Decision: Affirmed. The first three liens total more than the value of the property, hence, there
was no security to cover any of the lien held by Farm. Therefore, it was not a secured debt. As an
Add. Case: SallieMae Servicing v. Banks (W.D. Va., 2001)–Banks borrowed $23,000 from
SallieMae under a student loan note. Six years later he filed a petition for Chapter 13, asking
that the obligation, which had risen to $31,571, be reduced to $4,030 and that interest and late
charges on the student loan be eliminated. The bankruptcy court approved Banks’ plan. Sallie
Mae later sent Banks a notice that he owed $43,342 on the loan. The bankruptcy court granted
Banks’ request that his obligation be limited to $4,030. Creditor appealed.
Decision: Reversed. Student loans are nondischargeable absent undue hardship. When a debtor
fails to demonstrate he would suffer an undue hardship if forced to repay his student loan, then
Issue Spotter: Credit for the Bankrupt?
It may be true that the debtors cannot file bankruptcy, but they can go so far in the hole that they
cannot pay their bills. Such creditors are, in fact, prepared to incur high costs in dealing with
such debtors–high collection costs, delays in payments, payments spread out over a long period
of time–so no, these are not a low-risk group of clients.
The Bankruptcy Proceeding—A key feature of bankruptcy is the emphasis on creditors
receiving fair treatment. Once bankruptcy is declared, creditors can not improve their positions.
Nor can the debtor improve a favored creditor’s position. The trustee sees that no creditors
improve their positions by any means. Any transfers of debtor’s property within 90 days of
bankruptcy are void.
Role of the Trustee—The trustee is in charge with the objective to maximize the amount of the
debtor’s assets for distribution to the creditors. Some of the debtor’s property (as determined by
state law) is exempt from bankruptcy. The trustee sells the debtor’s nonexempt property unless
the court orders other-wise. The proceeds are distributed with all creditors holding a claim
against the debtor entitled to share in the distribution.
Add. Case: In re EquiMed (D. Mary., 2001)–EquiMed was in Chapter 7 and a trustee
appointed. The trustee named 80 defendants in a complicated proceeding. After more than a
year, the parties reached a settlement. Creditors of EquiMed, unhappy with that, petitioned to
have the trustee removed, contending he should have pursued litigation rather than settle claims
against many parties. Failure to litigate reduced the money EquiMed could recoup, so the
creditors lost faith in the trustee.
Decision: Motion denied. A court may remove a trustee for cause. Cause is determined
case-by-case. In general, that means substantial actions that directly affect the rights and
interests of the public. There is usually misconduct or negligence. Creditors have not shown
sufficient cause for removal here. While the settlement proposed by the trustee and the many
Priority Classes of Creditors—Certain creditors take priority in receiving shares of the debtor’s
assets. Secured creditors take top priority. All creditors of a class must be paid before the next
lower-priority creditors can be paid anything. The priority classes in bankruptcy usually are as
follows:
1. Secured creditors
2. Costs of preserving and administering the debtor’s estate
3. Unpaid wage claims
4. Certain claims of farmers and fishermen
5. Refunds of security deposits
6. Alimony and child support
7. Taxes
8. General (unsecured) creditors who file a proof of claim
Discharge in Bankruptcy—The final stage is the bankruptcy discharge; the assets are liquidated
and the proceeds distributed among the creditors. The debtor is freed of debt starts anew. The
bankruptcy remains on the credit history for ten years. The discharge may be denied if the debtor
committed certain offenses including: Fraudulently conveyed property before the bankruptcy;
Refusing to answer material questions in the proceeding; Unjustifiably failing to keep financial
records; and failing to satisfactorily explain losses in assets. Some debts are not discharged by
bankruptcy. This is to discourage the use of bankruptcy to evade certain responsibilities:
Alimony and child support payments
Back taxes
Most student loans
Some debts incurred immediately before filing bankruptcy
Debts incurred by fraud against the creditors
Fines owed to the government
Add. Case: In re Kennedy (6th Cir., 2001)–Kennedy sued Mustaine for making false and
defamatory statements about her to third parties. The court held in her favor and awarded her
$65,000. Mustaine’s insurance company was held not liable for the damages because the
defamatory statements were inherently injurious and so were not covered by insurance. Mustaine
filed Chapter 7 bankruptcy and sought to discharge all debts, including the $65,000 damage
award. The bankruptcy judge held that the damage award was not dischargeable because it was
the result of “willful and malicious injury by the debtor.” The district court affirmed. Mustaine
appealed.
