CHAPTER
30
BANKRUPTCY
I.
OBJECTIVES:
This chapter is intended to provide a survey of the law of bankruptcy in order to acquaint
the
student with the purpose, approach and major concepts embodied in the Bankruptcy Act. After
reading the chapter and attending class, a student should be able
to:
1. Explain the purpose of the Bankruptcy Code.
2. List and describe the major types of bankruptcy proceedings.
3. Explain the procedure by which Chapter 7 (liquidation) proceedings are begun.
4. Understand what assets are included in the bankruptcy estate and the nature of exemptions.
5. Understand when the trustee can avoid prior transactions made by the debtor to reclaim assets
for the bankruptcy estate.
6. Distinguish among claims, allow able claims, secured claims, and priority claims of creditors.
7. Describe the process by which the property in a debtor’s estate is distributed to creditors and
the debtor is granted a discharge in bankruptcy.
8. List the kinds of debts that are not dischargeable.
9. Compare the major types of bankruptcy proceedings.
II. ANSWER TO INTRODUCTORY PROBLEM
A. The first question following the hypothetical that appears at the beginning of the chapter asks
what assets a bankrupt debtor may claim as exempt from his/her creditors. State exemptions,
which may be elected in lieu of those provided under the federal bankruptcy law, vary
from
state to state. The categories of federal exemptions are set out on pages 832 and 833.
B. The second question asks which debts of a debtor may be discharged (and by implication
which are not). To be dischargeable, the debts (claims) must be “provable” and the debtor
must not have committed any of the acts which are a bar to discharge. In addition, certain
debts are specifically exempt from discharge (see list on page 840).
C. The third question asks for a comparison of Chapter 7 to Chapter 13. The comparison is set
out in the Concept Review on page 855.
D. The fourth question relates to the new ‘means test” added in the 2005 act which requires
that
certain debtors must pursue a chapter 13 plan and are not eligible for a Chapter
7liquidation
and discharge. The means test is discussed at page 827.
III. SUGGESTIONS FOR LECTURE PREPARATION:
A. Introduction
1. Begin the lecture with a general
recitation
of the purposes of bankruptcy.
a. To give the honest debtor a clean start;
b. To protect debtors from
creditors;
c. To protect creditors from
debtors;
d. To protect creditors from other creditors.
Chapter 30- Bankruptcy
30-1
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2. Explain that the rules of the federal Bankruptcy Act are designed to serve these
purposes.
Refer to these basic purposes wherever possible to aid students’ understanding of the
law.
3. Briefly explain the four types
of bankruptcy
proceedings: liquidation,
reorganizations,
family farm, and consumer debt
adjustments.
B.
Liquidation
1. Generally. To convey the effect of liquidation to the students you might use
the
following graphic
explanation.
Using balance sheet form, set out two columns on the chalkboard, one titled “Assets,”
the
other titled “Liabilities” or “Debts.” Place some dollar amount in each column,
for
example, $30,000 assets and $50,000 liabilities. Announce that the trustee in
liquidation
takes the debtor’s assets and pays what liabilities he can, then erase the dollar
amounts
from the asset and liability accounts. Liquidation, it should be said, wipes the slate
clean.
The debtor has no assets, but then he has no
liabilities.
Next, state that there are exceptions to this rule that liquidation wipes the slate
clean.
First
,
there are exempt assets. Then write “exempt assets” in the assets column.
Second,
note that there are non-dischargeable debts and write
“non-dischargeable
debts” in
the
liabilities column. Third, note there are acts that bar discharge and write “all debts
if
debtor committed an act that bars discharge” in the liabilities column. Fourth, note that
a
debtor may reaffirm or revive dischargeable debts and write “reaffirmed debts” in
the
liabilities
column.
2. The Petition in
Bankruptcy.
