal insolvencies are 0.5% of the population. But should the laws be changed to allow that number to be doubled? Could it be in Scotland’s best economic interests if the number was double that?

The problem with bankruptcy is the University of Wales carried out research and believes there are over 2 million iceberg bankruptcies in the UK[1]. That is people who are paying only the minimum each month to their debts and cannot reduce their overall indebtness. People, that is, who could become bankrupt if they were to lose their jobs and if they don’t, will never repay all their liabilities. With some experts believing up to 30,000 jobs could be at risk in Scottish local authorities alone in the next couple of years[2], and assuming of those 2 million iceberg bankruptcies, up to 200,000 could be in Scotland, it’s not difficult to see we could see the numbers of personal insolvencies increase quickly over the next couple of years.

This is likely to be aided with new bankruptcy laws due to be implemented in November 2010 as part of the Home Owner and Debtor Protection (Scotland) Act 2010. Certificated sequestrations (the formal name for what most people consider to be bankruptcy in Scotland) will allow anyone who can show they can’t pay their debts as they fall due to apply for sequestration. That of course doesn’t mean everyone who meets that criteria will, as sequestration can result in people losing their homes and other assets, but where people have negative equity and cars worth under £1,000 (soon to be £3,000) bankruptcy may become an option.

But the question needs to be asked is this a bad thing? Of those 200,000 iceberg bankruptcies in Scotland, the reality is many of these people cannot reduce their indebtness. That is their situation is unlikely to improve and in most cases, will only get worse. That is people who are being left without any disposable income to spend on consumer goods in their local economies for prolonged periods of time, can’t take their children even modest holidays and are so dependent on credit that their debts only get worse. This is also people who are constantly juggling their credit cards and loans, suffering from stress and the frustration of not being able to address their problems. The links between debt and mental health are clear and well established.

So could we help more people to go bankrupt? It may even help the Scottish economy, breathing life back into consumers who are effectively dead financially – up to 200,000. Could we increase the rules in bankruptcy to protect people who have modest amounts of equity in their homes, so they don’t need to sell their home if they go bankrupt, but get to keep it? Such ideas aren’t that fantastic. In the United States, federal homestead protection laws protect the first $15,000 of equity in the home in bankruptcy. Some states have their own laws, which allow higher amounts and in states like Florida, there is no cap on the amount of equity someone can have.

In the United States, there is credit rationing between states, unlike in the UK, which means is it is easier to obtain credit in some states as opposed to others. This is often used as a reason for Scotland not going radically on its own, even though under devolution it could, but, then why not? The availability of credit throughout the EU varies as does the cost, which is part and parcel of having your own legal system. Why should the Scottish Government not use a economic lever like bankruptcy laws to control the availability of credit and indebtedness in Scotland, considering the wider social problems it can have.  In the United States the rate of self–employment and business start up is higher than it is here and one of the reasons for that is commonly believed to be the bankruptcy laws, which make people less risk averse. With thousands of jobs cut due in Scotland and a need to increase growth in the private sector, including business start ups, why should the Scottish Government not consider reforming our bankruptcy laws to encourage this?

But there lies a problem. Politically, even 30,000 insolvencies a year in Scotland is likely to be unacceptable, although very possible, soon. There could be repercussions if bankruptcy numbers begin increasing, like credit rationing and increased homelessness (especially under the current laws). We could, therefore, see obstacles being reintroduced into Scottish bankruptcy laws to artificially keep the numbers low. Artificially low that is because the number of people who will be able to go insolvent each year won't really reflect the numbers that are really bankrupt. So we end up with a bottle kneck, where we only allow so many through, not for economic reasons, but for political ones. This has happened before. Prior to 1985 in Scotland the number of bankruptcies in Scotland were less than 300, by 1993 after changes in the law, the numbers increased to over 11,000 and bankruptcy became a consumer remedy, instead of just a remedy for business people. This caused controversy as it saw huge costs for the public purse. The current situation, however, is completely different with the Accountant in Bankruptcy office soon to be full cost recovery – that is costing the public purse nothing. When the laws were changed again in 1993 the numbers went back down to 4,300 – but that didn’t mean the number of people needing to go bankrupt had fallen, just that there were thousands who were trapped in debt traps and weren’t being allowed to escape. Even by 2007/8 (14 years later) the number of insolvencies had only increased to 13,600. In 2008 the lid was again lifted  with changes in the law and the numbers increased to approximately 22,000 in the space of a year.

