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The Shadow Consumer Bankruptcy System

posted by Alan White

    Bankruptcy filings have not risen at anything like the rate at which consumer debt defaults have risen since 2007.  Part of the explanation may lie in the shadow bankruptcy system, a network of alternative service providers who purport to save debt-burdened consumers from the bankruptcy court.  While consumers being sued on delinquent credit cards and mortgages receive solicitations in the mail from bankruptcy attorneys, they are also deluged with a variety of other offers of aid.  These range from foreclosure rescue scams to a wide range of legitimate and dubious debt advice and counseling services, to debt elimination and debt settlement schemes.  While pondering this post I searched in the usual places for any good empirical data on the number of consumers participating in non-profit counseling, or the number of customers enticed by those who promise to make debt disappear, with no success.   We don't seem to know how many debtors go to these debt advice services.

    The shadow consumer bankruptcy system is similar to, but distinct from, Richard Hynes’ notion of an informal consumer bankruptcy system, which consists essentially of delinquent consumers not seeking help at all, from bankruptcy court or anywhere else, because they are adequately protected from creditor enforcement through state exemptions, debt collection statutes and a lack of any assets to seize.   My observation that bankruptcy filings have not kept pace with consumer overindebtedness is congruent with Professor Hynes’ observation that civil debt enforcement lawsuits have not kept pace with the rise in consumer debt defaults.  If creditors don’t always sue, and consumers don’t always file bankruptcy, what else is going on?

            Perhaps it is simply a matter of risk-based pricing:  it is cheaper now for the credit industry to write off a certain amount of uncollectible consumer debt and recover the losses through pricing, than to waste resources in futile efforts to enforce all debt contracts.  This possibility leaves open the serious problem of external costs imposed by the hugely increased number of debt defaults, on borrowers, lenders and communities, as well as the question of what impact the shadow bankruptcy services have on debtors and creditors.   Some good research and information on the shadow consumer bankruptcy system would inform the policy debate around the degree of harm and distress caused by excessive consumer debt, and the effectiveness of bankruptcy law and its alternatives in reducing those harms.


The problem is that the response to these scam artists have been wholly inadequate.

You see ads for mortgage foreclosure outfits (almost all scammers) who make it sound like they are official intermediaries for "Obama Mortgage Help Programs" - or companies that claim that there is some government credit card program that they are helping to implement.

The state AGs, the Justice Department, the FTC, etc. go after the people making these phony claims on a piece meal basis - but the scammers are smoke. They run their scam ads, bring in their victim/clients, fleece them, disappear, and then re-form with a new name, and maybe a new lie.

Piece meal enforcement just doesn't work.

What might work is some government sponsored ads about the real options available to people in financial trouble - responsible credit counseling from National Foundation for Credit Counseling agencies, Chapter 13 bankruptcy, and HUD mortgage counselors. If people heard half the amount of advertising for those options that you hear for the scammers, that would do more good than all the whack-a-mole enforcement efforts you see today.

True non-profit agencies don't have the money to do the kind of advertising that is needed, and I think Chapter 13 Trustees are prohibited from advertising (or even encouraging people to file a Chapter 13), and for some reason, you never hear about HUD counselors on TV or the radio advertisements.

The public information field has been ceded to the scammers - and we need an antidote for the misinformation they are blasting at desperate people on radio and late night TV.

AMC it is surprising the Feds aren't able to do more about it. I mean after all any sort of advertising is going to leave a paper trail (eventually) to someone who signed a check paying for the ads.

The principal reason behind the reduced number of bankruptcies is more likely due to the changes in the bankrupcty laws which force more borrowers into (more expensive) Chapter 13 filings as opposed to Ch. 7

Not buying the "shadow bankruptcy" idea. Yes, it's interesting, but it's not what I'm seeing.

A lot of debtors who fall in with the unsavory element end up in bk anyway. They get taken for a ride and then get sued by their creditors as a final kick in the pants. Love it when trustees file adversary proceedings to set aside fraudulent transfers. Doesn't happen nearly often enough IMHO.

I think the real story is complicated. A lot of people can get by for a long time, sometimes years, in an insolvent state. They move and leave no forwarding address, change phone numbers, work jobs that pay in cash. Secured creditors, mortgage and auto loans especially, have a crazy backlog. People are living in foreclosed homes for two years!

Hi, Alan. Dan Ray, editor of CreditCards.com here. For a story we published Monday on credit counseling, we went in search of that same data you mentioned. While the credit counseling industry is too diffuse to come up with an overall number, we did get data from the two biggest accrediting agencies for nonprofit credit counseling firms, the NFCC and AICCCA.