Note that permitting voluntary petitions protects
debtors
fro
m
creditors by allowing the debtor to threaten liquidation (in which the creditor
is
likel
y
to get about 10 percent of his claim) when a creditor is aggressively
seeking
payment. This protects the debtor from harassment. The involuntary petition
allows
creditors to obtain at least some payment when the debtor is not paying his debts.
Note
that the debtor need not be insolvent (that is, liabilities exceed assets), but need merely
be
not paying his debts as they come due. However, insolvency is also a grounds to
force
liquidation. Note that the filing of a bankruptcy petition operates as an automatic
stay,
holding in abeyance various forms of creditor action against a debtor or her
property.
Discuss the basic steps in the bankruptcy process that follow the filing of a petition
and
list
the property interests that are considered to be the estate of the petitioner in
bankruptcy.
5. Exempt Assets. Explain that fundamental human decency requires that some
debtor’s
assets not be taken from him in liquidation. Therefore, the Bankruptcy Act reconciles
the
debtor’s and the creditor’s interests by allowing the debtor to retain certain assets.
List
these exempt assets on the asset side of the balance sheet and explain why
these
exemptions are appropriate. Then see whether your state’s law provides an
alternative
exempt asset provision for debtors. Note the changes in the exemptions and their
limits
as a result of the 2005
act.
Examples: Problem Cases #1 and
2.
In Re Rogers (page 831). Where a debtor in a Chapter 7 proceeding had acquired
an
interest in property more than 1,215 days before the proceeding was commenced and
then
during the 1,215 day period declared it to be her homestead, the court allowed the
claim
of
exemption. The court observed that congress had been concerned with the
acquisition
of vest3ed economic interest during the 1,215
period-but
that in this instance
the
propert
y
interest had vested prior to that
period.
Points for Discussion: What is the rationale for the provision in bankruptcy law
that
permits the bankrupt to retain certain property, including some household goods?
Discuss
the rationale for the rule concerning acquisition of interests in real property during
the
1,215 day period immediately preceding the filing of the bankruptcy action. Also
note
that it is not illegal for the debtor to restructure his assets in contemplation of
liquidation
to better avail himself of the
exemptions.
Ethics in Action: Should the homestead exemption be limited? (page 835): This
question
raises the issue of whether the decision to strike an appropriate balance between
the
debtor
and his /her creditors as to the assets a debtor should be permitted to retain
free
from the claims of creditors should be left to the states or whether it should be limited
to
some degree by federal law. One can argue that the state legislatures should make
the
balancing decision between the assets a debtor should be permitted to retain and
the
asset
s
of a debtor that should be surrendered to the creditors. On the other hand,
because
the creditors may well be located in other states from where the debtor has
his/her
residence may mean the creditors’ position is not given sufficient weight. Should
the
answer vary from state to state–is national consistency desirable? Should the
answer
depend on the vagary of whether the debtor happened to already have his or her assets
in
exempt assets or arranges this situation in anticipation of bankruptcy? This
question
offer
s
a rich lode of considerations to develop in class
discussion.
4. The Trustee. Clarify the role of the trustee to ensure that all the debtor’s eligible
assets
are available for distribution to creditors and that only valid creditors’ claims are
paid.
Special attention should be given to defenses the trustee may assert against creditors,
for
example, fraud, misrepresentation, breach of warranty, and failure of
consideration.
5. Avoidance of Liens. Discuss the ability of the debtor to void certain liens against
exempt
properties that impair his exemptions. Note that the liens that can be avoided are
judicial
liens or non-possessory, non-purchase money security interests. Also note that
debtors
ca
n
redeem property from
creditors.
6. Voidable Preferences. Explain voidable preferences clearly, as the CPA Exam
requires
the
student’s working knowledge of voidable preferences. The purpose of the
rule–to
prevent
debtors and creditors from cheating other creditors–should be emphasized.
Note
that the
preferential period is the 90 days before the filing of the liquidation
petition.
Under the
old act it was four months. Creditor knowledge of the debtor’s insolvency
is
irrelevant.
