Michael M. Greenfield
Walter D. Coles
Professor of Law
Washington University in St. Louis
M E M O R A N D U M
October 31, 2003
To: Consumer
Debt Counseling Drafting Committee
From: Michael
Greenfield, Reporter
Subject: Initial
Report
A. Introduction
Consumer
credit counseling agencies assist consumers who have problems managing their
debts. They do so by providing some or all of the following services:
Counseling
agencies are compensated for these services primarily in two ways. The creditor
that receives payments pursuant to a DMP may make a payment to the counseling
agency based on the amount of funds it has received. And the consumer who
receives individual services may pay for them. In addition, though less likely,
counseling agencies may receive money from such funding entities as United Way.
B. History
The consumer credit counseling
industry originated in the early twentieth century in the form of debt
adjusters (also known as debt poolers, debt consolidators, debt managers, or
debt pro-raters). This first generation of credit counselors consisted of
profit-seeking enterprises that communicated with a consumer’s creditors
seeking to persuade them to accept less than full payment in satisfaction of
the consumer’s obligations. If the creditors agreed, the debt adjuster would
collect a monthly payment from the consumer and forward appropriate portions of
it to each of the creditors. They often charged hefty fees, leaving little for
distribution to the creditors. The instances of deceptive advertising and
defalcation of clients’ funds were numerous enough that, starting in the 1950s,
legislatures in more than half the states outlawed the business. E.g., N.Y.
Gen. Bus. Law §§ 455-457. Of the remaining states, approximately two thirds
opted for a regulatory approach, requiring licenses, imposing requirements on
how the businesses operate, and restricting troublesome practices. E.g., Mich.
Comp. Laws Ann. Ch. 451, §§ 451.451-.465 (repealed in 1976 and replaced by §§
451.411-.437).
Many states excluded not-for-profit
organizations from the scope of these statutes, enabling non-profits to render
counseling services free of regulation. This led to the growth, starting in the
1950s, of non-profit counseling agencies, the second generation of credit
counselors. The growth of these non-profits was fueled by the National
Foundation for Consumer Credit (now renamed the National Foundation for Credit
Counseling), which was created by retailers and banks that issued credit cards.
These creditors supported the formation of non-profit credit counseling
agencies as a means of helping consumers in financial difficulty get back on
track and pay their credit card debts. The objectives were full repayment of
debt and the avoidance of bankruptcy.
The
counseling agencies provided community education, met individually with
consumers, helped them develop or improve budgeting skills, and, when
appropriate, enrolled them in a “debt management plan” (DMP). To establish a
DMP, the agency negotiated with each of the consumer’s unsecured creditors to
obtain concessions from them, in the form of some combination of reduced
interest rate, waiver of default or delinquency fees, and monthly payments in
an amount less than the contractual minimum. Thereafter, the consumer made
monthly payments to the agency and the agency disbursed a pro-rated amount to
each of the participating creditors. The creditors supported the counseling
agencies by returning to them a percentage—often 15%¾of the payments they received. The NFCC
called this contribution the creditor’s “fair share.” The agencies also
sometimes received charitable contributions from other sources and imposed
modest fees on the consumer. This second generation of counseling agencies
still operates.
Consumer advocates generally
acknowledged the educational and budgeting benefits that the counseling
agencies provided, but were critical—or at least skeptical—of their overall
usefulness. They perceived the agencies as collection agents for the credit
card industry and were critical of the limited range of advice the agencies
provided. The last thing a card issuer wanted to see was a consumer filing a
petition in bankruptcy. Formed and supported primarily by the credit card
industry, most counseling agencies never recommended bankruptcy, and many never
even mentioned it as a possibility.
