Addressing the Moral and Ethical Pitfalls of Filing for Bankruptcy
The Bencher—September/October
By Kristina E. Feher, Esquire
An issue that often surrounds bankruptcy is whether filing for bankruptcy is morally wrong. People consider their moral compass. Life happens. Society weighs in. There are moral and ethical rules that created our system of bankruptcy, yet it continues to be questioned as a solution. Moral feelings of relationships and loyalty surface. Societal pressures clash with the bankruptcy system and procedure. Substantive disclosure requirements exist for the debtors and their counsel.
Yet, there are countless stories of debtors sued for perjury or failure to disclose, or the courts sanction lawyers who fail to maintain their ethical obligations. The pitfalls created by our own moral compasses and society’s ethical rules pose pitfalls that debtors and attorneys alike have not yet fully addressed. With the potential influx of cases as the pandemic subsides, an opportunity arises to address these pitfalls in the present.
Is filing for bankruptcy morally wrong?
People considering filing for bankruptcy (a potential debtor) and some attorneys question whether filing for bankruptcy is morally wrong. This question of thought usually stems from principles that a person was raised with, as well as their compass of right or wrong. In addition to the moral question, we must consider the financial reality of whether someone can or cannot pay their debts as they become due. The moral dilemma from a potential debtor comes from the idea that they purchased an item but have not yet paid off the item. A potential debtor fails to see the creditor’s take on the debt.
A potential debtor’s take on the debt is that they purchased a $90 blender with a credit card. They have made significant payments, but their credit card balance is not at $0.00. This causes the potential debtor to feel morally obligated to repay the debt at whatever cost. As a bankruptcy practitioner, I address these concerns often. It is important for a potential debtor to see the creditor’s take on the debt. Creditors have insured and insulated their risk for unpaid debts. Most creditors can claim a tax deduction if they write off bad or uncollectible debts.
According to the IRS, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless. To show that a debt is worthless, you must establish that you’ve taken reasonable steps to collect the debt. (IRS Tax Topic No. 453, Bad Debt Deduction, March 12, 2021, www.irs.gov/taxtopics/tc453). Additionally, creditors calculate the risk of repayment into the loan they provide by considering credit scores and other potential repayment issues into the loan amount or interest rate.
Life happens. Bankruptcy is the built-in safety net to help people get their finances back on track. The passing of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in 2005 included a new “Means Test” to keep people with higher incomes from filing for Chapter 7 bankruptcy. The rules for the Means Test are found in 11 U.S.C. §707(b). The test requires a determination of whether household income is above or below the “median income” level for similar household sizes in your state. The U.S. Department of Justice provides tables to understand what the median income is and updates those numbers quarterly.
If a household falls below the median income, the potential debtor may file Chapter 7. However, if the household falls above the median income, the potential debtor would need to file a Chapter 13 and repay and reorganize their debt through monthly payments to a bankruptcy trustee.
Is filing for bankruptcy ethical?
When considering if filing for bankruptcy is ethical, it is important to understand the historical rules created to provide bankruptcy as an option and safety net for people. Our society created the system of bankruptcy to exist and now sustains this process through our federal courts. From the beginning, the concept of bankruptcy and canceling debt exists. In the Bible, the book of Deuteronomy addresses “The Year for Canceling Debts” and states that at the end of every seven years you must cancel debts. Deut. 15:1-11 (New International Version).
A potential debtor also views relationships and loyalty as a high priority, and this view extends to their bank relationship. It is common for us to have relationships with our bankers and have loyalty to our bank. We appreciate the familiar faces and comfort we find in those relationships. What potential debtors fail to see until it is too late is the way the bank corporation views this relationship. Banks are now charging maintenance fees or account fees on most types of accounts. Returns and interest on savings accounts remain low. The banks charge 22% interest for their credit cards. Yet, a potential debtor is the one who feels bad for filing for bankruptcy because they want to preserve that banking relationship. I often remind creditors that their local bankers often do not have any control over account fees, interest on savings accounts, and credit card interest. Because those are separate and apart from your local bank branch, separate your relationship with your local branch for your (nonexistent) relationship with your bank.