Also mention that the preferential period is one year for insiders.
Knowledge
by the
creditor of the debtor’s insolvency is no longer
relevant.
a. Dan owes Carrie $1,500 on a two-year-old loan. Dan pays Carrie $1,500 in cash
on
May 1, when his debts exceed his assets. Dan files a petition in bankruptcy
on
August 1. (Not a voidable
preference.
)
b. Same as #a, except Dan files the petition in bankruptcy on July 15.
(
Avoidable
preference.
)
c. Same as #b, except Dan gives Carrie a security interest in his automobile instead
of
cash. (Avoidable
preference.
)
d. Same as #a, except Carrie is Dan’s sister. A voidable
preference.
)
e. Supply Co. sells Retail Co. $5,000 of merchandise on May 1, terms 2/10, net
30.
Retail pays Supply on May 30, at which time Retail is insolvent. Supply files
a
petition in bankruptcy on July 15. (Not a voidable
preference.
)
7. Preferential Liens. Discuss the activities that a debtor may engage in without the lien
(or
the payment) being considered preferential. Note that this permits a debtor to continue in
business.
8. Fraudulent Transfers. Explain the reason the trustee may recover property that
is
fraudulently transferred out of the debtor’s estate. Note that an illicit intent is
usually
required. Point out that a fraudulent transfer will bar discharge of all the debtor’s
debts.
In Re Bernard Madoff Investment Securities, LLC (page 836). The court held that
the
Trustee had sufficiently pled facts in his complaint to avoid and recover
various
fraudulent transfers made by Bernie
Madoffin
the course of his Ponzi
scheme
.
.Additional Example: Problem Case
#3.
C. Claims and Distribution of the
Estate
1. Discuss claims. Distinguish allowable, secured and priority
claims.
2. Discuss the order of priority in which the assets in the bankruptcy estate are
distributed.
D. Discharge in
Bankruptcy
1. Discharge. Discuss the nature of discharge and the rationale for it–that it gives
the
debtor a fresh
start.
2. Acts That Bar Discharge of all Debts. List the acts that bar discharge of all debts on
the
chalkboard on the liability side of the balance sheet earlier suggested as a framework
for
explaining the Bankruptcy Act. Note the purpose of this rule: to give only the
honest
debtor a fresh start and to deter the debtor from cheating
creditors.
Example for Discussion: Problem case #
4.
3.
Non-dischargeable
Debts. List on the chalkboard the non-dischargeable debts on
the
liability side of the balance sheet earlier suggested as a framework for explaining
the
Bankruptcy Act. Note the reasons these debts are not discharged, especially that
for
education loans, which is of special interest to
students.
Krieger v. Educational Credit Management Corporation (page 840):
I
n
the case,
the
court upheld the bankruptcy judge’s discharge of the debtor’s student loans,
concluding
that she had established that their repayment would constitute an undue
hardship.
Points for Discussion: Note the position taken by the concurring judge. Ask the
students
why the bankruptcy code and the courts review the potential discharge of
student
loans particularly
closely.
Examples: Problem Cases #5 and
6.
4. Reaffirmation Agreements. List affirmed debts on the chalkboard on the liability side
of
the balance sheet. Note that the new Act makes reaffirmation very difficult, evidencing
a
Congressional purpose to ensure that the debtor has a fresh
start.
5. Dismissal for Substantial Abuse. Note the provision added to the Bankruptcy Act by
the
1984 amendments that authorizes the bankruptcy court to dismiss a petition where
it
concludes a debtor is substantially abusing the bankruptcy process. Explain the kind
of
situations that led to this provision being added. The discuss the changes to
these
provisions in the 2005 act concerning the introduction of a means test that
were
controversial and the subject of an intense debate over a number of years before
being
adopted in
2005.
Chapter 30
-Bankruptcy
In re Siegenberg (page 843). The bankruptcy court dismissed the chapter case on
the
grounds that it was filed in bad faith and could also be considered to be an abuse of
the
bankruptcy
process.
