978-0077733735 Chapter 21 Lecture Notes

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Chapter 21 – Bankruptcy Law: In Theory, in History, and in Practice

Chapter 21

Bankruptcy Law: In Theory, in History, and in Practice

I. Key Terms

Automatic stay (p. 501) Impaired classes (p. 508)

Case trustee (p. 500) Liquidation (p. 496)

Confirmation (p. 508) Means test (p. 497)

Debtor in possession (p. 506) Order for relief (p. 499)

Disposable income (p. 499) Reorganization (p. 505)

Homestead exemption (p. 501)

II. Learning Objectives

1. Summarize the history of bankruptcy law in the United States.

2. Discuss federal and state control of bankruptcy law.

3. State the criteria necessary to be eligible to file voluntarily for Chapter 7 bankruptcy.

4. Explain the “means test” that is required for filing Chapter 7 bankruptcy.

5. State the criteria necessary for creditors to force debtors into involuntary bankruptcy.

6. Distinguish between an order for relief and automatic stay in the bankruptcy process.

7. List the federal exemptions debtors can exclude from the bankruptcy process.

8. Recognize those debts that have priority payment status under the Bankruptcy Code.

9. Explain Chapter 11 bankruptcy, emphasizing the reorganization process.

10. Discuss the requirements for Chapters 12 and 13 bankruptcy.

III. Major Concepts

21-1 The Checkered History of Bankruptcy in the United States

The final version of the bankruptcy clause is found in the U.S. Constitution in Article I,

Section 8, Clause 4, which states that Congress has the power to “establish . . . uniform

laws on the subject of Bankruptcies throughout the United States.” The clause empowers

Congress to pass bankruptcy laws without actually requiring that Congress do so. The

open-ended nature of the bankruptcy clause has led to periods in history during which no

federal bankruptcy law was on the books. It wasn’t until 1898 that permanent bankruptcy

legislation came about in the United States, with a law that gave businesses protection

from creditors and lasted, with modifications during the Great Depression, for 80 years.

The Bankruptcy Reform Act of 1978 brought major changes, making it easier for

businesses and individuals to obtain bankruptcy relief. In 1978, Chapters 11 and 13 of the

Bankruptcy Code were created. The 1994 Bankruptcy Reform Act created the National

Bankruptcy Review Commission. In 2005, following a period of easy credit with many

people spending far above their means, Congress made it more difficult to declare

bankruptcy by enacting far-reaching changes to the Bankruptcy Code.

21-2 Liquidation – Chapter 7, Bankruptcy Code

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Chapter 21 – Bankruptcy Law: In Theory, in History, and in Practice

Chapter 7 of the Bankruptcy Code covers ordinary bankruptcy, which is also called

liquidation. To qualify, debtors must pass a means test, undergo counseling, provide a

federal income tax return, and take a course in financial management. A case trustee sells

the debtor’s property and uses the cash to pay creditors a portion of the amount owed to

each one. The process can be either voluntary or involuntary.

21-3 Reorganization- Chapter 11, Bankruptcy Code

Reorganization under Chapter 11 of the Bankruptcy Code allows businesses to

overcome financial difficulties without selling all their property. Instead, a

reorganization plan is drawn up that changes the debtor’s payment schedule. The new

schedule allows the debtor to keep the business going while paying creditors.

21-4 Family Farmer or Fishing Business Debt Adjustment – Chapter 12, Bankruptcy

Code

Chapter 12 of the Bankruptcy Code applies to family farmer and fishing businesses in

financial difficulty. Under Chapter 12, a family farmer or fishing business can maintain

the activity while following a debt adjustment plan to satisfy creditors.

21-5 Individual Debt Adjustment – Chapter 13, Bankruptcy Code

Chapter 13 of the Bankruptcy Code applies only to individual debtors with established

steady incomes. Such debtors can prepare a debt-adjustment plan that will provide for

repayment of outstanding debts.

IV. Outline

I. The Checkered History of Bankruptcy in the United States (21-1)

A. Reengineering the Constitution

1. The bankruptcy clause in the U.S. Constitution is part of the effort of the framers to

insulate the leadership of the new republic from the influence of the people.

2. Article I, Section 8, Clause 4 states that Congress has the power to “establish…

uniform laws on the subject of Bankruptcies throughout the United States.”