The late 1980s and 1990s saw a
dramatic increase in credit card debt. Consumers’ income rose, and card issuers
relaxed their standards of creditworthiness. The increase in debt was
accompanied by an increased opportunity for credit counseling agencies. Many
new entities arose, unaffiliated with the NFCC. They formed competing trade
associations e.g., the Association of Independent Consumer Credit Counseling
Agencies (AICCCA) and the American Association of Debt Management Organizations
(AADMO)). These new agencies—the third generation—relied heavily on advertising
and telemarketing, and many conducted their business with consumers entirely by
telephone or over the Internet. Perhaps because of their aggressive marketing
and innovative business methods, their share of the counseling market grew from
approximately 20% in 1996 to approximately 80% in 2001. Their focus was on the
creation of DMP’s, not on budgeting and education, which often fell entirely by
the wayside.
Since many states prohibited
for-profit debt management businesses, members of this third generation of
agencies were organized as non-profit entities. Many of them, however, did not
operate as charitable or educational institutions. They uncritically enrolled
all their customers in a DMP, even if it were not suitable for them, and they
charged fees much higher than the fees charged by the agencies affiliated with
the NFCC. At the traditional level of the creditors’ fair share contribution,
and with the educational function stripped away, many agencies generated
revenues much larger than needed to provide debt management services. They
funneled off these excess revenues in such ways as salaries that were out of
line with the salaries paid by other kinds of non-profit entities in the
community, and as compensation to affiliated entities for back-office services.
Meanwhile,
credit card issuers discerned that some of the counseling agencies were
accumulating large surpluses and were enrolling in DMP’s consumers whom the
issuers believed could pay their debts without the concessions the issuers had
been giving. They responded by reducing the concessions they were willing to
make and by reducing the amounts they were willing to return to the counseling
agencies. Some creditors have stopped supporting the agencies altogether, and on
average the amount returned to the agencies has dropped from more than 12% to
less than 8%. This decrease has adversely affected the ability of counseling
agencies to provide individual counseling and community education.
The
objective of the counseling agencies discussed to this point is to enable
consumers to repay their debts in full. There is, however, another segment of
the industry—the fourth generation—whose members do not have this objective at
all. These entities are sometimes known as debt settlement companies, and they
have formed trade associations of their own (e.g., the National Association of
Consumer Debt Settlement Companies (NACDSC) and the National Debt Settlement
Association (NDSA)(formerly the National Foundation for Debt Settlement)).
Instead of helping the consumer pay his or her creditors in full, they attempt
to persuade creditors to settle for less than the full amount of the consumer’s
debt, writing off the rest. Thus they represent a revival of the first
generation of counseling agencies. Unlike their forebears, however, they do not
negotiate with the creditors in advance of a consumer’s default. Instead, they
encourage the consumer to default. The consumer makes monthly payments to the
agency, not to the creditors. The agency accumulates those payments until they
reach a target percentage of the consumer’s debt to his or her creditors. Then
the agency submits an offer to the creditors (on the consumer’s behalf) to
settle the debt for the amount in hand. During the period when the agency is
accumulating payments from the consumer, the creditors receive nothing. As a
result the creditors impose additional finance charges and delinquency fees and
may undertake collection activity.
C.
The Bankruptcy Code and Other Legislation Mandating Consumer Credit Counseling
A
pending amendment to the Bankruptcy Code (Bankruptcy Abuse Prevention and
Consumer Protection Act, H.R. § 106(a)) imposes two requirements relevant to
this project. First, as a condition to filing for relief, a debtor must present
a certificate from an approved counseling agency that he or she has been
informed of alternatives to bankruptcy. Second, as a condition to a discharge,
the debtor must have completed a course of study on personal financial
management. These counseling functions must be obtained from agencies certified
by the U.S. Trustee as meeting certain standards. This amendment has the
potential to double the number of consumers who seek credit counseling.
In
addition to this proposed federal requirement, several states already have
enacted legislation requiring or encouraging certain consumers to obtain credit
counseling. New York imposes this requirement in connection with high-cost
mortgage loans. Florida and Illinois do so in connection with certain payday
loans.
