Why Are Chapter 13 Debtors Not Allowed To Borrow?

26 Sep Why Are Chapter 13 Debtors Not Allowed To Borrow?

In most bankruptcy courts a Chapter 13 debtor is not allowed to borrow money without the court’s permission, based either on a court order or local rule. This tradition has existed in most places for as long as anyone can remember. Why?

It may come as a surprise to most people but the Bankruptcy Code does not have any prohibition on a Chapter 13 debtor borrowing money while in their case. It does prevent any new non-tax creditor from filing a claim in the repayment plan unless it was incurred with either the court or trustee’s permission. But most consumer lenders do not wish to be included in a reduced repayment plan that will eventually eliminate the balance of their debt so that provision is virtually a dead letter.

There is also a provision of Chapter 7 (sec. 727(a)(9)) that appears in part designed to prevent a consumer from completing a Chapter 13 case and promptly thereafter filing a Chapter 7 in order to wipe out new debt, at least unless the consumer paid a substantial portion of the old debt off in the plan. This provision makes perfect sense if Congress was worried about consumers simply using credit cards to pay off old debt — at much reduced amounts — and then wiping out the new credit cards as well.

There are good reasons why a debtor should not be able to take out secured loans. The house, car or other property are subject to the claims of the creditors in the case first. Courts would not want you to be able to borrow away equity in your property which might otherwise protect the interests of your unsecured creditors.

There are also good reasons why a debtor probably shouldn’t be borrowing money overall. Chapter 13 can be a learning process for consumers. Figuring out what you can afford and cannot afford — purely based on what you bring in — is an important step for consumers trying to make their lifestyle to match their income. Credit can be a way of avoiding hard choices that someday must be made.

And, of course, Chapter 13 is generally intended to lead to the highest reasonable repayment of unsecured debt. So a court could conclude that if you have enough income to pay new borrowings, then perhaps you ought to be paying back your old creditors more instead. That’s hard to argue with, as a general proposition.

On the other hand, a Chapter 13 plan is intended to be a new contract with your creditors. It is governed by the court and trustee, and there are many ways to modify it during the course of the case, but the idea is generally to structure a new deal between the parties. The old creditors don’t really care how they get paid, as long as they get their fair share. If the payment comes from new debt the consumer wants to take on, so be it. If the only way the debtor can make the required payments is by borrowing from somewhere else, this hardly bothers the typical debt collector, in my experience. It may just be a bad idea for the debtor.

In reality, most courts and trustees tend to treat the process of allowing a consumer to borrow more money as though they are supervising an incompetent person in a guardianship. In a sense of course the court and trustee have every right to investigate and question the debtor’s financial affairs while they are receiving the protection and benefit of the bankruptcy process.

But as a matter of policy does this make sense? After all, the courts that prohibit new debt are acting as policy makers here. Congress has not seen fit to bar a consumer from new debt, even in the anti-consumer 2005 amendments. So the primary branch of government constitutionally empowered to define federal bankruptcy policy has not intervened this way.

In reality, courts that impose this restriction may be harming the debtors in the long-term. Consumers could use credit during their cases in many ways without harm. First and foremost for many, they might be able to rebuild their credit if they use it responsibly. Second, debtors with regular but “spiky” income — like commission sales — may be able to “smooth” the peaks and valleys of their income with credit. Many employers require travel which is only reimbursed, not paid in advance — and have you ever tried to rent a care or hotel room without a credit card? Third, such consumers may be able to more rapidly address problems like an emergency car repair or property damage. Fourth, most self-employed consumers are almost unable to transact business without the use of credit cards simply as payment devices.

It is certainly true that a consumer building up a cash reserve and using a debit card may be able to do many of these things. But in the era of means testing, the reality is that most consumers simply cannot build up large cash reserves for these sorts of scenarios. There is no “cash cushion” allowance in the means test. And if they did not have those reserves when entering Chapter 13, they may simply be playing “catch up” for months or years to get to that stage. For many of the debtors described above, their business or job are often badly damaged at this initial stage.

No doubt a few courts also impose this rule to discourage creditors from taking on new risks. A new lender can be wiped out if a Chapter 13 is later converted to Chapter 7 with the new debt included as a “gap” claim. But presumably the marketplace is efficient enough to deal with lenders who provide the consumer equivalent of debtor-in-possession financing without securing any protection.

Certainly a debtor who is forced to go “cold turkey” from credit might be forced to figure out how to manage on the existing income. Or fail out of their Chapter 13 case. In other words, the ‘education’ provided by the bar on new debt is the equivalent of throwing the credit-reliant consumer into the deep water and either they sink or swim. Perhaps some of the mandatory financial management education will help but I won’t be holding my breath. No wonder there’s a high failure rate for Chapter 13 cases.

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I have been a bankruptcy attorney since 1989. Our firm represents consumers filing bankruptcy almost exclusively, although I have represented bankruptcy trustees as well as creditors. For 2017-2019 I served on the American Bankruptcy Institute's Commission on Consumer Bankruptcy. Our Report recommended numerous changes to improve bankruptcy law to make it serve everyone in the process more effectively. If you live in Eastern Missouri, visit our website, send an e-mail or give us a call (314) 781-3400. Our website: STLBankruptcy.com
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