Danger of debt settlement schemes: why bankruptcy may be a better option

Indebted Americans are becoming victims of debt settlement companies who make alluring and, more likely than not, false promises to relieve debtors' obligations by claiming they can negotiate settlements with creditors for half the amount that is owed. Instead, debtors often end up lining the pockets of the debt settlement companies while receiving little to nothing in return, or even winding up worse off.

Federal government investigations into debt settlement companies

In 2010, the federal Government Accountability Office released a report outlining the potential dangers and fraudulent practices of some for-profit debt settlement companies. The GAO conducted the study due to numerous allegations that these companies engaged in fraudulent, deceptive and abusive practices, including demanding fees from debtors before settling any debts on their behalf or even failing to do anything at all, a practice the Federal Trade Commission was considering banning.

The GAO posed as potential debtors when approaching the debt settlement companies and found that 17 out of the 20 companies they sought advice from collected fees before rendering any services.

The FTC has since prosecuted many cases against debt settlement firms who lied about the price of their services. One of the cases involved AmeriDebt, Inc., which perpetuated a fraud that it was a non-profit credit counseling agency, but was actually directing its profits to for-profit companies and other individuals. AmeriDebt, Inc. also lied about its up-front fee by keeping it for itself rather than using the fee as a disbursement to creditors as it had promised. The company settled with the FTC for $35 million on the eve of trial.

Newark case study

A Newark limo driver who rented out rooms in the house he owned lost his job temporarily. Subsequently, he saw an ad for a debt settlement company and signed up with them. The debt settlement company first took $1,200 from him. After paying over $5,000 to the company, the Newark man was still sued by his creditors for debts of $13,000 and $5,000, and the debt settlement company told him he didn't have enough funds to pay the creditors. When he finally quit the settlement program, even though they hadn't settled any of his debts, the company still kept over $5,800 in fees. As a final blow, the company filed for bankruptcy shortly thereafter, and the man was unable to recover anything from them.

Bankruptcy as a possible solution

Bankruptcy is a possible option for those with overwhelming debt who want to steer clear of debt settlement companies, get free from the majority of their debts and make a fresh start.

Bankruptcy is a broad term for a Federal law that allows businesses and individuals to escape from debt and pay off their creditors. Although, there are various types of bankruptcy, the two most commonly used are Chapter 7 and Chapter 13.

Under Chapter 7 bankruptcy, a person's assets are liquidated with the exception of the most necessary assets. In exchange for discharging the debt, the bankruptcy filer turns all nonexempt property over to the bankruptcy trustee to be sold to pay off the debts.

Chapter 13 bankruptcy results in a debt adjustment plan. The filer keeps all property, but pays all disposable income directly to a bankruptcy trustee every month. The trustee makes payments to creditors from this income under a plan the bankruptcy court approves. The debts are usually paid over a three to five year period.

Bankruptcy can be a more secure and verifiable means of settling debt than working with a debt settlement company for various reasons. In debt settlement schemes, creditors can refuse to settle with debtors, whereas, in bankruptcy, once the court approves the petition, the court's order is controlling with regard to creditors. In debt settlement schemes, creditors may report a debt reduction to the Internal Revenue Service, and the IRS considers that debt reduction as taxable income. In bankruptcy, consumers will not pay tax on either reduced or discharged debts.

If you are struggling with debt, before contracting with a debt settlement company, it would be wise to seek the counsel of an experienced bankruptcy attorney. An attorney can help you review your options and advise you about the best way to settle your debt and move forward.