Now many may complain that with bankruptcy increasing their will be more small businesses not getting paid and ending up bankrupt themselves, laying off employees and creating a death spiral. The truth, however is the, the top ten creditors in bankruptcies are huge high street or multinational creditors, not small local businesses – although many of these suffer when local consumers spend years with no disposable income because of debt repayments and cannot be fully economically active in their local communities. The reality is, many of these big international firms still make profits even with thousands of bankruptcies each year and there is other multi national finance companies that specialise in buying up and speculating in their bankruptcy debts to make profits.

We need to change the way we see bankruptcy. Traditionally, in Scotland and the UK we have seen it as a method of debt recovery (which it isn’t – less than 13% of all personal insolvencies are initiated by creditors), but as part of the social safety net we have in society that allows people debt relief and the ability to rehabilitate themselves, not because of recklessness or fecklessness, but usually because of bad luck and misfortune. We need also to see bankruptcy laws as economic levers in society that can be used to reduce indebtedness for future generations by forcing creditors to ration the availability of credit and also as tools that can help encourage people to start up their own businesses by sending out the message, just because you go broke, doesn’t mean you lose everything.

If other countries can use their bankruptcy laws intelligently like this, there is no reason we can’t in Scotland. One percent of the Scottish population going bankrupt in the coming years is not a scandal, but a necessity for our future economic health. 0.3-0.5% is not enough with up to 200,000 iceberg bankruptcies out there.


[1] http://www.aib.gov.uk/Resource/Doc/4/0000840.pdf

 

[2] http://www.heraldscotland.com/news/politics/2000-staff-facing-axe-in-latest-council-cuts-1.1052835

Principal Home Protection in Bankruptcy

Principal Home Protection in Bankruptcy

First published in the March 2009 edition of SCOLAG.

Alan McIntosh argues Fergus Ewing’s new Debt Action Forum needs to consider making personal insolvency in Scotland more consumer friendly and increase protection for homeowners.

The traditional view in Scotland of personal debt, has been the debtor who becomes notour bankrupt, becomes embarrassed by their debts and should realise all their worldly assets for the benefit of their creditors and, hopefully, obtain their forgiveness.

Whether this should be the view in 2009 is debateable. Much has changed with regards insolvency and the stigma attached to it. It is no longer seen, necessarily, as something people should be embarrassed about, but rather as one of the unfortunate financial risks we all face in today’s society, the causes of which are as much out of our control as within it. Also, it needs to be questioned the desirability of such a legal remedy having such dire effects and carrying an embarrassing social stigma in today’s society. It was one thing this being the case, when even as recently as 1985, the number of personal insolvencies in Scotland could have been counted in their hundreds[1], but by the end of this financial year, that number could be closer to 20,000[2]. Also, is it fair the individual should bear the full burden of their downfall, when both the Government and the finance industry are, at least, partly if not equally culpable?  From the 1980s onwards, where the origins of this current credit crisis lies, Government done everything possible to deregulate financial services and encourage the growth of the consumer market (underpinned with vast amounts of easily accessible, unsecured credit).

The question now needs to be asked, as we enter the severest recession in 60 years, is whether the thousands of debtors who now find themselves in the position they do, partly as a result of the government and the finance industry’s actions and incentives, should face Dickensian style ruin?

One of the biggest dangers facing many normal working families in the years ahead is their large quantities of unsecured personal debt. It is not uncommon for these debts to equate to 1-2 times the debtor’s net annual income. That is, levels of debt that it should have been obvious to creditors, if not the debtors themselves (many of whom lacked proper financial skills), was ever repayable.

One argument, which has been advocated already by others in Scotland’s wider legal community[3] is personal insolvency is now primarily a remedy for consumers and needs to be modernised, like the sale of goods and contracts for and of services were, to make it more consumer friendly. This would arguably include new protections for debtors and their families.  Such protections could include the protection of the family home and the income of debtors’[4], ensuring they and their families are not forced into poverty.

Unlike many legal systems, however, Scotland’s bankruptcy laws have never treated the home of homeowners as an essential item, but as a realisable asset, to be used to swell insolvent estates for the benefit of creditors.

This may have been acceptable in the past, where the number of bankruptcies were small and social housing was more prevalent, but there is something nonsensical about a legal remedy, which treats the toys of a child as an essential item, but not the home the child lives in; or considers a personal computer or television to be something a debtor cannot do without, but does not afford the same consideration to where the debtor lives.

