Why broke people shouldn’t always choose bankruptcy

There’s more than one way to deal with being broke. While instinct might suggest simply filing for bankruptcy, it’s also worth considering a consumer proposal – a legal agreement allowing a debtor to repay an agreed upon portion of his or her debts to creditors.

Choosing the best method to resolve debts comes down to how each will impact someone’s income, assets and monthly payments.

People used to favour bankruptcy. Prior to 2008, there were as many as six personal bankruptcy filings for every consumer proposal. In 2009, the year personal insolvency filings in Canada peaked, there were three personal bankruptcy filings for every consumer proposal.

In September 2009 the federal government enacted changes in the Bankruptcy and Insolvency Act that made personal bankruptcies longer and more expensive. This, in turn, made it easier for people to file a consumer proposal instead. Today it’s a fairly even split nationally, while in Ontario there are now more consumer proposals than bankruptcies.

There are times when filing for bankruptcy is the correct way to deal with financial problems; and sometimes filing a consumer proposal makes more sense. A bankruptcy trustee has a duty to present all options to debtors and help them make decisions based on the assets they own, the income they earn and what they can afford.

What is a consumer proposal?

In a consumer proposal, a person offers to settle unsecured debts for a portion of what he owes. There are no new interest charges on debts included in a proposal. In most instances, the total repayment ends up being around one-third of a person’s unsecured debt. With the average insolvent debtor owing around $60,000 in unsecured debts, that means he would typically pay $20,000 under a consumer proposal.

From the creditor’s perspective

So why would creditors accept one-third of what they’re owed? Simply because there’s a chance of getting even less money back from someone who is bankrupt. A consumer proposal is an alternative to filing for bankruptcy, and the debtor is likely to declare bankruptcy if he can’t make a deal with creditors. As long as the debtor offers terms that require him to repay more than creditors would get in a bankruptcy, it makes sense to accept the consumer proposal.

Creditors accept a proposal by voting on it. Each dollar of unsecured debt represents a vote, and creditors representing a simple majority of unsecured dollars need to agree to the terms. Technically, when a consumer proposal is filed, the law assumes it will be accepted. It’s only if creditors with 25% of the total debt ask for a meeting of creditors that a vote even takes place.

From the debtor’s perspective

Consumer proposals have the same legal protections as bankruptcy. Debtors automatically receive a Stay of Proceedings, which halts any lawsuits, wage garnishments or similar actions. It also prohibits any new actions. To remove the Stay, a plaintiff needs to bring a motion before the Bankruptcy Court and argue the legal action should be permitted. These motions are fairly uncommon and usually only occur when there are allegations of misdoings on the part of the defendant, or when the plaintiff requires the Court to determine the amount of the claim.

When the debtor fulfills the obligations set out in the proposal, he receives a Certificate of Full Performance, which, like a bankruptcy discharge, eliminates the debts spelled out in the proposal.

Why choose a proposal?

When a person files personal bankruptcy, he is saying, “I cannot afford to repay any portion of my debt. I need to avail myself of the relief provided under the law to have my debts cleared.” However, there is a cost to having the debts erased.

A bankrupt person exchanges the things he owns for the unsecured debts that he owes. While he doesn’t lose everything, (every province has an Executions Act exempting things such as furnishings, personal possessions and, in some provinces, cars), he may lose his home equity, investments, and other property.

While RRSPs and pensions are largely protected in bankruptcy, other non-registered investments, and RESPs, are not. In addition, bankruptcy law bases a person’s payments on his household income and size. The more a bankrupt person earns, the higher his bankruptcy payments will be.

When someone files a consumer proposal, the payment terms are agreed to up front. This benefits the debtor in several ways. No assets are seized and sold, and there are no penalties if his income increases during the proposal. A proposal will always cost an insolvent debtor more than filing for bankruptcy, but the payments are fixed and may be spread over a five-year term. This often means they’re more manageable than the payments required in a bankruptcy.

There are, of course, debtors for whom a bankruptcy might negatively impact their employment. For example, people who must be bonded or handle trust money are not bondable if they file for bankruptcy. By filing a consumer proposal, a debtor can honestly say, “I have never filed for bankruptcy” on any form or application.

Ted Michalos, B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.