Points for Discussion: Ask the students to identify the facts/elements that the court
gave
the greatest weight to in reaching its decision to dismiss the
case.
Additional Example: Problem Case
#7.
E. Chapter 11:
Reorganizations
1. Explain the rationale for the reorganization proceeding and indicate the kinds of
debtors
for whom it is
available.
2. Set out the sequence of steps in a reorganization and describe the development
and
approval of the plan. Note the two different ways that a plan may be
approved.
In
reMade
in Detroit, Inc. (page 848):
I
n
this case, the court refused to confirm
the
reorganization plan put forward by the debtor on the grounds that it was not realistic
and
sufficiently concrete to allow the court to conclude that it was
feasible.
3. Call the students’ attention to contemporary reorganizations involving
well-known
corporations and potentially controversial issues such as product liability (e.g.,
asbestos
)
or labor agreements that the corporation appears to be trying to avoid or
limit.
Ethics in Action: Using Bankruptcy to Manage Product Liability or to Change
Labor
Contracts (page 850): This problem initially raises the issue of whether a
procedure
designed for companies in financial extremism should be extended to situations where
the
company simply would be better off if it could escape some of its obligations. Is it
ethical
to try to escape commitments voluntarily made? The product liability situation
may
approach–or constitute the–situation contemplated by Chapter 11, namely that
the
company needs some time to work out of its financial difficulties and the presence of
the
bankruptcy court may provide some fairness to the competing claimants with
product
liability claims. For example, the Mabey case (problem case #8 in this edition and a
full
case in the
11th
edition) presents a very difficult policy dilemma. Viewed from a
public
health/welfare perspective and from the perspective of the those harmed, it is
probably
preferable for them to receive treatment soon while they are still in their child
bearing
years; viewed from the perspective of the policy behind the bankruptcy act, the
decision
is appropriate since it also protects the interests of the other claimants to the
bankrupt’s
assets.
4. The Global Business Environment: Transnational Insolvency Proceedings (page
852)
:
F. Chapter 12 Family
Farms
1. Discuss the rationale for providing special treatment for farmers through the Chapter
12
proceeding. Note that state exemption laws are frequently used as a means for
providing
special assistance to family farmers. Also note that the 2005 law extends
protection
under chapter 12 to family owned commercial fishing
operations.
2. Note the elements that are necessary for a farmer to be able to qualify for relief
under
Chapter 12 and describe the
process.
G. Chapter 13: Consumer Debt
Adjustments
1. Discuss the rationale for the Chapter 13 proceeding and describe the process,
including
the requirement for approval of the plan by the
court.
Chapter
30-
Bankruptcy
In re Burt (page 853). In this case, the court agreed with the contention of a creditor,
Ford
Motor Company, that its claim should not be reduced (crammed down) to the value of
the
automobile on which it held a purchase money security interest that included
some
monies owed as negative equity on a
trade-in.
Points for Discussion: Note that the courts are divided on how to handle this
issue-and
that in some other jurisdictions the court would exclude the negative balance from
the
claim secured by a
PMSI..
Example: Problem Case
#9.
2. Compare the advantages (and disadvantages) to a debtor of proceeding under Chapter
13
as opposed to Chapter 7. See the Concept Review on page
819.
N.
RECOMMENDED
REFERENCES:
A. Benjamin Weinstraub and Alan N. Resnick, Bankruptcy
Law
Manual, Warren, Gorham
&
Lamont, Inc. Discusses and explains the major provisions of the bankruptcy
law.
B. Brian Blum, Bankruptcy
and
Debtor/Creditor:
Examples
and
Explanations
(2010).
C. Douglas Baird, The
Elements
of Bankruptcy,
5th
edition (Concepts and Insights)
(2010).
D. David Buchbinder, Basic
Bankruptcy
Law
for
Paralegals (Aspen
2011
).