A major ethical issue for a potential debtor is their standing or reputation in their community. Bankruptcy has often been viewed as a result of a potential debtor’s poor spending habits or lack of financial literacy. The data, on the other hand, do not support that view. The leading reasons for bankruptcy have held fairly constant for some time—job loss or a decline in income and medical problems (Porter and Thorne 2006; Sullivan, Warren and Westbrook 2000; Warren and Tyagi 2003).
Using data from the 2007 Consumer Bankruptcy Project, Thorne (2010) reported that filers 65 and older were in bankruptcy because of credit card interest rates and fees, medical problems, a decline in income, and aggressive debt collection practices. Regardless of age, leading data suggest that income problems and medical costs top the list of events that push households into bankruptcy. Thorne, Deborah and Foohey, Pamela and Lawless, Robert M. and Porter, Katherine M., “Graying of U.S. Bankruptcy: Fallout from Life in a Risk Society” (August 5, 2018). Indiana Legal Studies Research Paper No. 406, http://dx.doi.org/10.2139/ssrn.3226574.
The common reasons for bankruptcy filing can happen to anyone at any time. A job loss, medical problems, and divorce have very little to do with financial mismanagement. The pandemic created significant job losses that have still not made their way through the court system. With some foreclosures and evictions still on hold, our courts have not yet begun to see the flood of cases that will start as people address mortgage forbearances, evictions, and missed payments. Medical problems can also be due to accidents, preexisting conditions, or from a lack of health insurance. Combine all of these with how costly our system of medicine can be and medical debt usually drowns a household.
I also practice family law and know firsthand how expensive divorces can be. Many divorces also include a division of debt. When people shift their spending from a two-person household to two one-person households, plus debt payments, things can get expensive without even considering if the spouses have children. For these potential debtors, bankruptcy may be their only option.
Disclosure Requirements
In bankruptcy, there are significant disclosure requirements that can pose ethical pitfalls for debtors and attorneys alike. First, under 11 U.S.C. §521, debtors are required to disclose all of their creditors, a list of their assets and liabilities, a schedule of their current income and expenditures, and a statement of their financial affairs. Next, under 11 U.S.C. §341, they are required to attend a meeting of creditors where they must, under oath, answer questions about the bankruptcy documents, and disclosures. Finally, under 11 U.S.C. §541, they must disclose any interest in property received within 180 days after the filing of the bankruptcy petition if they receive any of the filing: a bequest, device, or inheritance; a property settlement agreement with the debtor’s spouse; or as a beneficiary of a life insurance policy or of a death benefit plan.
Attorneys are also subject to disclosure requirements in bankruptcy cases. First and foremost, under Federal Rule of Bankruptcy Procedure 2016(b), a bankruptcy practitioner must disclose in the debtor’s bankruptcy filing the amount of fees charged and received prior to the filing of the bankruptcy petition. The disclosure must also comply with 11 U.S.C. §329 to disclose whether the attorney agreed to share or shared the compensation with any other entity. Courts will review the disclosure of attorney’s fees for reasonableness. Some courts have already established “presumptively reasonable” amounts for cases in their area or district.
In Chapter 11 cases of business reorganizations or high-debt individuals, debtor’s attorneys are also required to disclose whether the attorney represented any of the creditors listed by the debtor. The attorney must also disclose to the bankruptcy court whether there exist any conflicts of interest and whether the attorney or the firm has an interest adverse to the debtor. Adverse interests could include serving as an employee of the debtor or representing the debtor’s financial adviser, general partner, lessor, or lessee. The attorney must also disclose that the firm and the debtor’s attorney do not have any connection or relationship with the debtor other than employment as bankruptcy counsel. Other connections or relationships could include security interests, guarantees, or assurances for compensation. In business bankruptcies, a debtor must disclose any equity holders. Under 11 U.S.C. § 101(16), (17) that includes anyone who holds a share in a corporation, an interest of a limited partner in a limited partnership, or a right to purchase, sell, or subscribe to a share, security, or interest of a share in a corporation or an interest in a limited partnership.