B. Federal Control of Bankruptcy

1. It can be argued that uniform national bankruptcy law for reasons including

consistency, uniformity, and justice.

2. The framers also added the bankruptcy provision as a measure to ensure the moneyed

elite would have access to a legal process to help them get their money back from

delinquent debtors.

3. In No. 10 of the Federalist Papers, Madison does not directly write about bankruptcy,

but he expresses a desire for a republic rather than a democracy so that the minority

moneyed class can be protected from the majority working class.

C. Gaps in Federal Bankruptcy Law

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1. The open-ended nature of the bankruptcy clause, which does not require that

Congress pass bankruptcy laws, has led to periods in history during which no federal

bankruptcy law was on the books.

2. The first federal bankruptcy law in the United States was enacted in 1800 and lasted

three years before it ws repealed.

3. In 1840 debtor’s prisons were abolished in the United States, and a year later a second

bankruptcy law was passed lasting two years.

4. Congress enacted a third bankruptcy law in 1867 that lasted eleven years.

5. In 1898 permanent bankruptcy legislation came about in the United States with a law

that gave businesses protection from creditors and, with modifications, lasted for

eighty years.

6. The Bankruptcy Reform Act of 1978 brought major changes.

7. The 1994 Act continued honing the law and created the National Bankruptcy

Commission.

8. In 2005 Congress made it more difficult to declare bankruptcy.

D. State Control of Bankruptcy

1. In the absence of any federal law covering bankruptcy, the states are free to enact

their own bankruptcy law.

2. Once Congress passes a bankruptcy law, state laws are not declared null and void, but

are, instead, frozen in legal suspended animation until Congress either abolishes or

amends the bankruptcy law.

3. States can plug their own provisions into state statutes that cover anything not

covered by federal law, just so long as the state laws do not impair contracts

4. States are without the power to create any bankruptcy law that impacts property

outside their boundary lines or that diverges from federal bankruptcy laws.

5. States that must be involved in a bankruptcy proceeding are required to obey the

mandates of the federal bankruptcy court.

6. Any state law that touches on bankruptcy and outlaws fraudulent transfers will be in

accord with federal bankruptcy law, since both seek to stop fraud.

II. Liquidation – Chapter 7, Bankruptcy Code (21-2)

A. Introduction

1. Chapter 7 provides a system in which debtors are forced to sell much of their property

and use the cash to pay their creditors a portion of the amount owed.

2. The process of selling assets to pay creditors is called liquidation.

B. Commencing the Action

1. The debtor may be an individual, partnership, corporation, or other type of business.

2. The process may be voluntary or involuntary.

3. Requirements for filing a voluntary petition are as follows:

a. The debtor satisfies the means test.

b. The debtor meets with an approved nonprofit credit counselor before filing for

bankruptcy.

c. The debtor provides a federal income tax return for the most recent tax year.

d. The debtor takes a course in financial management after filing for bankruptcy.

4. The means test consists of three steps, the passing of any one of which allows the

debtor to file for Chapter 7.

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5. Debtors who do not qualify for Chapter 7 relief may be able to proceed with another

form of bankruptcy.

6. In order to file for bankruptcy, debtors file official forms with the nearest U.S.

Bankruptcy Court.

7. Under Chapter 7 of the Bankruptcy Code, creditors may be able to force debtors,

other than farmers, into involuntary bankruptcy if the debtor fails to pay bills

generally as they become due.

C. Order for Relief

1. An order for relief is the court’s command that the liquidation begin.

2. In a voluntary filing, the petition itself becomes the order for relief.

3. In an involuntary case, the court does not issue the order immediately because the

debtor is allowed a certain period of time in which to contest the filing.

4. When an order for relief is issued, a case trustee is named by the court who has

responsibilities including liquidating the assets of the debtor for the benefit of all

interested parties.

D. Automatic Stay

1. When a voluntary or involuntary petition is filed, an automatic stay goes into effect.

2. This is a self-operating postponement of collection proceedings against the debtor

except debt resulting from the following:

a. Fraud.

b. Amounts owed for back taxes.

c. Family support.

d. Student loans that do not impose a hardship on the debtor.

E. Federal Exemptions

1. Under the fresh-start approach of the federal Bankruptcy Code, debtors are permitted

to exempt or exclude certain items of property from the bankruptcy process.