D. Existing Regulation
In 1996 Congress enacted the Credit
Repair Organizations Act, 15 U.S.C. §§ 1679-1679j. The focus of that
legislation is entities that purport to be able to improve the consumer’s
credit reports or credit rating. It would apply to many consumer credit
counseling agencies, but the definition of “credit repair organization”
excludes non-profit organizations that are exempt from federal taxation. Though
this legislation is not applicable to credit counselors, the committee may wish
to draw on many of the restrictions it imposes on credit repair organizations.
As noted above, more than half the
states ban consumer credit counseling (with a loophole for entities that
provide counseling services on a non-profit basis). Of the rest, most have
statutes regulating the business. These statutes take a variety of approaches;
some create an elaborate licensing structure, others mandate or prohibit
specified practices. These approaches and these statutes provide another
resource on which the committee may draw in fashioning a uniform act.
E. Issues To Be Addressed
Assuming that the drafting committee
does not recommend outlawing credit counseling altogether, there are numerous
facets of the business that might be addressed. They include:
1. Lack of
adequate training for individual counselors. Some agencies are affiliated
with trade associations (NFCC, AICCCA) that require the agencies to use
counselors who have been certified as having been trained to provide financial
management counseling services. Employees at other agencies typically have
received no training as counselors.
2.
Diminution or elimination of the counseling function. The reduction in
amounts that creditors pay counseling agencies has led to a reduction of the
counseling and public education functions at many agencies. Often there is no
face-to-face interaction between counselor and consumer. Sometimes the
counseling and educational functions occur by telephone or on-line, but many of
the third-generation agencies have no counseling or public education functions.
Enactment of the proposed bankruptcy amendment would necessitate that agencies
incorporate counseling activity, at least for those consumers who are
contemplating filing for bankruptcy. The effectiveness of long-term oversight
by the U.S. Trustee is an unknown.
3. Use of
deception to initiate communication with the consumer. Print and web site
ads, television ads, and telemarketing callers may promise more (e.g., credit
repair) than the counseling agencies can deliver. They may misrepresent that
the agency will provide counseling services even though the agency’s sole
service is operation of a debt management plan.
4. Use of
deception and high pressure tactics to induce consumers to enroll in a DMP.
Many consumers who consult counseling agencies only need assistance with
budgeting and general financial management skills. They do not need a DMP. But
agency employees, especially those who are not trained as counselors, may be
paid according to the number of consumers they enroll in DMP’s. The agency
itself derives income from the creditor only if the consumer enrolls in a DMP.
With reduced payments from creditors, an increased portion of the agency’s
income now comes from the set-up fee paid by consumers. These incentives are
conducive to deception and high pressure. For example, some agencies induce
consumers to enter a DMP by suggesting that they may earn referral fees by
referring other consumers to the agency.
5. Use of
deception in connection with fees. Some agencies misrepresent or fail to
disclose accurate information concerning the amount the consumer must pay for
the agency’s services. Many counseling agencies tell consumers that there is no
charge for their services. Instead, they tell consumers that they will be asked
for voluntary contributions. At some agencies, this representation is false,
and the fees are mandatory. At others, the pressure to make the so-called
voluntary contribution is so intense that it is in effect a fee for services
rendered. Some agencies fail to disclose in advance that there will be fees in
addition to the ones that are disclosed.
6. Failure
to disclose the percentage of the agency’s consumers who successfully complete
a DMP. Typically fewer than a third of the consumers who enroll in a DMP
see it through to the end. Failure of a plan means that the consumer still owes
the debts to his or her creditors, but has diverted to payment of the agency’s
fees money that otherwise could have reduced those debts. The consumer should have
the information helpful to making the decision to undertake a DMP. A
requirement of disclosure of the success rate may provide agencies with an
incentive to enroll in a DMP only those consumers the agency believes will
complete it.
7. Failure
to disclose the fact and amount of compensation received from creditors.
