In my last post I discussed reaffirmation of debts in bankruptcy. Near the end of the post I described some loans I had seen my clients take out with interest rates as high as 496%. At the end of the post I said that that loan shark rate was perfectly legal and promised to tell you why. This post fulfills that promise by providing you with a bit of history. I know, there’s no future in history – bad joke. But this history may prove both enlightening and entertaining.
On April 20, 2005 President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) (uncharitably referred to by some as “BAPCraPA”). BAPCPA made some sweeping changes to the Bankruptcy Code. These changes affect not only debtors contemplating bankruptcy, but also attorneys – and not just bankruptcy practitioners.
I. The Origins Of American Bankruptcy Law
Article 1, section 8 of the U.S. Constitution grants Congress the power: “To establish . . . uniform rules on the subject of bankruptcies throughout the United States.” Why did the Founders feel that it was necessary to include this power in the relatively short list of enumerated congressional powers?
At the time – on September 13, 1788 the Continental Congress proclaimed that the Constitution had been ratified by the requisite nine states, i.e., three-quarters of the states – debtors unable to pay their debts faced particularly draconian consequences.
The typical scenario involved the seizure and sale of all of the debtor’s assets and distribution of the proceeds to the creditors. If the debtor still had outstanding debts after losing everything, he was thrown into debtor’s prison until the remaining debts were paid. Since the debtor couldn’t earn money to pay his debts while in prison, if he had no relatives or friends who would pay the debts for him, he faced life imprisonment. Thus, a thief might be imprisoned for a year, while a debtor who couldn’t pay his debts – perhaps simply because of the unforeseen vicissitudes of economic life – might spend the rest of his life in prison.
If one subscribes to the sensible idea that a state imposed punishment should be proportional to the value embodied in the violated law, then one would be forced to conclude that being unable to pay one’s debts was a much more serious crime than say theft.
In considering the problem of bankruptcy, the Founders appear to have been inspired by, among other things, the biblical Law of Moses. This ancient law of Israel prescribed the death penalty for working on the Sabbath, for taking the Lord’s name in vain, for having sexual relations with someone other than one’s spouse, and a fairly lengthy list of other crimes. However, in the midst of this rather strict law the Founders read the following:
At the end of every seven years thou shalt make a release. And this is the manner of the release: Every creditor that lendeth aught unto his neighbour shall release it: he shall not exact it of his neighbour, or of his brother; because it is called the Lord’s release.
Deut. 15:1 – 2.
This law of mandated debt forgiveness appealed to them, but it created a problem: If everyone had to forgive all debts every seven years, a free market economy would come to a screeching halt because no one would build houses or other big ticket items for sale, since no one would be able to pay for such things in seven years.
Therefore, they adopted the idea that debts would be forgiven for debtors who simply had no way to ever repay them. This would offer a second chance to those who had fallen on hard times – a more attractive proposition than life imprisonment. But debtors who did have the resources to pay would be required to repay their debts.
In spite of this noble sentiment, during the ensuing 110 years Congress failed to exercise the bankruptcy power. Instead, the courts served as referees in debtor/creditor disputes, without the guidance of a uniform bankruptcy law. Finally, in 1898 Congress passed the Uniform Bankruptcy Act, and that law controlled for the next 80 years.
During the 1960s there was a significant increase in bankruptcies among college students just before graduation. These students were discharging their student loans just prior to obtaining high paying jobs. Congress feared that if this practice continued, then the available pool of money to fund the educations of future generations would dry up.
There were other problems with the Uniform Bankruptcy Act of 1898 as well, so in 1978 Congress enacted the Bankruptcy Reform Act of 1978. This was the law until October 17, 2005.
II. The Origins Of BAPCPA
Ironically, the seeds of BAPCPA were sown in 1978 the very year that the Bankruptcy Reform Act was enacted.
A. The Marquette Decision
At the time, forty-seven of the fifty states had anti-usury laws, though the maximum allowable interest rates varied from state-to-state. Minnesota had the lowest interest ceiling in the country: 8 percent.
Unfortunately, at least for lenders, the high inflation and high interest rates of the late 1970s conspired with state usury limits to make lending unprofitable. Thus, when a lender borrowed from the Federal Reserve it paid a higher rate than it was allowed to charge its customers.
In 1978, the Supreme Court profoundly changed all of this with a ruling in the case of Marquette Nat’l Bank v. First of Omaha Serv. Corp., 439 U.S. 299 (1978).
