Debt Firms Play ‘Whack-a-Mole’ Using Lawyers to Skirt Fee Ban

Debt-settlement companies that offer to negotiate with creditors on behalf of consumers are switching tactics to skirt rules banning up-front fees by working with lawyers and charging retainers.

“It’s like playing whack-a-mole,” said Suzanne Martindale, a San Francisco-based staff attorney for Consumers Union. “We do expect we’ll continue to see more businesses cropping up trying to exploit loopholes.”

The U.S. Federal Trade Commission in October 2010 barred debt-settlement companies that use telemarketing from accepting up-front fees. The rule stemmed from complaints about practices that included charging thousands of dollars in fees on promises to reduce consumer debt and never delivering, according to a 2010 report by the U.S. Government Accountability Office.

The ban doesn’t always apply to legal retainers, so to get around the restriction, debt-settlement firms are affiliating with lawyers to charge initial fees of as much as $7,000 or more. Settlement firms generally only work with credit-card and other unsecured debt, meaning debt not backed by assets such as a home or car.

U.S. consumers had about $792 billion in outstanding revolving debt in July, according to Federal Reserve data. That’s down from a high of more than $970 billion in 2008 and equates to almost $16,000 in debt on average for households that carry a balance, according to

No Contact

“They operate under the illusion of there being lawyers involved, although in fact you will probably never speak to one,” said Lisa Madigan, attorney general of Illinois.

Madigan filed a civil complaint against Legal Helpers Debt Resolution LLC alleging the firm’s clients often never meet or speak with an attorney, and that the firm engaged in a number of deceptive business practices including implying that their services were offered by a U.S. government program. The complaint was filed March 2 in the Seventh Judicial Circuit Court in Sangamon County. Legal Helpers filed a motion to dismiss the case in July.

Legal Helpers’ clients who ask to speak with an attorney have always been able to speak with one, said Jason Searns, general counsel for the firm. Before October the firm did no direct marketing and only bought client referrals from outside vendors, meaning Legal Helpers couldn’t have engaged in deceptive marketing, he said. The court hasn’t ruled on Madigan’s allegations.

When customers enroll in a debt-settlement program, they’re usually told to stop making minimum payments to creditors and instead to pay into a trust or escrow account. Once that account has accumulated enough money, the firm negotiates with creditors to try to settle in cash for an amount less than the consumer’s outstanding debt.

Fees Accrue

The problem with charging up-front fees is that all of a consumer’s monthly payments may go toward the settlement firm’s charges first, meaning customers may not accumulate a positive balance in their accounts for months after starting a program, according to critics such as Martindale of Consumers Union.

Customers may continue to accrue late fees or interest in addition to possible negative marks on their credit reports, and may still be sued by creditors after enrolling in a program, said William Binzel, corporate secretary for the National Foundation for Credit Counseling, a Washington-based network of nonprofit credit-counseling agencies.

“I think a consumer goes into a debt settlement thinking ‘At last, I’ll solve the problem,’ only to find out nine or 10 months down the road that while they’ve been paying into this account they’re actually deeper in debt, and may be subject to being sued by creditors,” Binzel said.

Complaints Against Firms

The Better Business Bureau has received almost 2,500 complaints about debt-relief firms this year, according to Katherine Hutt, a spokeswoman. The bureau started tracking the debt-relief services industry as a separate category in 2010 in response to a “significant increase” in the number of complaints it received about the companies, she said.

The FTC has made no specific exemption for attorneys, said Joel Winston, associate director of the division of financial practices for the Washington-based agency.

“To the extent that there are firms who think that somehow the claim ‘I’m providing legal services’ exempts them from the rule, they’re mistaken,” he said. Winston declined to say whether all so-called “attorney-model” firms are violating the fee ban. He said the FTC had not brought any enforcement actions against firms for violating the up-front fee ban.

No Licensing

There are no federal licensing requirements for debt-settlement companies. Most firms are closely held and many operate as multiple legal entities, meaning it can be difficult to get an accurate estimate of the total number of companies and the size and nature of their businesses, said Martindale of Consumers Union, a nonprofit consumer advocacy group and the publisher of Consumer Reports magazine.

“It remains a very opaque industry,” she said.

There are about 200 to 300 debt-settlement firms in the U.S., according to estimates from Andrew Housser, an executive board member with the American Fair Credit Council, a lobbying and membership group for debt-settlement companies.

In the past two years, attorney-model firms, or ones affiliated with lawyers, have become a majority, said Amy Clark Kleinpeter, an Austin, Texas-based attorney who represents consumers against debt-settlement firms.

“Most seem to have converted relatively easily,” she said.

Some also have started meeting with clients face-to-face when signing documents, because the FTC rule was directed at telemarketers, and may not cover agreements made in person, Housser said.

Craigslist Ad

In at least one instance, Morgan Drexen, a legal-services firm that contracts with lawyers and is involved with negotiating settlements on behalf of those attorneys’ clients, may have advertised employment for attorneys licensed in specific jurisdictions on the classifieds website of Craigslist Inc., according to a complaint against the firm filed by Darrell McGraw, West Virginia’s attorney general, on May 20 in the Circuit Court of Kanawha County.