Consumers may believe that the counseling agency is acting on behalf of the
consumer, when in fact the agency is beholden to his or her creditors. With the
Federal Trade Commission’s blessing in 1997, the NFCC began requiring its
member agencies to disclose this dual loyalty to its consumer customers.
Indeed, since a counseling agency is an agent of the consumer, counseling
agencies that fail to make this disclosure may be subject to liability for
breaching obligations imposed by the law of agency.
8. Failure
to inform the consumer of all the options. Just as a DMP may not be
appropriate because the consumer needs less, so also a DMP may not be
appropriate because the consumer needs more. Many agencies do not treat
bankruptcy as an alternative, and most do not include bankruptcy among the
recommended solutions for a consumer’s problems. This derives from the
agencies’ connections to the creditor community and reflects the fact that if
the consumer is not in a DMP the agency receives no payment from the creditors.
9. Failure
to inform the consumer of the significance of secured debt. Secured
creditors, e.g., mortgagees and auto lenders, do not cooperate with counseling
agencies. The consumer must continue to pay them outside the plan. Some
agencies may fail to make this clear to the consumer.
10. Failure
to disclose the impact of a DMP or a debt settlement program on the consumer’s
credit report. The consumer may not be aware of the impact of each of these
on his or her credit report. The consumer may be misled into believing that
bankruptcy would have a greater negative impact than a DMP would have.
11. Refusal
by the agency to deal with creditors that do not financially support it.
Some unsecured creditors, including some credit card issuers, refuse to make
any payment to counseling agencies. If the agency refuses to include these
creditors in a DMP, the consumer is left to deal with them outside the plan.
12. Absence
of a written contract detailing the obligations of each party under a DMP.
13. Receipt
of funds from the consumer before the creditors have agreed to participate in a
DMP. If the agency advises the consumer to start paying the agency before
it has secured the creditors’ assent to the plan, the consumer will be in
default, triggering delinquency fees and perhaps collection activity.
14. Imposition
of high fees for the services rendered. Historically, the NFCC-affiliated
agencies charged consumers nothing or a nominal amount for operating a DMP.
With the decline in the amounts that creditors pay the agencies, they have
increased their fees to consumers. In 2001 the average for NFCC agencies was
$19 for creating a DMP and $12 per month for administering it.
The
third-generation agencies tend to charge much higher fees than the
second-generation NFCC agencies. A typical set-up fee is $50, though at some it
is an amount equal to the aggregate monthly payment that in subsequent months
will be distributed to creditors. The monthly fee for these agencies varies; at
some, the fee is $5-10 per account; at others, it is a percentage of the total
monthly payment; at still others, it is a flat fee.
The
fourth-generation (i.e. debt-settlement) companies impose even higher fees.
Their set-up fee may be as high as the aggregate monthly payment, and they
often charge a percentage (typically 25%) of the amount of debt that the
creditors write off.
Some
existing state statutes place a cap on fees. At the low end, the cap may be $39
plus the lesser of $50 or 1% of the debts covered by a DMP. At the high end, the cap is 15% of each
monthly payment.
To the extent counseling agencies
market their non-profit status, they may be playing on a perception of
consumers that the mission of non-profit entities is charitable or educational,
with fees set at the level necessary just to cover expenses. There is an
element of deception, therefore, when the fees produce excessive reserves or
when they are funneled to for-profit companies that are affiliated with agency
insiders, or when the expenses are inflated by overly generous salaries to
agency executives. The committee might address this deception, as well as the
propriety of price controls and the appropriate level of any such control.
15. Failure
to disburse funds to creditors. The consumer who is enrolled in a DMP makes
a single monthly payment to the counseling agency. The agency in turn is
supposed to send payment to each of the participating creditors. There are
instances in which agencies have failed to make those payments. There are
instances in which agencies have refused to make payments to creditors that did
not agree to a DMP, but failed to inform the consumer that payment was not
being made. There are more numerous instances in which agencies have failed to
make payments promptly. Problems also may arise because the due dates of the
payments to creditors are not coordinated properly with the date on which the
agency receives payment from the consumer.