If it's cool to pass along URLs, the story (with the chart showing the data about halfway down) is at http://www.creditcards.com/credit-card-news/questions-to-ask-to-find-select-find-right-credit-counselor-1265.php.

The short answer: The two agencies saw about 5 million consumers in '07, about 6 million in '08 and about 7.3 million in '09

If the primary financial problem for consumers is mortgages, then we shouldn't expect a lot of bankruptcy filings, and debt settlement woudl eat into the credit card debt problem--it is primarily a credit card debt business.

Maybe part of the answer is that for collection purposes, the lawsuit isn't worthwhile. The only reasons to bother with a lawsuit are (1) to show you mean business and (2) to avail oneself of judicial collection. But #2 isn't especially effective and the benefits of #1 are small. I think it is probably more cost effective for debt collection firms to simply to dun consumers in most cases and hope for a payment that exceeds the price they paid for the debt.

To add some of my own anecdotal evidence as a consumer bankruptcy attorney, I see clients and potential clients at different stages of financial distress: The "I'm still current, but won't be for long" at the front end and "I just got served with my second lawsuit by a credit card company" at the back end.

Another factor is the conversion of unsecured to secured debt. Nearly everyone I deal with took out a HELOC in '05 or '06 or '07 and used part of that money to pay off their credit cards. They fall behind on the mortgages and now are locked out of the credit cards, too, because their FICO scores have dropped considerably.

So yes, the primary financial problem with the people I see is mortgage debt that's higher than it was in previous economic downturns due to this switching unsecured for secured. Ultimately, I think the BK filings will stay high for quite some time. It's a function of income and with high unemployment, there's simply not enough earnings to service the debt.

I do think there is a significant shadow industry of former mortgage, collections and other miscellaneous telemarketers who run chop shop operations making big promises for high fees. Your typical (and ethical) BK attorney, on the other hand, charges less and usually tells the client her credit is going to be trashed, but absent fraud, there will be a discharge. People will pay larger fees for bigger "promises," and may know they have a fraud problem (they want to hide assets, give preferential treatment, etc).

To Tranzor Z: describe trustee clawbacks on these and whether the trustee is getting anywhere. I am not seeing it here, but I regularly talk with a friend down south, and he is seeing it, too. In fact, his firm aborted its branch out into BK practice as a result after a high percentage of low fee Chap 7 cases blew up.


For obvious reasons, I can't provide specifics about the clawback cases I know of.

What you can do is a national PACER bk case search by party name for shady outfits you may know of. They often go by various aliases and seem to change names frequently, but that should get you started.

I will say that the handful I know of all settled pre-trial. Trustee usually farms out to bk litigation firms. The nice thing is that more detailed disclosures are required in bk to get court approval so you can glean some good intel from the trustee motions.

Hope that helps. Also, to clarify my earlier point: I understood Alan to be saying that the "shadow" bk industry was an alternative to bk. My point was not to say these firms don't exist. Of course they do. It was to say IMO they're usually at best a temporary detour from the inevitable.

I had personally tried those debt consolidation/settlement before filing for bankruptcy, you really have to be careful and ask them the right questions, because a lot of them are just out to take your money for an extended period of time before even attempting to help you pay off the debt, if at all.

I recall the past when trying to determine why consumer bankruptcy filings were high and was asked by a President of a large credit card bank to visit the mail room and count the number of 341 notices daily like that would do anything.Everyone seemed intent to find the cause of bankruptcy filing and then try to find a predictable model of prediction to future swings in filing numbers. I always had difficulty trying to figure out how many repeat filers were in the numbers. My experiences in over 4M consumer cases mananged was probably about 98%-99% consumers belonged in bankruptcy. Most banks had about a split of 50-50 of bankruptcy related charge off to credit charge off. BAPCPA did change that ratio but most did not expect the large increases in credit charge offs partially or more due to the economy tanking. Well with higher credit card charge off the more potential of collection down the road....wrong. The consumers who should have been in bankruptcy were and remain the subject of collection efforts but more charge off did not mean more recovery of collection results. Maybe BAPCPA did remove some bankruptcy filing mill law firms" but at the same time according to a recent study of the median costs of going bankrupt jumped significantly in both chapter 7 and chapter 13. Maybe these increased costs contributed to consumers not filing or trying more to file pro se, or seek debt settlement alternatives from for profits and non profits and attorneys, or just do nothing. I agree the system today isn't working and needs to be fixed but after all I have commented upon consumers will continue to file bankruptcy and reason is income.Bankruptcy law should be fair to everyone, not favor any side and avoid special interests across the board.

Its a shame that so many people are filing for bankruptcy. One has to wonder that if they were giving proper advice, maybe they could have avoided it.

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