2. Exemptions are subject to adjustment to reflect changes in the Consumer Price Index.

3. Exemptions can be doubled for married couples who file jointly.

4. Exemptions include the federal homestead and household exemptions, exemptions for

necessities, exemptions for certain benefits and support payments.

F. State Exemptions

1. The Bankruptcy Code allows states to use a list of exemptions created by the state

legislature rather than the federal exemptions.

2. Every state has its own set of bankruptcy exemptions.

3. States are permitted to give debtors a choice of using the state’s exemptions or

requiring debtors to take the state exemptions.

G. Trustee’s Duties

1. After the order for relief is granted, a trustee will be appointed to take control of the

debtor’s property.

2. The trustee may avoid certain payments or transfers made by the debtor, operate the

business of the debtor for a limited time if approved by the bankruptcy court, and sell

the debtor’s property to obtain cash to be paid to creditors.

3. The Bankruptcy Code provides a priority list that indicates which categories of debts

are paid first.

4. Most secured creditors have the right to take collateral to satisfy debts secured by the

collateral.

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H. Exceptions to Discharge

1. Once the trustee completes the required steps, with some exceptions, debts are

discharged even if there was not enough money to pay them.

2. Certain debts arising from misconduct of the debtor, such as debts arising because of

the debtor’s fraudulent behavior, cannot be discharged.

3. Certain debts that the debtor owes the government and several types of court-enforced

debt, such as alimony and child support, cannot be discharged.

4. Debts that were not discharged under a previous bankruptcy cannot be discharged.

5. Bankruptcy debtors may not discharge excessive expenditures occurring around the

time of the bankruptcy filing.

I. Restoring Credit Following Bankruptcy

1. A personal bankruptcy filing remains on a debtor’s credit report for 10 years and has

a detrimental effect on the ability to establish a line of credit.

2. In bankruptcy a good number of debts become discharged, which improves the

debtor’s debt-to-income ratio—a factor that potential creditors look at carefully.

3. Many debtors switch from credit cards to debit cards.

4. Some banks offer secured credit cards through which customers deposit money in the

bank to guarantee that their credit charges will be paid.

5. Credit card issuers sometimes allow debtors to continue using their credit cards if

they agree in writing, after the bankruptcy filing, to pay off the old debt.

6. People who are able to make a down payment and have steady income may be

eligible for a mortgage loan as soon as two years following a discharge in bankruptcy.

III. Reorganization – Chapter 11, Bankruptcy Code (21-3)

A. Structure

1. Chapter 11 of the Bankruptcy Code provides a method for businesses to reorganize

their financial affairs and still remain in business.

2. In a reorganization a qualified debtor creates a plan that alters the repayment

schedule.

3. Chapter 11 filing is available to sole proprietors, partnerships, and corporations

(except for commodity brokers and stockbrokers) and may be either voluntary or

involuntary.

B. Special Features of Chapter 11

1. A debtor is referred to as a debtor in possession because the debtor keeps possession

and control of the assets, continues to run the firm, and performs most of the

functions that a trustee performs in other types of bankruptcy.

2. A trustee may be called in if there are problems.

3. When an order for relief is filed, an automatic stay goes into effect.

C. The Reorganization Plan

1. The debtor has the exclusive right to file a reorganization plan for 120 days, which

may be shortened or lengthened by the court.

2. When the exclusive period ends, creditors (and the trustee, if any) can file competing

plans.

3. A creditors’ committee is appointed to investigate the operation of the business and

assist the debtor in possession in developing and administering a reorganization plan.

4. A bankruptcy plan will group claims against the debtor into the following classes:

a. Secured creditors.

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b. Unsecured creditors entitled to priority.

c. General unsecured creditors.

d. Equity security holders, such as shareholders and limited partners.

5. The law requires equal treatment for all creditors grouped in a class.

6. If the plan has not changed the legal rights of the members of a class, then no

approval is required from that class.

7. Impaired classes, those whose creditors receive less than the full value of their claims,

have the right to vote on the plan.

8. In the case of individual debtors, the plan cannot be confirmed over a creditor’s

objection without committing all of the debtor’s disposable income over the next five

years.

9. The court will hold a hearing on the confirmation of the reorganization plan.

10. A confirmation officially places a plan in operation.

11. The debtor is discharged from any debts that arose before the date of confirmation.

IV. Family Farmer or Fishing Business Debt Adjustment – Chapter 12, Bankruptcy Code (21-4)

A. Qualifications

1. The Family Farmer or Fishing Business Debt Adjustment Act is designed to help

farming and fishing proprietors, with regular income, create a plan for debt repayment

that will allow them to keep their family businesses running.