The Media Spotlight
What makes for good news? The countless stories of debtors sued for perjury or failure to disclose assets. “Real Housewife of New Jersey” Teresa Giudice received a sentence of 11 1/2 months in federal prison for pleading guilty to 41 counts of fraud. Giudice admitted to intentionally omitting and concealing material facts in her statements and schedules. She failed to file tax returns for five years. She also failed to report her earnings from the “Real Housewives” TV reality show income on her bankruptcy petition and schedules.
Another celebrity accused of committing bankruptcy fraud is Abby Lee Miller, the reality TV star on “Dance Moms.” Miller failed to report most of her income from the show in her bankruptcy petition and schedules. Her charges included bankruptcy fraud, concealment of assets, and making false declarations. Once the allegations surfaced, she had checks made out to other people and funneled her income through corporations she set up to avoid depositing into known accounts. She received a sentence of one year and one day in federal prison; two years of supervised release after the prison stay; a $40,000 fine; and $120,000 in restitution for a charge of illegally bringing Australian money into the United States.
A third celebrity accused of bankruptcy fraud is former New York Mets and Philadelphia Phillies baseball player Lenny Dykstra. When Dykstra filed his bankruptcy case, he listed debts of $10–20 million but only $50,000 in assets. Later, he was accused of hiding and then selling $400,000 worth of sports memorabilia, appliances, sconces, and plumbing fixtures from his mansion, disclosing none of this to the bankruptcy court in his official bankruptcy forms. Prosecutors charged him with obstruction of justice, bankruptcy fraud, concealing assets, and making false statements. After entering into a plea deal, he spent six and a half months in federal prison. He also received 500 hours of community service and an order to pay restitution of $200,000.
Under section 523(a)(2)(A) of the Bankruptcy Code, an individual debtor can lose the ability to be discharged from “any debt…for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by…false pretenses, a false representation, or actual fraud…” 11 U.S.C. § 523(a)(2)(A). Under 18 U.S.C. § 151, the U.S. attorney can bring charges against a debtor who has committed bankruptcy fraud. To prove fraud, the U.S. attorney must be able to show that the defendant knowingly and fraudulently made a misrepresentation of material fact. The most common instance of misrepresentation occurs in the debtor’s petition, statements, and schedules. The U.S. trustee can also identify misrepresentations during the Section 341 meeting of creditors. If a debtor filed for bankruptcy under Chapter 11, the debtor must complete periodic reports, which is another common place for misrepresentations. Bankruptcy fraud carries a sentence of up to five years in prison; a fine of up to $250,000; or both under 18 U.S.C. § 152.
Federal courts do not shy away from sanctioning lawyers who fail to maintain their ethical obligations. Federal Rule of Bankruptcy Procedure 9011 can impose sanctions on an attorney for the filing of a sanctionable pleading or other paper. Zealous advocacy when aggressive can lead to sanctions. Rule 9011(b)(3) provides that by signing a bankruptcy petition, an attorney certifies “to the best of [his] knowledge, information, and belief, formed after an inquiry reasonable under the circumstances, the allegations and other factual contentions have evidentiary support or, if specifically so identified, are likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.” One case with such a sanction was In re Parikh. The inaccuracies and omissions in the debtor’s Chapter 7 petition “should have been apparent to the debtor’s counsel because the information was either publicly available or provided to the Chapter 7 attorney by the debtor himself.” 508 B.R. 572, 588 (Bankr. E.D.N.Y. 2014). The bankruptcy court declined to impose monetary sanction; instead, the court determined that publication of its decision was an appropriate sanction against the Chapter 7 attorney and his firm. Id., at 595–596.
Ultimately, although a bankruptcy filing is not ethically wrong, potential debtors must address their own moral compass when filing for bankruptcy. Life happens. What we can financially afford to do may conflict with what we believe we must morally do. History and the government created a safety net to save those who find themselves at rock bottom. A potential financial lifesaver, bankruptcy should be considered a serious option for those struggling to make ends meet based on their own situation. An experienced bankruptcy attorney can address the moral dilemmas a potential debtor faces as well as the ethical obligations the potential debtor has for disclosure.
Kristina E. Feher, Esquire, is the managing member of Feher Law in St. Petersburg, Florida. Feher practices in the areas of bankruptcy and family law. She is the membership co-chair of the Canakaris American Inn of Court in Clearwater, Florida.