Debt is a very important part of our economy. Nearly every American owes some kind of debt to someone else. These debts come in all shapes and sizes — home mortgages, credit cards, automobile loans or leases, apartment leases, medical bills, student loans and taxes are all examples.
Consumer debt is a primary engine of the United States economy. As of 2019, total debt in the United States added up to almost $4 trillion in an annual economy of about $20 trillion.[1] Just credit card and other revolving debt exceeded $1 trillion.[2] In 2018, Americans borrowed about $88 billion to pay for healthcare alone.[3]
The largest percentage of debt is held in home mortgages (about a third of total debt), followed by student loans, credit cards, automobile loans and leases and medical debt. Medical debt is the number one cause of bankruptcy.[4] To break that down individually, the average American is about $12,000 in debt, corresponding to about a quarter of the average income. The economy, both household and national, runs well when debts get paid on time. When they are not paid on time, litigation may result, and debtor-creditor law is engaged.
This course presents an overview of the legal relationship between debtors and creditors. Specifically, it is about what happens when a debtor-creditor relationship is established by the parties and then broken by one of them. The course is not about how those relationships are established – that is the purview of contract law and some other laws, such as torts and taxation. The course is, for the most part, about unsecured debt obligations. Secured obligations are covered by our video-course on secured transactions.
In this module, we’ll overview many of the laws that affect this area, including those coming from common law, state law and federal law.
A debtor is a person or other legal entity who owes money or services to another person or company. This party to whom the debt is owed is called the creditor. The money or service that the debtor owes to the creditor is called the debt or the obligation. A debtor may also be referred to as the obligor and the creditor, the obligee.
A debtor’s obligation can arise from various circumstances, including loans, extensions of credit, taxes, leases, medical bills and tort claims for damages. Debts can be written or oral, and agreements can be express or implied, in accordance with contract laws. Debts can also be created by law, as in taxation or when a defendant loses a court case.
Debts can be secured by collateral, such as a house or car, or they can be unsecured. Unsecured debts like credit card debts, personal taxes and unsecured loans, can start as unsecured and become secured through actions of law, as when an enforcement of judgment action is filed, and a lien attached, or property seized to satisfy a judgment debt.
Debtor-Creditor Law
The debtor-creditor relationship consists of both rights and duties. “Rights” describe what is owed to the creditor, such as the right to repayment of a loan or the right of a landlord to enter property if the rent is not paid. “Duties” describe the required actions of the debtor, such as the duty to pay taxes or to repay loans. However, those roles may be expanded under some state and federal statutes. For example, under federal law, a creditor has the right to collect on a debt, but has the duty to report accurate information to credit reporting agencies. Likewise, a debtor has the duty to repay a debt, but has the right to live free from telephone harassment in the collection efforts for that debt.
There are numerous federal and state laws that deal with the rights and obligations of debtors and creditors. These laws stretch back virtually to the beginning of money and trade, but modern laws have become primarily concerned with consumer protection. They touch other areas of the law as well, such as taxation and landlord-tenant law.
Debtor-Creditor law is civil in nature, though criminal laws may be involved in cases involving certain kinds of fraud. Being unable to pay a debt is not a criminal offense, although owing money to the government in the form of unpaid fines or taxes can trigger contempt charges that can land a person in jail. Still, the “debtors’ prisons” of the eras of Charles Dickens and Daniel Defoe are relics of the past. Dickens wrote three books in which protagonists went to prison because they could not pay their debts. This era of law gave rise to such phrases as “the poorhouse.” One famous debtor’s prison was called “Clink,” and gave rise to the phrase “being thrown in the clink.”
Debtor’s prisons originated in England in medieval times and were operating until the country passed the Debtor’s Act in 1869.[5] Other countries around the world followed suit, and the United States has never allowed formal debtor’s prison.
Unlike tort and contract law, most debtor-creditor law is statutory, state or federal. That is especially true when it comes to protecting debtors from unfair collection practices, as in the case of the Fair Debt Collections Practices Act.[6] However, there are a few common law causes of action which can limit the collection process, even if they are rarely used or successful. They typically operate where debtor and credit law intersects the law of contracts and torts.
Applicable Torts
Before consumer protection and debtor protection statutes were created, it was difficult for a debtor to respond against creditor bad behavior like persistent phone calls, home visits and the like. Debtors through the years have responded to this behavior by filing lawsuits against obnoxious creditors under several tort theories, including defamation, invasion of privacy and intentional infliction of emotional distress.