16. Failure
to respond to inquiries of consumers who are enrolled in a DMP. Articles in
the popular press report instances of consumers’ inability to communicate with
agencies once a DMP is under way.
17. Misappropriation
of money paid by consumers in a DMP. There are instances in which the
counseling agency absconded with funds.
18. Misappropriation
of financial information. The consumer must disclose detailed financial
information to the counseling agency. The agency may give or sell this
information to third parties that hope to do business with the consumer.
19. Abuse
of tax-exempt, non-profit status. Non-profit status is a function of state
law and typically requires that the corporation be organized for a public or
charitable purpose (Or. Rev. Stat. §65.047(b)) or for “any lawful purpose not
involving pecuniary profit or gain for its directors, officers, shareholders,
or members” (Mich. Comp. Laws §450.2251). Tax-exempt status is a function of
the federal Internal Revenue Code and requires, among other things, that the
entity not be operated for the private inurement of any person. Some agencies
pay lavish salaries to directors or executives. Some agencies have
relationships with companies owned by agency insiders and channel large sums to
those companies in the form of above-market lease payments or contracts for
ancillary services, such as operation of the DMP’s. Some agencies refer
consumers to insider-owned companies for consolidation loans or other services.
The
IRS recently announced that it was auditing a number of existing counseling agencies
and would be increasing the rigor of its reviews of new applicants for
tax-exempt status. (N.Y. Times, Oct. 14, 2003). (Additional information is
available at the IRS web site (search for “credit counseling.”)) The committee
may wish to consider limitations on the governing structure of counseling
agencies and the appropriateness of restrictions on an agency’s engaging in
transactions with insiders.
20. Solicitation
of consumers who reside in a state distant from the counseling agency. The
interstate nature of operations adds to the difficulty of supervising the
agency and enforcing the law against it.
21. Practice
of law without a license. Counseling agencies examine a consumer’s
financial situation and may recommend that the consumer do or do not file for
bankruptcy. Debt settlement companies may advise the consumer what to do if he
or she is dunned or sued, and they routinely represent that they have the
expertise to know when to make a settlement offer to the consumer’s creditors.
These activities may amount to the unauthorized practice of law. (Home Budget
Serv., Inc. v. Boston & Massachusetts Bar Ass’ns, 335 Mass. 228, 139 N.E.2d
387 (1957))
In addition to considering each of
these aspects of the industry’s operations, it will be necessary to determine:
F.
Bibliography
Among the numerous publications on
credit counseling, several stand out. If you wish to pursue the literature, I
recommend you start with some or all of the following, in the following order:
Loonin &
Plunkett, Credit Counseling in Crisis: The Impact on Consumers of Funding Cuts,
Higher Fees and Aggressive New Market Entrants (Report by Consumer Federation
of America and the National Consumer Law Center, April 2003) (accompanies this
report)
Losing
Credibility: Troubling Trends in the Consumer Credit Counseling Industry in
Massachusetts (Report of the Senate Committee on Post Audit and Oversight,
April 2002)
Williams,
Consumer Credit Counseling Services: A Growing Private-Sector Response to
Counterproductive Collection Practices that May Lead to Bankruptcy, 7 J. Bankr.
L. & Prac. 47 (1997)
Hoffman,
Consumer Bankruptcy Filers and Pre-Petition Consumer Credit Counseling: Is
Congress Trying to Place the Fox in Charge of the Henhouse? 54 Bus. Law. 1629
(1999)
Millstein
& Ratner, Consumer Credit Counseling Service: A Consumer-Oriented View, 56
N.Y.U. L. Rev. 978 (1981)
Felsenfeld,
Consumer Credit Counseling, 26 Bus. Law. 925 (1971)