According to McGraw’s complaint, Morgan Drexen employees do all debt-settlement work for clients themselves, and the attorneys it works with only “rent” their bar licenses and firm names to the company. Morgan Drexen denied the allegations, and said it provides administrative support to attorneys and that the attorneys it works with are responsible for handling settlements, according to the firm’s answer to the complaint.

The company said it would pay one lawyer in West Virginia a monthly fee of $500 for the first 300 West Virginia clients she served and $2 for every additional client, according to a copy of the attorney’s contract with Morgan Drexen.

‘Personal Services’

“Legal services are personal services, they’re not commodities that can be bought and sold like a bag of coffee beans,” said Douglas Davis, assistant attorney general for West Virginia. No judgment has been entered in the case, according to the clerk’s office.

Some firms began shifting to an attorney model before the FTC rule took effect because of loopholes for lawyers in state laws, said Scott Johnson, chief executive officer of USDR Inc., a settlement firm. Morgan Drexen has operated under its current business model since the company’s inception in 2007, according to the company’s assistant general counsel Erich Schiefelbine.

Illinois passed a law banning up-front fees by settlement companies in 2010 that didn’t cover retainers for lawyers providing similar services. Minnesota in 2009 passed a law limiting startup and overall fees for debt-settlement firms and creating licensing requirements that also has an exemption for lawyers. Nevada in 2009 passed a law requiring registration and limiting setup and monthly fees that exempts legal services provided in an attorney-client relationship.

Plan Costs

Legal Helpers has been a debt-resolution law firm since 2009, according to Searns. The firm charges 15 percent of a customer’s debt over the first 18 months to cover the costs of the settlement plan, Searns said. It also charges a $900 “legal flat fee” over the first six months to nine months to cover attorney representation if a customer is sued by creditors, he said.

The firm has about 12,000 clients and represents about $500 million in debt. That’s an average debt of almost $42,000 per client, Searns said, and would equate to up-front fees of $7,150.

The FTC fee rule shouldn’t apply to Legal Helpers because its lawyers and paralegals meet with clients face-to-face, meaning their activities are not governed by the telemarketing rule, and because it provides comprehensive legal services to clients, Searns said.

‘Point of Contact’

Thomas Ballance, 55, who is disabled and lives in New York, was earning $761 a month in Supplemental Security Income and had no other assets in 2009 when he enrolled with the United Law Group Inc., an affiliate of Morgan Drexen at the time, for debt-settlement services, according to Anamaria Segura, an attorney at MFY Legal Services Inc., who has worked with Ballance. His credit-card debt was more than $30,000 when he enrolled in the settlement program.

“Because Morgan Drexen will be your initial point of contact, we request that you direct all further questions to your Client Coordinator,” said a copy of a Morgan Drexen letter to Ballance from February 2009.

Ballance agreed to pay $1,788 to the United Law Group as an engagement fee, according to the attorney-client agreement. Supplemental Security Income is exempt from collections, meaning Ballance’s creditors could not have garnished his income, said Segura. Ballance hasn’t filed a claim against United Law Group, she said. The United Law Group’s website is now listed as an unregistered domain and the firm’s phone number has been disconnected.

Rule Compliance

The attorneys Morgan Drexen works with are complying with FTC rules and don’t charge up-front fees for settlement services, said Jeffrey Katz, general counsel for the Costa Mesa, California-based firm.

Debt-settlement clients who enrolled with the Williamson Law Firm LLC, an affiliate of Morgan Drexen, after the FTC rule took effect paid “engagement fees” of as much as $3,250 in some cases, according to Morgan Drexen files obtained by Bloomberg News.

The Williamson Law Firm doesn’t charge a retainer for debt-settlement clients, said Lawrence Williamson, principal partner for the Kansas City, Missouri-based firm. Bankruptcy clients of the firm pay engagement fees, and some bankruptcy services may include settling debts, he said.

Debt-settlement companies may be subject to examination by the U.S. Consumer Financial Protection Bureau as part of the agency’s nonbank supervision program, according to Jen Howard, spokeswoman for the agency, which launched in July. The agency is studying the issue and must determine it by a rule, she said.

Membership Plummeted

Trade groups say their membership has plummeted since the FTC rule took effect. Membership in the United States Organizations for Bankruptcy Alternatives has declined to about 30 firms from more than 200, according to Executive Director Jenna Keehnen. The American Fair Credit Council, formerly called the Association of Settlement Companies, has fallen to about 35 firms from about 220 firms, Housser said.

Both groups require that members comply with the FTC rule and only charge so-called “performance-based” fees, meaning fees that are assessed only after a debt is settled.

“They haven’t left the industry, they’ve left the trade associations because they don’t want to abide by a performance-based service fee,” said USDR’s Johnson.

The Illinois case is People v. Legal Helpers Debt Resolution LLC, 11-00286, Illinois Circuit Court for the Seventh Judicial Circuit (Sangamon County); The West Virginia case is State of West Virginia v. Morgan Drexen, 11-00829, West Virginia Circuit Court (Kanawha County).

Before it's here, it's on the Bloomberg Terminal. LEARN MORE