For ordinary Americans, bankruptcy may be a chance to start over, but it generally means starting over from scratch, with little more than a few personal possessions and -- if they're lucky, some home equity.
But for the "well-heeled and well-advised," as one lawyer called them, bankruptcy can mean millions of dollars stashed, safe from creditors, in one of several different shelters available under current law. And even though the bankruptcy bill passed by the Senate 10 days ago contains provisions designed to restrict these strategies, experts say it appears several of them will remain viable if the bill is signed into law.
These experts point to three provisions of current law that give high-rolling bankrupts benefits that don't help the poor and middle class very much.
First, and best known, is the homestead exemption. Although a federal law, bankruptcy defers to the states in many ways, particularly regarding what assets an individual filing for bankruptcy may shield from creditors. Most states allow some protection for a residence, but generally it is fairly limited. However, filers who reside in a handful of states, notably Florida and Texas, can keep multimillion-dollar houses because in those states homesteads are defined by acreage, not value.
Second are "asset protection" trusts. These are legal entities that can be established in five states and a number of foreign countries, to shield from creditors assets of the person who established the trust.
Third is a provision of law that bars filers who owe more than about $1.2 million from filing under Chapter 13 of the bankruptcy law, but allows them into Chapter 11, which is meant for businesses. Since Chapter 11 is designed to keep a business going, it allows the debtor to retain income earned after the bankruptcy filing while using only assets the he had at the time of filing to pay past debts.
Critics of the bill argued that if Congress were going to pass a law making bankruptcy less hospitable for poor and middle-income people, it ought to do the same for the wealthy.
Lawmakers did make some modest changes. But, said Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys, "I don't know if they're going to affect the wealthy very much. Most of them can plan, and they do."
One change that will likely be effective, attorneys said, applies to individuals in Chapter 11. Under the new provision, the court would examine the debtor's income, calculate how much he needs to live on, and make the rest available for creditors.
Far less effective, critics said, will be a provision that requires that in order to claim the full homestead exemption in states that allow very large ones, a debtor will have to have lived in the state at least 40 months. Otherwise, the exemption will be limited to $125,000.
"This says the full multimillion-dollar exclusion is available to longtime residents . . . but not to the recent carpetbagger," said Harvard law professor Elizabeth Warren, a critic of the bill.
In fact, noted Sommer, one type of person who might now get caught is a retiree who moves to, say, Florida, buys a big house and then gets sick and is forced into bankruptcy by medical bills.
And barely grazed by the bill, critics said, is one of the biggest and best shields available to those who know how to play the game, the asset protection trust.
For decades, many wealthy individuals expecting trouble -- from creditors, ex-spouses, failed businesses -- have been transferring assets to these trusts. But until recently, they had to go offshore to one of a number of countries with permissive laws, where a properly drawn trust is almost completely out of reach for claims from creditors in the United States.
More recently, a handful of states in this country have changed their own laws to make it easier for the well-to-do to use trusts to shield assets from creditor claims. As long ago as 1997, Delaware and Alaska enacted such changes, followed since by Nevada, Utah and Rhode Island. The states have argued that allowing such trusts prevents revenue that they generate from going abroad.
Continuing to allow U.S.-based asset protection trusts to shield assets from creditors in bankruptcy is "an ugly loophole that protects millionaires," Sen. Charles E. Schumer (D-N.Y.) said in a floor statement.
Just before approving its version of the bill, the Senate did adopt an amendment that would make it harder to use a domestic asset protection trust to defraud creditors. The measure would allow a bankruptcy court to review transfers to an asset protection trust going back 10 years and, if fraud can be shown, to return the assets to pay creditors.
Its sponsor, Sen. James M. Talent (R-Mo.), said it allows the court to "break open the trust" to get at money and other assets placed there to escape creditors.
But Schumer and others dismissed this change as ineffective, because proving fraud is too difficult.
On its face, it sends "a clear signal from Congress" to states engaged in a "race to the bottom" to attract new trusts, "that self-settled domestic trusts are not a good thing," said Jack Williams, director of financial recovery services at the accounting firm BDO Seidman LLP. But the "weakness is that it is still a matter of proof. The bankruptcy trustee still has to show the debtor engaged in fraud with the intent to hide, delay or defraud creditors. It's a facts and circumstances test," which is expensive to show and usually is based on circumstantial evidence, Williams said.
Further, critics noted, anyone prescient enough to set up a trust and move assets into it well before getting into trouble would likely be untouched by the new rule. Schumer offered an amendment, rejected by the Senate, that would have allowed the bankruptcy court to simply void transfers of more than $125,000 to an asset protection trust if they occurred within 10 years of the debtor's bankruptcy filing.
However, George Mason University law professor Todd Zywicki said the fact that concern over these trusts has surfaced only recently, though the bill has been under consideration for eight years, suggests the trusts don't pose a crisis. "Judges have tools, such as denying discharge" of debts, for dealing with cases where they think assets are being hidden, he said.
"If it turns out to be a problem, Congress can go back and amend the law," he said.
Many states have long permitted individuals to place assets in trust for another person, typically a spouse or child, to shield those assets from that person's creditors through what has been dubbed a "spendthrift clause."
However, until 1997, states uniformly forbade "self-settled" trusts -- those in which the person providing the assets and the beneficiary are the same -- from enjoying the same kind of protection from creditors. But that year Delaware and Alaska eased that prohibition, and others have since followed suit.
Now, Delaware, Alaska and the others allow individuals to place assets in trust for themselves with extensive creditor protection as long as the trust meets various anti-fraud and procedural requirements. Generally, the person who places assets into the trust, known as the settlor, does not need to live in the state in which the trust is located, though an in-state trustee or other representative is required.
The change is just one element of wider-ranging shifts in state trust law. In recent years, a number of states have repealed laws against perpetuities, which forbade trusts that last forever. With those rules abolished or greatly eased, individuals can establish what have come to be called "dynasty trusts" for their heirs, in which assets can be held without being subject to estate taxes as generations come and go.
Dynasty trusts can also include spendthrift clauses that allow them to fend off plaintiffs, ex-spouses and other creditors for centuries.
The legal changes are fueled by states' desire to make themselves attractive to trusts, which generate fees and other income, and in many cases tax revenue.
It would be possible for Congress to craft a statute that would snuff out both domestic and foreign asset protection trusts, Harvard professor Warren said.
"No one has a right to a discharge [of debts] in bankruptcy," she said, so Congress could set conditions that would force debtors to expose trust assets to creditors, if they want the protection of the bankruptcy law.
As it is, Warren said, if self-settled trusts are unavailable, it would be a simple matter to make someone else -- a spouse, child, sibling, or other trusted relative -- the beneficiary and use an ordinary spendthrift clause.
"Only a childless, unmarried, orphaned hermit who could think of no one to make the ultimate beneficiary [of his trust] has to worry about the Talent amendment," she said.