Defamation is a tort that means making false statements about another that are damaging to reputation. If the defamatory statement is printed or broadcast over media, it is called libel. Otherwise, it is called it is slander[7].
An example of this tort in the debt collection process could be publishing a notice in a newspaper that a person owes a debt when, in fact, there is no debt, or when the amount of the debt is incorrect. Truth is a defense to this tort, so there is no cause of action, for instance, for publicizing a true debt. In addition, an element of this tort is damages, so a plaintiff would have to prove that the false information caused some kind of damage to succeed.
Invasion of privacy has several applications, including public disclosure of private facts, wrongful intrusion, misappropriation of a person’s name or likeness and casting a person in a false light.[8] This tort can be used if collection practices are egregious.[9] Unlike defamation, invasion of privacy can apply where true information is released. Actual damages are also required of this tort, such as loss of business.
Invasion of privacy is sometimes alleged where the creditor has contacted the debtor’s place of employment and informed the employer of the debt. While a creditor may contact an employer of a debtor for legitimate purposes, such as effecting a wage garnishment and to confirm information provided by the debtor, courts have found that egregious behavior, such as multiple harassing contacts can amount to invasion of privacy.
Courts have also found for the debtor in invasion of privacy cases where the creditor has contacted the debtor’s neighbors, published the debt in a local newspaper or posted a notice of the debt at the debtor’s place of employment.
Invasion of privacy for intrusion on the solitude of the debtor can apply when debt collection efforts rise to the level of harassment. For example, a creditor or debt collector may not camp out in front of the debtor’s house, constantly knock on the door, constantly phone, follow the debtor around, harass the debtor’s family and so on. Debtors who are experiencing that sort of harassment may seek a restraining order.
Beyond invasion of privacy, extreme harassment can constitute intentional infliction of emotional distress, which can bring compensatory and punitive damages. This means the plaintiff acts outrageously with the intention of causing the defendant to suffer severe emotional distress.[10] This may include, for example, the collector threatening physical harm to a plaintiff or threats of financial harms that are outlandish or unrealistic. For example, threatening to sue if the debtor doesn’t pay a debt is legal, but threatening to “make it so that you’ll never get a loan or job in this town again” may constitute intentional infliction of emotional distress. The behavior must be so severe that “it could be expected to adversely affect mental health.” It may also take the form of behavior that seems designed to disrupt the debtor’s life rather than realistically trying to collect a debt.
This cause of action is difficult to prove in many jurisdictions, often requiring “actual damages” as an element of the tort. These damages may be proved by medical bills from a psychotherapist who could testify that the harassment caused the debtor to seek therapy.
While these common law causes of action remain available to harassed debtors, many state and federal consumer protection laws also provide their own civil actions against creditors and debt collectors, with some statutes pre-empting or rendering unnecessary these common law torts.
Assignment for the Benefit of Creditors
Sometimes, debtors may agree to give something to creditors in exchange for some relaxation of collection efforts. For example, the debtor might give an unsecured creditor a security interest in his car in exchange for the creditor’s agreement to stop collection actions for three months.
On common type of transfer of property interests for the benefit of creditors is the “assignment for the benefit of the creditors.”[11] The debtor assigns the title to a piece of property to a trustee for a liquidation sale for the benefit of debtors.
For example, assume Bob is a debtor who owns a building. Bob owes money to multiple creditors and is having trouble paying all of them on schedule. Bob could assign or transfer ownership of the building under these laws to Nancy, who is then put in the legal position of a trustee. Nancy would then be tasked with selling the building and distributing the proceeds of the sale to the creditors. In doing so, she is required to follow the same state fiduciary laws as any other trustee. The process is very similar to the creation of a trust and is often governed by a state’s trust laws.[12]
The concept works similarly to a bankruptcy proceeding, but is simpler, applies only to the building and does not require court supervision. Of course, unlike a bankruptcy filing, this maneuver does nothing to stop other collection efforts. Still, the assignment can be used as a way to avoid bankruptcy if the debtor’s financial life can be helped with these simpler transactions.[13]
After the sale of the property, the trustee must distribute the proceeds from the sale in order of legal priority. This is usually in the order that the debts were created. If the trustee favors some creditors over others in a manner to which they are not legally entitled, that may constitute a fraudulent conveyance, and it may be unwound by a court.
If there is a shortfall in that not all debts are paid completely, the remaining debts are still owed to the various creditors. Unlike a bankruptcy proceeding, there is usually no discharge of remaining debt after liquidation of the property. Any attempt by the debtor or trustee to discharge an unpaid debt under a common law assignment may be considered a fraudulent conveyance.