In Marquette the solicitor general of Minnesota attempted to prevent First Omaha from soliciting credit card customers in Minnesota at the higher Nebraska interest rates by contending that the exportation of Nebraska’s interest rate would make it difficult for states to enact effective anti-usury laws. The Supreme Court agreed that such might be the case, but it decided that the usury issue was a legislative problem to be handled by Congress. The Court held that section 85 of the National Bank Act allowed a lender to charge the highest interest rate allowed in the lender’s home state, regardless of a lower rate limitation in the customer’s state of residence:
The question for decision is whether the National Bank Act, Rev. Stat. § 5197, as amended, 12 U. S. C. § 85, authorizes a national bank based in one State to charge its out-of-state credit-card customers an interest rate on unpaid balances allowed by its home State, when that rate is greater than that permitted by the State of the bank’s nonresident customers. The Minnesota Supreme Court held that the bank is allowed by § 85 to charge the higher rate. 262 N. W. 2d 358 (1977). We affirm.
B. Citibank Moves To South Dakota
Once Citibank learned of the Marquette decision, it approached the governor and legislature of South Dakota with an offer they couldn’t refuse: do away with your anti-usury laws and we will set up shop in Sioux Falls. As a result South Dakota’s tax revenues will skyrocket, and South Dakota will get a lot of new jobs.
The governor and the legislature gave Citibank what it asked for and suddenly Citibank could charge any interest rate it wanted in any state in the union. Other banks and states followed suit, with Wilmington, Delaware and The Lakes, Nevada becoming major centers of business for credit card companies.
C. Debtors Escape From The Credit Card Plantation
In the wake of Marquette, credit card companies issued cards with low introductory teaser rates that increased modestly after the introductory period. However, the typical credit card contract includes micrographic statements that permitted the issuer to change the rate, terms, and conditions at any time and for any reason.
The main reason for a sudden interest rate increase to say 30% – permitted by the fine print in the contract – is missed payments. Two other changes are usually triggered by missed payments: (1) a reduction in the available credit limit to below the actual balance – thus triggering balance overage fees, and (2) universal default.
With universal default, when a debtor is declared to be in default with one creditor because of a missed payment, he is immediately in default with all of the other issuers of credit cards he has. Thus, his interest shoots up, not only on the one card with the missed payment, but on all of his other cards as well.
The typical debtor who misses a credit card payment does so because he is facing financial difficulty, perhaps due to a job loss, or a health or family crisis. The debtor then is suddenly faced with a huge interest increase, overage penalties, and universal default. The debtor who was unable to make the payment that triggered the cascade of horror is even less able to pay the greatly increased payments. As a result, the creditor files suit in state court, obtains an abstract of judgment, and then has the local sheriff initiate wage garnishment or seizure of liquid assets. With a 25% wage garnishment, the poor fellow simply can’t make ends meet. Therefore, he exercises his constitutional right to bankruptcy – his only option at this point.
After Marquette and the new usurious climate, the number of personal bankruptcies started to increase rapidly. In effect, debtors were escaping from the credit card plantation. As a consequence, the credit card companies decided that something had to be done to staunch the flow of debtors from their clutches – this in spite of the high profits they had reported.
In fact, the credit card companies were doing so well that they stepped up their solicitation rates, even in the face of increased bankruptcy filings. Moreover, they didn’t target the higher income population, but focused their recruitment efforts primarily on lower income people.
The credit card companies had addressed the earlier problem of those pesky state anti-usury laws by getting states to repeal them. Now the problem they faced was the result of federal bankruptcy law. Since bankruptcy was enshrined in the Constitution, total repeal was out of the question. Instead, they had to get the Congress to change bankruptcy law to make it harder for debtors to get relief, and to reduce the relief available.
In addition, it was necessary to reduce the discretion exercised by those pestilent bankruptcy judges (which, by the way, are NOT Article III federal judges, but Article I federal judges, since their authority is derived from Congress via Article I, section 8 of the U.S. Constitution), and to restrict the relationship between debtors and their bankruptcy attorneys.
Early efforts were successful in the House of Representatives, but either stalled in the Senate or met with presidential hostility. However, after patient funding to the tune of, quite literally, hundreds of millions of dollars over nine years, they got the finest legislation that money could buy. On April 20, 2005 the president signed BAPCPA into law. A few provisions immediately went into effect, with the remainder taking effect on October 17, 2005.
Thus, not only did 1978 yield the Marquette decision that eventually made loan shark interest rates perfectly legal, it set the stage for BAPCPA. And as I have previously discussed, in 1977, the year before Marquette, Congress passed the Community Reinvestment Act that set the stage for the housing market nightmare from which the nation is still reeling.