Reducing bankruptcy to 12 months ignores realities of insolvency

The proposed federal government changes to insolvency that reduce the bankruptcy period from three years to 12 months need to be questioned.

It has been argued the shortened default period will have the desired impact on encouraging entrepreneurial activity and reducing the associated stigma of being a bankrupt.

While this may indeed allow a bankrupt a “fresh start”, it ignores the reality of what typically causes personal insolvency in Australia. Research indicates alternative reform measures are more effective tools in reducing the stigma of bankruptcy.

The proposal to shorten the bankruptcy period are amid a suite of insolvency law reforms proposed by the Productivity Commission, that were released in April at the same time as the government’s National Innovation and Science Agenda.

These included:

• Retaining the bankruptcy trustee’s ability to object to discharge and to extend the bankruptcy period to eight years

• Retaining the permanent record of bankruptcy in the National Personal Insolvency Index

• Consultation with relevant industry and licensing associations, to align licencing and industry restrictions with the reduced one year default bankruptcy period

• Reducing current restrictions on a bankrupt obtaining credit or undertaking overseas travel to one year, subject to any extension for misconduct

• Imposing a continuing obligation on the bankrupt to assist in the proper administration of their bankruptcy, even after discharge

• Retaining the bankrupt’s obligation to pay income contributions for three years, regardless of the one year discharge, with the possibility of income contributions to be extended to five or eight years.

There are a number of compelling arguments against the proposal.

First, shortening the discharge period will have no effect on the numerous restrictions which currently exist under Australian Law and professional association rules. These restrictions add to the stigma of bankruptcy in employment and business.

Researchers Nicola Howell and Rosalind Mason suggest alternative reform measures are more effective tools in reducing the stigma of bankruptcy.

These measures include a review of the continuing need for entry barriers to occupations or professions based on bankruptcy; or changes to the accessibility or public record permanency of the National Personal Insolvency Index (NPII).

For example, a registered chartered accountant loses their registration on becoming bankrupt based on the premise that the restriction is imposed to protect consumers from those involved in the mismanagement of business. However, registration is lost, regardless of whether their bankruptcy arose as a result of consumer debts as opposed to business debts.

Suggested changes to the NPII include the NPII no longer providing a permanent public record of a person’s bankruptcy, or alternatively, imposing restrictions on those who can access the NPII.

Second, a shorter discharge period to improve entrepreneurial activity ignores the reality of what typically causes personal insolvency in Australia.

Statistics consistently show that the majority of bankruptcy cases are caused by factors such as unemployment and excessive use of credit, rather than carrying on a business.

Figures from the Australian Financial Security Authority show that since 2007-2008, consumer debt has accounted for 75% (lowest: 2012-13) to 85% (highest: 2008-09) of debtors entering bankruptcy. The latest available figures in 2014-15 was 78%.

Third, justifying a reduced default bankruptcy period by comparing it to countries such as United Kingdom, New Zealand and Ireland, is flawed. For instance, when the United Kingdom made a decision to reduce its discharge period to a similar period in 1998-99, its level of consumer-related debt was 35%. Australia experiences a much higher percentage of this type of bankruptcy, so a comparison in terms of entrepreneurial activity may have little relevance.

The Federal Government’s insolvency law reforms are aimed at “striking a better balance between encouraging entrepreneurship and protecting creditors". A better way to achieve this balance is to categorise bankrupts according to their level of indebtedness to income, ownership of property and number of bankruptcies.

Using these thresholds as a means of determining their level of culpability means that bankrupts could be classified as “reckless”, “unfortunate” and “able”.

Relying on the repealed s149T Bankruptcy Act 1966 (Cth), (which previously provided for a shortened bankruptcy discharge period from 1992-2003) eligibility of a 12 month default bankruptcy period would then be restricted to “unfortunate bankrupts”. Unfortunate bankrupts being those bankrupts who are unable to pay their creditors at all, or who are unable to pay the trustee’s remuneration and expenses in full.

Reckless bankrupts are those whose bankruptcy arises from their own disregard or carelessness in accumulating debt, without the ability to repay that debt. Previously, a bankrupt was ineligible to apply for early discharge if he or she satisfied the criteria in s149Y Bankruptcy Act 1966 (Cth), such as their debts exceeded 150% of his or her income.

Able bankrupts are those bankrupts who neither fall into the “reckless” or “unfortunate” categories and thus have some measure of ability to repay their debts.

Specific education measures, such as mandatory financial literacy education, may also be more productive in reducing the incidence of bankruptcy long term. In a recent study by Melbourne Law School, several participants of an online survey specifically attributed their clients' ongoing financial problems to a lack of financial literacy. One advocate reported that “some clients view bankruptcy as a way of financial management to be considered more than once”.

The advantage of imposing financial education on undischarged bankrupts is that it reduces the possible risk of repeat bankruptcies that might result if the default bankruptcy period is reduced.

Insolvency laws invariably must balance the competing interests of creditors, debtors and the general community. Australia’s present laws regarding bankruptcy discharge periods and associated restrictions on debtors during those periods reflects the current balance, which may be considered “creditor protective”.

Reducing the bankruptcy discharge period and its associated restrictions to one year will re-balance these interests in favour of the debtor. However, such changes will not achieve the Federal Government’s stated purpose as outlined in the Innovation Statement.