Just three months before the nation's new bankruptcy law kicks in, unanswered questions surround a key provision meant to reduce the number...

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Just three months before the nation’s new bankruptcy law kicks in, unanswered questions surround a key provision meant to reduce the number of personal bankruptcies.

The law will require people to consult with a nonprofit credit-counseling agency before they can file for bankruptcy protection. But the result could be to steer them to an industry in turmoil over regulatory allegations of fraud, audits by the Internal Revenue Service and criticism from Congress.

“The ultimate nightmare scenario is that families struggling with serious debt trouble will be forced under the new law into the hands of unscrupulous credit counselors,” said Travis Plunkett, legislative director for the Consumer Federation of America.

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Credit counselors are uncertain about how the new mandate will work. It is unclear who will be approved to offer pre-bankruptcy counseling or how much they can charge. Questions also remain about who will pay for it — the cash-strapped consumers, their creditors, or some other source.

A principal backer of the new bankruptcy law, which takes effect in mid-October, says the requirement for counseling could convince up to 10 percent of the 1.6 million people who file for bankruptcy each year to find a way to pay off their debts instead.

“Good credit-counseling agencies can really help; there’s no doubt about it,” said Sen. Jeff Sessions, R-Ala.

Getting help with debts

Services: Look for a credit counselor that offers a variety of services, including budget counseling, and savings- and debt-management classes. Avoid organizations that push a debt-management plan without analyzing your financial situation.

Fees: If an organization won’t help you because you can’t afford to pay their fees or make contributions, look elsewhere.

Contracts: Get all promises in writing, and don’t sign anything until you’ve read it first.

Debt-management plans: Ask the credit counselor how long it will take to complete the plan. Check with your creditors to be sure they offer the concessions described to you by the credit-counseling organization. Continue to pay your bills until the plan is approved by your creditors.

Debt-negotiation programs: Although some credit counselors can negotiate for lower rates with creditors, that is not the same as debt-negotiation programs, which can be risky and have a long-term negative impact on your credit report. Check the FTC’s web site, www.ftc.gov/credit, for more information about debt-negotiation companies.

Debt consolidation loans: You might be able to lower your cost of credit by consolidating it through a second mortgage or home equity line of credit. But if you can’t make the payments, you could lose your home.

Credit repair: Beware of any organization that tells you it can remove accurate negative information from your credit report. Legally, it can’t be done.

Sources: FTC, The Seattle Times

But the Consumer Federation’s Plunkett said that by the time people are on the brink of bankruptcy, “it’s likely that the vast majority are too far gone financially to benefit.”

How many use credit counselors each year is unclear, but estimates range from 2 million to 9 million people.

Even more uncertainty surrounds the services, which vary widely and can include a confusing array of terms, such as “debt consolidation,” “debt negotiation” and “debt settlement.”

The government has raised questions about what services a legitimate credit-counseling agency should offer.

For now, some credit counselors offer a range of services, from budgeting advice to debt-management classes. Others specialize in one service, such as negotiating better interest rates with a client’s credit-card companies. They often collect money from clients each month to disburse to creditors.

Then there are scam artists who promise to quickly erase consumers’ debts, but instead charge them enormous fees and drive them further into a financial hole while destroying their credit ratings.

“There needs to be a major overhaul of this entire industry,” said Joel Winston, associate director for the Federal Trade Commission’s division of financial practices. “One issue is, what did Congress mean when it said ‘credit counseling’ ?”

Industry abuses

Credit-card companies and other creditors launched the credit-counseling industry in the 1960s as a group of nonprofits that counseled people face-to-face. Some charged small fees or asked for contributions from clients.

From the beginning, many counseling agencies offered debt-management plans, a popular program in which counselors negotiate with creditors to lower clients’ interest rates and stop making collection calls. The agencies get a cut of the money they retrieve from consumers who might not have paid those debts otherwise.

But critics say some agencies became focused on the fees rather than their clients’ best interests, urging consumers into debtmanagement plans even when their debts were too steep for them to benefit from such a plan.

Perhaps more significantly, to some lawmakers and the IRS the idea of nonprofits chasing fees smacked of profiteering.

A report this spring from the Senate’s Permanent Subcommittee on Investigations focused on agencies that push debt-management plans as a way of reaping profits for companies with which they are affiliated.

