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Are Private Debt Collectors a Bad Bet for Cities?


Studies find municipalities are more cost-effective using their own people. And there's less palm greasing

States and cities are desperate for cash—so desperate they're turning to private debt collectors to go after delinquent taxpayers and other scofflaws. The thinking is that it's cheaper to outsource the task of collecting unpaid utility bills, library fines, and the like to independent contractors than to hire more public employees.

Turns out the opposite may be true.

That, anyway, was the conclusion of the IRS, which on Mar. 6 ended a four-year, $80 billion program to chase down tax deadbeats. "After a thorough review of the program, I have decided not to renew the contracts," says IRS Commissioner Douglas H. Shulman, who plans to hire more than 1,000 tax collectors at the agency. "I believe this work is best done by IRS employees." Recent IRS studies have found that the program recouped far less than the IRS could have collected on its own.

It gets worse. Not only are private debt collectors less effective than public ones, but a number of companies benefiting from the privatization trend have been slammed by regulators and prosecutors for overcharging municipalities, bribing public officials, and other predatory behavior. Some municipalities have stopped outsourcing their debt collection efforts altogether.

Private players defend their practices, arguing that they pursue debts that municipalities don't have the resources or skills to recover. "The entities wouldn't get that money otherwise," says Bruce Cummings, president of Municipal Services Bureau, a large debt collector in Austin, Tex., that recently won a contract with the government of Hamilton, Ohio. "The industry provides a worthwhile service."

That argument continues to hold sway for many states and cities suffering from declining tax receipts and a deep economic downturn. Consider tiny Bluff City, Tenn. To help fill its depleted coffers, the town of 1,500 near the Virginia border is farming out its collection work to private contractors. Officials figure that the city is owed $50,000 in back taxes and unpaid speeding tickets—real money in a municipality with an annual budget of $1 million. "We're fighting a very tight budget," says Todd Malone, Bluff City's mayor. All told, some $24 billion of uncollected municipal debt is up for grabs nationwide, according to mygovwatch.com, which tracks government contracts. That's up from $16 billion a few years ago.

Debt collectors are also angling to cash in on the U.S. Treasury's "bad bank" proposal to buy mortgages, credit-card debt, auto loans, and other distressed assets. An investing consortium has offered a plan to purchase portfolios of toxic debt. If they have their way, debt collectors would help work out the underlying loans, tracking down delinquent borrowers and ultimately sharing in the profits. The debt collection industry feasted on similar government work after the savings and loan crisis of the late 1980s. "This is a real growth area," says Mike Ginsberg, president of industry researcher Kaulkin Ginsberg.

The privatization boom, oddly enough, comes just as the IRS is retreating from private collectors. The government's decision follows research done by the IRS taxpayer advocate, Nina E. Olson. She found that two firms, CBE Group in Waterloo, Iowa, and Pioneer Credit Recovery (SLM) in Arcade, N.Y., collected $37 million last year on behalf of the IRS, pocketing $7.5 million in fees and commissions. Olson calculates that if the IRS had used that same $7.5 million to retrain existing staff, the agency would have collected $250 million. "You really do get much more money for spending $1 on a federal employee than you do paying a $1 commission to a private collection firm," says Olson.

THE UPPER HAND

The IRS and other public agencies have a major advantage in their collection efforts. Unlike private players, federal and municipal employees can impose liens or garnishee wages to recoup unpaid debts. Private debt collectors, in contrast, rely mainly on their powers of persuasion to get consumers to pay up.

The companies cited by the IRS dispute claims of inefficiency. Randall Kamm, vice-president for government services at CBE Group, says the program never operated at its full capacity. "The program was designed for 10 vendors [not two]," says Kamm. "It never had a chance to work properly." Pioneer didn't return calls for comment.