States that allow this kind of action generally do not require that the creditors approve the assignment, sale and distribution. On the other hand, the entire process is sometimes considered unnecessary, since the debtor can just sell the property and distribute the funds itself. Still, it is a solution that is available to debtors that may provide some organization and process to satisfying an array of debts.
Assignments for the benefit of creditors are now regulated in most states, while in others, they are governed solely by common law rules.[14] In some states, debtors may choose between “common law” assignments and “statutory” assignments.
Differences between “common law” assignments and “statutory” assignments include:
— Most state statutes do not allow the trustee to determine preferences among the creditors, while the common law does allow this. This means that, under most state laws, the trustee has virtually no control over which creditors get paid when. State law governs the order of payment. Secured creditors and employees owed unpaid wages generally get paid first, and then payments to unsecured creditors are distributed proportionately.
— Virtually all state statutes require recording the assignment, filing schedules of assets and liabilities, bonds to be secured by the trustees and notice to the creditors.[15]
— Some state laws allow the discharge of a debt in the case of a shortfall. Some commentators feel that this kind of law is unconstitutional, because it seems to usurp bankruptcy laws. Bankruptcy law is exclusively reserved for the US Congress by the Constitution.[16] However, the Supreme Court has determined that debt discharge may be allowed without interfering with federal powers of bankruptcy law[17].
Creditors, though, do have one way of making sure that the sale proceeds are distributed fairly: They can try to force the debtor into involuntary bankruptcy, or threaten to do so if they perceive unfair conduct by the debtor or trustee. Because of that possibility, any debtor who chooses to assign property needs to make sure that the process is fair to all parties.
Workouts
Debtors and creditors are always free to modify their debt terms by agreement. In the case of one debtor with multiple creditors, there are several types of agreements that can be negotiated, all with an eye towards avoiding bankruptcy. These are called workouts. A workout is a written contract between a debtor and multiple creditors. Workouts, allowable under common and state debtor-creditor laws, are controlled by contract law. They require the participation of two or more creditors because of contract consideration requirements.
The first type of workout between a debtor and multiple creditors is called a composition. This is an agreement between a debtor and two or more creditors that each creditor will take less than the full amount owed in settlement of the debt. The second type of workout is an extension, where the time to pay the debts is extended for a specified period.
One problem that can arise with workouts, especially under common law, is where not all creditors participate in the process. This is tantamount to a secret agreement or “preference,” which may not be allowed under debtor-creditor law. In that case, a creditor who is not party to the workout can void the agreement. Again, any unhappy creditors can force the debtor into involuntary bankruptcy, so it is in everybody’s best interests to keep all agreements above board.
[1] Federal Reserve statistics.
[2] https://fred.stlouisfed.org/series/REVOLSL
[3] Gallup survey, Jan.- Feb. 2019. Reported at USA Today April 2, 2019; http://nymag.com/intelligencer/2019/04/americans-borrowed-usd88-billion-for-health-expenses-in-2018.html
[4] The Motley Fool, citing a Comet Finance study published Feb. 2018; https://www.fool.com/retirement/2018/02/15/its-official-most-americans-are-currently-in-debt.aspx
[5] http://www.legislation.gov.uk/ukpga/Vict/32-33/62
[6] https://www.ftc.gov/enforcement/rules/rulemaking-regulatory-reform-proceedings/fair-debt-collection-practices-act-text
[7] Dictionary.law.com.
[8] Dictionary.law.com.
[9] Ex.Dawson v. Assocs. Fin. Servs.Co., 529 P.2d 104 (Kan. 1974)
[10] Cornell Law School Legal Information Institute.
[11] https://legal-dictionary.thefreedictionary.com/Assignment+for+Benefit+of+Creditors
[12] Bankruptcy and Related Law in a Nutshell, 9th Ed. (2107), in general pp. 461-472.West Academic Publishing.
[13] See Andrew B. Dawson, Better Than Bankruptcy?, 69 Rutgers U.L. Rev. 137, 143 et. al. (2016).
[14] See General Assignments for the Benefit of Creditors, G. L. Berman (4th ed.) for a complete state-by-state analysis.
[15] See, ex. Florida S. Chap 727.; California Code of Civil Procedure Sec. 493.101-494.060 and Secs. 1800-1802.
[16] Article I, Section 8, Clause 4.
[17] Johnsonv. Starr, 287 U.S. 527 (1933); International Shoe Co. v. Pinkus, 278 U.S. 261 (1929) Int’l Shoe Co.v. Pinkus, 278 U.S. 261 (1929)