One of the largest credit-counseling nonprofits, Seattle-based American Financial Solutions was cited as an example of an agency whose ties to a for-profit company might be getting in the way of its nonprofit mission. Congressional investigators found that a for-profit company required American Financial Solutions to enroll 30 percent of its callers in debt-management plans which that company serviced.

Robert Ilgenfritz, CEO of American Financial Solutions, said his agency eliminated that provision from its contract with the company more than a year ago, after investigators raised the issue.

Even now, about 30 percent of the agency’s callers go into debt-management plans, “but there’s no requirement,” Ilgenfritz said. “That’s incidental to our mission, which is to educate and counsel people.”

The Senate report accused some agencies of charging excessive fees, sending clients deeper into debt, and using high-pressure sales tactics.

Such abuses have led the IRS to examine almost 50 credit-counseling organizations, representing more than half of the industry’s revenues, IRS Commissioner Mark Everson told the Senate Finance Committee this spring. At that time, the IRS had revoked or proposed revocation of tax-exempt status for agencies representing more than 20 percent of the industry’s revenues.

The IRS said that in late 2003, there were 872 active tax-exempt credit-counseling agencies, the most recent figure available.

This year, the IRS included abuses in the credit-counseling industry on its annual “dirty dozen” list of the most egregious tax-abuse schemes. The Federal Trade Commission has tried to root out some of the worst offenders.

In March, it settled charges against four organizations that had promised debt relief to consumers. Three of the companies — known by various names, including National Consumer Council, Debt Management Foundation Services and Better Budget Financial Services — went out of business. The companies and their principals will pay more than $6 million combined in consumer redress.

A fourth, AmeriDebt, shut down after the FTC and others accused it of falsely claiming to be a nonprofit and deceiving consumers into paying $170 million in hidden fees.

The new bankruptcy law could force more agencies out of business.

The U.S. Trustee Program, a unit of the Department of Justice charged with implementing the new law, must determine which agencies can do pre-bankruptcy counseling.

“Counselors who are not on the list are going to be run out of Dodge, because they will not serve any purpose with respect to a future bankruptcy,” said Samuel Gerdano, executive director of the American Bankruptcy Institute, an association of professors, accountants, lawyers and other bankruptcy professionals.

“If you were a financially troubled consumer and knew about this requirement, you’d want to look at the list” of approved agencies, he said. “You’d be wasting your time if you went to another one.”

Counselors in the dark

The U.S. Trustee Program began taking applications this month from agencies that want to provide pre-bankruptcy credit counseling, but agency leaders are scratching their heads over certain provisions.

Some wonder why the trustee suggests that the average length of a credit-counseling session should be 90 minutes, which is longer than many agencies now spend with clients.

Another question is who will pay for the pre-bankruptcy counseling. The law allows agencies to charge a “reasonable fee,” but says they must provide services even if consumers are unable to pay the fee — which seems likely if they are near bankruptcy.

One credit-counseling industry association thinks the credit-card industry should foot some of the bill.

“They need to step up and say, ‘This is legislation we actively supported … and therefore we’ll step up to provide the funding necessary to ensure the fees charged to debtors remain as low as possible or nonexistent,’ ” said William Binzel, chief counsel for the National Foundation for Credit Counseling, which represents about 120 agencies that provide services to more than 1 million people annually.

But creditors don’t want to be on the hook.

Laura Fisher, spokeswoman for the American Bankers Association, which represents banks and credit-card issuers, said agencies are allowed to charge clients a fee under the new system.

She said, “Only agencies that want to be part of the bankruptcy system should be part of it.”

Even some new players interested in taking part are wondering how the law will play out.

Victoria Wright, a consumer bankruptcy lawyer in North Carolina, plans to leave her law firm in October to work for Hummingbird Credit Counseling and Education, a new credit-counseling agency that is applying to offer pre-bankruptcy counseling through the Internet.

She likes the idea of requiring education before bankruptcy, but said the U.S. Trustee Program is working with a law that is not clear about many things, including the credit-counseling provision.

“It’s about as clear as mud,” Wright said, “because this fabulous reform act was not written by legal scholars.”

Seattle Times researcher Gene Balk contributed to this report.

Melissa Allison: 206-464-3312 or mallison@seattletimes.com