Although, numerous measures have already been implemented by both the UK and Scottish Government to prevent repossessions by secured lenders, little has yet to be done to protect debtors from losing their homes as a result of unsecured debts.

One possibility is for the Debt Action Forum to urgently consider a Dwellinghouse Exemption Act or provisions, exempting the principal residence of debtors, to some degree, if not completely, in sequestrations and protected trust deeds.

Such a measure may seem radical, but is commonplace in many other legal systems. In the USA, for example, Homestead Exemption provisions exist preventing the homes of debtors from being sold by unsecured creditors. In Texas there is no value to the property protected and in urban areas covers up to 10 acres[5]; In New York the home is protected up to the value of $50,000[6]; whilst in Alaska there is a $54,000 exemption[7]. Similar provisions exist in Canada and vary from province to province.

It would seem pointless for legislators, in response to the credit crunch, to take steps to protect homeowners from repossession, only for them to lose their home as a result of failing to pay a credit card or personal loan.

The vast majority of debtors who have accrued large amounts of unsecured debts were never cautioned, like they would have been with secured lending, that their home were being placed at risk, but for thousands of Scottish debtors, this is the reality they face as they now default on credit cards and personal loans.

The difficulty in measuring the true extent of this problem is although it may be possible to determine how many homeowners were sequestrated or signed trust deeds, it not always possible to determine how many of these resulted in the debtor losing their home. Trustees do not regularly force the sale of debtors’ property, although they have the power to. Most bankrupts “agree” to the sale.

As the credit crunch continues to unfold and the true extent of irresponsible lending becomes clear, there is now emerging a danger, for not only over indebted homeowners, but for the public purse, that it will have to mop up this overspill from toxic, unsecured, financial products.

Yet this is already occurring through the publicly funded Mortgage to Rent Scheme, which was initially set up to protect debtors from losing their homes as a result of repossessions. Under the current rules, the social landlord who buys the debtor’s home, with the assistance of a public subsidy, only pays the secured lenders up to the market value of the property or that which is secured over it, whichever is the lesser. Where there is equity, the debtor is only entitled to £8,000 (if under 60) or £12,000 (if over 60). This means often the full price is not paid, but the debtor gets to remain in the home as a tenant. Where, however, the debtor has been sequestrated or has signed a protected trust deed, the trustee is treated as a secured creditor and is paid the full equity. Effectively, therefore, where this Scheme is used for bankrupts to keep them in their homes, public funds are being used to pay the trustees fees and the debtor’s unsecured creditors.

In addition the availability of affordable, appropriate housing in the public sector is already scarce and Shelter has said the Scottish Government needs to make available up to 30,000 homes for rent over the next three years. These numbers may have to increase if the demand on social housing is increased as a result of bankruptcy.

There, however, is an opportunity, with a Dwellinghouse Exemption Act or provisions, to reduce the social affects of the deepening recession and the pressure on increasingly strained public resources.

If the principal home was exempt in bankruptcy, unsecured lenders would have to evaluate the risks attached to their lending more cautiously, especially if they realised they would only be able to recover unsecured debts from moveable assets. This is likely to promote responsible lending.

Another consequence may be debtors will also find it more difficult, even after the economy recovers, to access similarly large amounts of unsecured credit, with more lenders seeking securities for their loans. This will have a cautionary affect on debtors and will avoid the situation where one partner in a family runs up unsecured debts, unbeknownst to the other and is later sequestrated, placing the whole family at risk of losing their home.

It may even create a situation where our homes become just that and not speculative assets, which give people a false sense of wealth and encourage over indebtedness.


[1] 1-21, McBryde, W, Bankruptcy, W.Green/Sweet & Maxwell, 1995 (First Edition)

 

 

[2] That is sequestrations and Protected Trust Deeds

 

 

[3] Donna McKenzie Skene, & Adrian Walters, Consumer Bankruptcy Law Reform in Scotland, England & Wales

 

 

[4] Scots Law does recognise that debtor’s should be allowed to retain amounts needed for their ailiment, but this now needs to be developed with the recommendation in AIB guidance that Trustees use trigger figures when calculating debtor’s essential expenditure. This is current practice in the Debt Arrangement Scheme.

[5] Chapter 41.001, Title 5, Texas Property Code

 

 

[6] S5206, CPLR, Consolidated Laws of New York

 

 

[7] S09.38.010 Homestead Exemption, Alaska Statutes