2. The law imposes eligibility requirements involving business operation and debt.

B. Chapter 12 Procedures

1. A filing under Chapter 12 creates an automatic stay of the collection of most debts.

2. Creditors may ask the court to exempt them from the stay, but the creditors would

have to show why the court should exempt them.

3. The court will appoint a trustee to handle the finances of the farm or fishing business.

C. The Chapter 12 Plan

1. Unless an extension is granted, the debtor has only 90 days to devise a reorganization

plan.

2. The law has requirements regarding payment and priority including that the plan

provide for payments to the trustee on a regular basis over a three-year period.

3. Within 45 days after the plan’s filing, the bankruptcy judge holds a confirmation

hearing to decide whether the plan is feasible and follows the standards of the

Bankruptcy Code.

V. Individual Debt Adjustment – Chapter 13, Bankruptcy Code (21-5)

A. Background

1. Chapter 13 of the Bankruptcy Code permits an individual debtor to put in place a

repayment plan.

2. Only individual debtors, including sole proprietors and self-employed people, can

take advantage of Chapter 13 provisions.

3. Requirements regarding the amount of allowable debt are in place.

4. If the Chapter 13 does not work out, under certain circumstances, the individual may

be allowed to convert to a Chapter 7 bankruptcy.

B. The Chapter 13 Plan

1. It is the debtor’s responsibility to file a debt readjustment plan under Chapter 13.

2. The plan must meet certain requirements including that the payments either satisfy all

debts or consist of all of the debtor’s disposable income during the plan’s period.

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3. Priority debtors must receive full payment.

4. The plan must be completed within three to five years.

C. Plan Confirmation

1. Chapter 13 creditors have no prior input while the plan is being created.

2. Chapter 13 will not allow the court to approve an objection if the debtor plans to turn

over100 percent of all disposable income to the trustee for debt repayment.

3. Alimony, child support, retirement account payments, long-term debts covered in the

plan and some tax claims must be satisfied in full, but every other debt may be

discharged.

V. Background Information

A. Cross-Cultural Notes

1. In Great Britain, you must owe at least $5,000 pounds to declare yourself bankrupt.

More information regarding bankruptcy in Great Britain is available at

https://www.gov.uk/bankruptcy/overview.

2. China’s Enterprise Bankruptcy Law came into effect in 2007, and there have been

some inconsistencies in its application. As China’s economic slowdown continues,

lawyers expect to see in increase in bankruptcy filings there. For more information

see “Amid China Slowdown, Foreign Creditors Face Bankruptcy Riddle” at

http://www.reuters.com/article/2015/05/18/us-china-debt-bankruptcy-idUSKBN0O30

0120150518.

B. Historical Notes

1. Samuel Clemens (Mark Twain) put up $250,000 to back a new printing invention—

the Paige typesetter. When the typesetter failed, Twain’s losses caused him to file for

bankruptcy. P.T. Barnum had made millions exhibiting human oddities and wild

animals, but unwise investments forced him to go bankrupt (he later recovered and

created “The Greatest Show on Earth”). In 1923, young Walt Disney completed

bankruptcy proceedings for his Laugh-O-Gram Corporation, which he had founded in

1921 using $15,000 from investors. Shortly thereafter, he left for Hollywood with a

few clothes and some drawing materials.

2. During the first 100 years after the Constitution gave Congress the right to enact

bankruptcy laws, few were passed. At the time, bankruptcy was seen as immoral.

However, after a period of financial panic in 1893, a permanent bankruptcy law was

passed in 1898 that allowed businesses and individuals to erase their debts by paying

what they could and liquidating. The law was amended in 1938 to include a

reorganization option.

C. State Variations

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1. The amount of a person’s homestead exemption varies from state to state. Arizona

allows a homestead exemption of $150,000, while Wyoming allows a homestead

exemption of $20,000 for an individual.

D. Quotations

1. Charles Fox, an English statesman, owed a great deal of money. His father once asked

him how it was possible for him to sleep or enjoy the comforts of life when he owed

so much money. “Your lordship need not be in the least surprised.” Fox answered his

father. “Your astonishment ought to be how my creditors can sleep.”

