The Federal Trade Commission is imposing new regulations that will prohibit most for-profit debt-relief companies from charging a fee before they have reduced a client's unsecured debts.
The FTC says the rules, which take effect Oct. 27, will prevent consumers from paying large up-front fees for debt-reduction promises that are not fulfilled. They do not limit the size of fees, only their timing.
The debt-settlement industry says the rules will force most companies out of business because it will take at least a year to collect any fees.
"There are not a lot of debt-settlement companies that can afford to spend month after month after month servicing clients without any money coming in," says David Leuthold, executive director of the Association of Settlement Companies.
In a typical debt-settlement contract, the consumer stops paying his unsecured debts, such as credit card and medical bills, and starts putting money into a savings account that he controls. When there is enough money in the account to settle one debt, typically after a year or more, the company negotiates with that creditor to accept less than the amount owed. This continues until all debts are settled, which typically takes three years.
Today, most companies charge clients a percentage of the debt they bring into the contract; 15 percent to 20 percent is common. Some demand the entire fee up front; others spread it over the first half of the contract period. If the client drops out before completion, and most do, he is out the fee and often deeper in debt.
Instead of charging in advance, a few companies charge a portion of the debt reduced, typically 10 percent to 50 percent.
Under the new rules, companies cannot collect a fee until they have reduced, settled or changed the terms of at least one of the consumer's debts and the consumer has made at least one payment to the creditor under the new agreement. If a consumer has enrolled multiple debts in one program, the fee for a single debt must be proportionate to the total fee that would be charged if all debts had been settled.
Under the new rules, companies can require the consumer to set aside their fees and savings for payment to creditors in a dedicated bank account, but the consumer retains control over the account. Companies also must make certain disclosures to consumers about their services, such as how long it will take to see savings and the potential hit to their credit scores.
Although some states regulate debt-settlement firms, these are the first federal rules that apply specifically to such companies nationwide. Because they are telemarketing rules, they apply only to companies that market by phone or take phone calls from people responding to print, broadcast or other ads.
They do not apply if a company has at least one face-to-face meeting with a customer before the agreement is signed. Nor do they apply if the business is conducted strictly online. Most debt-settlement companies won't qualify for these exemptions.
The rules do not apply to secured debt such as mortgages, although the FTC is working separately on rules to curb foreclosure-rescue scams. The new rules do apply to unsecured tax debts, but not if they have been secured by a tax lien, says Allison Brown, an FTC senior attorney.
The rules apply to all for-profit debt-relief firms including debt-management or credit counseling services that put consumers on payment plans with the goal of repaying their debt in full. The creditor might reduce interest rates or waive penalties, but generally does not reduce principal. Most of these services are nonprofit, so the new rules will not apply to them. However, most are subsidized by creditors and their fees are low.
The real target of the new rules were debt-settlement companies that falsely promise to reduce credit card debt by half or more in exchange for large advance fees.
"Too many of these companies pick the last dollar out of consumers' pockets -- and far from leaving them better off, push them deeper into debt, even bankruptcy," FTC Chairman Jon Leibowitz said.
John Ansbach, legislative director of the trade group United States Organization for Bankruptcy Alternatives, says the FTC should have gone after companies engaging in false advertising. Instead it "imposed an untested business model on an entire industry."
He predicts that "a lot of companies, if not the vast majority, will close their doors." And that, he says, "will be a disaster for consumers. Our members are the only independent (debt relief) companies who get paid by the consumer," he says.
Gerri Detweiler of Credit.com says debt settlement might make sense for only "a small slice of consumers," those who owe too much for credit counseling but can't or won't file for bankruptcy. These are people who could pay some, but not all of their debts but won't negotiate with creditors directly. "Some have too many creditors, don't know how or just can't handle the stress," Detweiler says.
Consumer advocates say that unscrupulous debt-settlement companies enroll clients who would be better off in debt management or bankruptcy. "They take anyone who contacts them," says Susan Grant, director of consumer protection with the Consumer Federation of America.