Some municipalities have seen inefficiencies as well. Montana's revenue director, Dan Bucks, decided to cancel the state's tax collection contract with Houston's GC Services in 2005 after a wave of taxpayer complaints about the firm. Bucks then plowed funds into the state's collection efforts. Montana's revenue department collects $21.08 for every $1 spent on salaries and expenses. GC Services' record: $5.01 collected for every $1 of cost. "Complaints have gone way down and cost-effectiveness way up," says Bucks. GC Services—which recently won a piece of an estimated $1 billion contract to handle debt collection efforts for the state of Missouri—didn't return calls or e-mails for comment.

Accusations of predatory behavior are proliferating, too. Private debt collectors in New Jersey "padded the bill," according to state investigators. In 2005, New Jersey officials discovered that Outsourcing Solutions (OSI) in Horsham, Pa., which had been hired to collect $1 billion in back taxes, had "lavished...gifts and entertainment," including $65,000 worth of liquor, meals, customized golf balls, gourmet chocolates, and imported cigars, on high-level officials in the state's revenue department. Those officials, says New Jersey's Commission of Investigation, then "turned a blind eye" as OSI overcharged the state government by around $1 million. "Other states are just as vulnerable to the same kind of abuse," says Lee Seglum, who headed up the state's investigation.

New Jersey fined OSI $2 million in 2007 and banned the company from new government contracts for five years. The state's attorney general recently brought criminal charges against three former OSI executives involved in the matter. Three former state officials have also been indicted. Meanwhile, OSI and its new parent, NCO Group, are still busy collecting back taxes and other government debt in 35 states. OSI didn't return phone calls or e-mails seeking comment.

Some firms have had numerous run-ins with regulators. Take San Antonio law firm Linebarger, Goggan, Blair & Sampson. In 2005 one of its partners pleaded guilty to bribing a San Antonio councilman to win the city's tax collection contract. Linebarger lost another contract with Mansfield, Tex., in 2006 after an employee made a controversial campaign donation to the town's mayor after his election.

Linebarger maintains that the firm provides an important service to municipalities, especially in a recession. "The current state of the global economy has certainly caused many [local officials] to take a second look at the valuable assistance we can provide to them and their constituents," says Joe Householder, a spokesman for Linebarger.

Chicago officials either overlooked or weren't aware of Linebarger's previous infractions—even in their own city—before inking a fresh deal with the firm. In early 2008 Linebarger forfeited a contract to collect overdue parking tickets after an investigation by Chicago Inspector General David Hoffman found that the firm had paid for an out-of-state trip by a top government employee. Yet in November Linebarger, which had earned $33 million in fees on the previous Chicago contract, landed another collection deal with the city worth $3.4 million. Linebarger says the firm has provided additional training to its Chicago employees, and the attorney admonished in the previous matter doesn't work on the new municipal contract.

UNSAVORY TACTICS

The growing prominence of private debt collectors only adds to critics' concerns about the industry, long known for its hard-nosed tactics with consumers. U.S. Air Force Captain Jose Iraheta, who is currently serving his second tour of duty in the Middle East, says Linebarger harassed his family over $7,000 in back property taxes on his Victorian-style home. Under Texas law, active armed services members can defer property taxes until they complete their overseas tours.

Nonetheless, says Iraheta, Linebarger sued and threatened to foreclose on the house—even though it had no legal authority to do so. Iraheta says he had to call for months from the Middle East via satellite phone before the firm agreed to drop the matter in June 2007. Iraheta is now suing Linebarger for damages and legal fees. Linebarger wouldn't comment on individual cases. Says Iraheta: "I have only a few rights, yet Linebarger tried to take those from me."

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Reining in Debt Collector Abuses

In a February 2009 report, the Federal Trade Commission urges lawmakers to reform and modernize the rules governing the debt collection industry. The commission proposes banning debt collectors from contacting consumers via cell phone or text message without their permission. It also recommends that companies get consumers' authorization before accessing their account records.

To read the full report, go to http://bx.businessweek.com/debt-collectors/reference/


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