VI. Terms

1. Chapter 13 bankruptcy is sometimes referred to as “wage earners’ bankruptcy.”

VII. Related Cases

1. In Ice House America, LLC v. Cardin, 751 F.3d 734 (6th Cir. 2014), the court ruled

that the 2005 amendments to the Bankruptcy Code did not abrogate the

absolute-priority rule as applied to pre-petition property of individual debtors filing

for bankruptcy under Chapter 11. (The individual debtor could not file under Chapter

13 because his debts were too large.) The absolute-priority rule provides that

unsecured creditors must be paid in full before the debtor can retain any property

under a plan of reorganization. The Court ruled that in a Chapter 11 case, the

absolute-priority rule applied to property held by the debtor when the case was

commenced, pre-petition property, but not to property acquired after the

commencement of the case.

2. Examples of bankruptcy fraud investigations of the IRS may be found at

https://www.irs.gov/uac/Examples-of-Bankruptcy-Fraud-Investigations-Fiscal-Year–2

015.

VIII. Teaching Tips and Additional Resources

1. Information regarding U.S. bankruptcy courts is available on the Internet site of the

U.S. Courts at http://www.uscourts.gov/FederalCourts/Bankruptcy.aspx. The site also

includes a link to a section titled “Bankruptcy Basics.”

2. An interesting article for class discussion titled “Famous Men, Not-So-Famous

Bankruptcies” discussing famous people in addition to those named in the text who

have filed for bankruptcy can be found at

http://www.boston.com/business/gallery/famous_bankruptcies/.

3. At article titled “The 7 Pillars of Responsible Credit Card Management” can be found

on the website of Fox News at

http://www.foxnews.com/story/0,2933,293221,00.html.

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4. The Federal Reserve has an article on credit card agreements at

http://www.federalreserve.gov/creditcard/.

5. Discuss the dangers of excessive credit card debt. The College Board has an article

on “How to Use Credit Cards Wisely” at

http://www.collegeboard.com/student/plan/college-success/9139.html.

6. At http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre41.shtm, the Federal Trade

Commission has an article titled “Filing for Bankruptcy: What to Know.”

7. The Federal Trade Commission has a site dedicated to managing money and dealing

with debt at http://www.ftc.gov/bcp/edu/microsites/moneymatters/index.html.

8. The Securities and Exchange Commission has information regarding corporate

bankruptcies at http://www.sec.gov/investor/pubs/bankrupt.htm.

9. Assign a short research paper on the history of bankruptcy laws with an emphasis on

how the laws have responded to the various economic problems of the country.

10. Show students the forms that are used in filing for bankruptcy. These can be obtained

on the Internet by going to

http://www.uscourts.gov/FormsAndFees/Forms/BankruptcyForms.aspx.

11. Chapter 7 bankruptcy can be filed only once in an eight-year period, beginning from

the date of the original application. With exceptions, the court must dismiss a

voluntary case if requested to do so by a victim of a crime of violence or a drug

trafficking crime by an individual debtor convicted of the crime.

12. Emphasize to your students that the automatic stay is one of the most crucial aspect of

bankruptcy law. It forces creditors to immediately stop harassing debtors. Violations

of the automatic stay meet with very severe penalties.

13. Ask students for which debts a bankrupt person should be held liable. Make a list of

the exemptions a debtor is actually allowed and compare it with the examples of debts

that the students produced. Solicit opinions about why the law permits certain

exemptions and not others.

14. Inform students that businesses can declare bankruptcy to avoid paying claims to

injured employees and consumers. Have students research recent large company

filings and prepare reports to be presented in class.

15. Explain to students that student loans are not dischargeable under bankruptcy unless

certain criteria are met.

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16. Make sure students are aware that Chapter 11, like Chapter 7, can be commenced

either voluntarily or involuntarily.

17. Inform students that based on federal and state law, only certain amounts may be

withheld by garnishment for debts or other obligations.

18. Chapter 13 is open to sole proprietors as well as wage earners—those whose principal

income is derived from wages, salary, or commission. However, neither stockbrokers

nor commodity brokers may file under Chapter 13. Challenge the class to discover

why.

19. As a form of review, list each of the chapter bankruptcies on the chalkboard and ask

students to list under each chapter who can file under that chapter and under what

restrictions. Then have them list the pros and cons of declaring that chapter

bankruptcy.

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