Decision: Affirmed. Because the tort here involved “willful and malicious injury” to the
reputation of the creditor, Kennedy, that debt is not dischargeable in bankruptcy. Only acts done
Add. Case: Citibank v. Eashai (9th Cir., 1996)–Eashai’s income was $1,200 a month. He spent
$3,300 a month, carrying the $2,100 monthly deficit on 26 credit cards. “Eashai engaged in a
credit card kiting scheme utilizing the credit available to him on his various credit cards to pay
for his living expenses and to make the minimum payments on his other credit card accounts,
including his Citibank account that is the subject of this litigation.” When he filed bankruptcy,
he owed Citibank over $22,500 ($141,000 on all credit cards). Citibank sought a determination
that his debt was nondischargeable, which the bankruptcy court so held. Eashai appealed.
Decision: Affirmed. The debt is nondischargeable because of fraud. “A debtor who uses cash
advances on one credit card to make the minimum payments on another credit card and has no
International Perspective: International Business Bankruptcy Complexities
The average bankruptcy takes 1.5 years to complete in the U.S. That is longer than in some
countries, but the cost of the proceeding is not bad among developed nations. The recovery rate
is lower in the U.S. than in some developed countries, such as the U.K. and Singapore, but much
higher than in many nations. According to the World Bank, cost and time in bankruptcy in the
U.S. is not bad.
Chapter 11—Applies to businesses that wish to remain in operation. Many businesses are worth
more if kept alive to generate revenue rather than liquidated when debts exceed assets. The
difference between the two values is the “going concern surplus.” Creditors hope to capture that
by allowing the business to stay in operation.
Reorganization—Chapter 11 stays further action by creditors. An initial hearing determines the
course of action. Usually the debtor continues to run the business as a debtor in possession under
a special duty of care to operate the business in the interest of all parties. A creditor’s committee
(made up of seven of the largest unsecured creditors) supervises management by cooperating
with the reorganized business. Any unusual action must be approved by the committee which can
replace the debtor in possession if his action’s are not in the interest of creditors.
CASE: In the Matter of Kmart (7th Cir., 2004)—Kmart owed money to thousands of suppliers.
The company requested that it be allowed to give preferential payments to “critical vendors” it
needed most to stay in operation. The bankruptcy judge agreed. Other creditors appealed this
change in the ordering of payments from the preference that would exist under usual priority
rules.
Decision: Reversed. The preferential payments that were made must be refunded since the
change in the order of payments was not justified. There is no reason for some vendors to be
Questions: 1. Assuming a vendor has no long term obligation, would they continue to sell to
Kmart if past debts were not paid?
As the judge explains–most vendors need not sell anything else unless they are paid for new
deliveries. Cash for new sales is not related to old sales–they have to be written off. So long as
2. Some critics of Chapter 11 contend that firms should be liquidated under Chapter 7, not
operate under court supervision. Can you think of the reasons for that argument?
As we see here, judges end up making complicated decisions about running a company. Buckets
of lawyers, accountants, and other experts pitch in from both sides to increase the chance of a
Add. Case: In re Gaslight Club (7th Cir., 1986)–Gaslight operated private dining clubs around
the U.S. It filed bankruptcy reorganization under Chapter 11. Fredricks, president and majority
shareholder of Gaslight, was designated debtor in possession. Gaslight lost another $1.6 million
under Fredricks. The creditors’ committee filed a motion to force Gaslight to sell some property
so that creditors could recover something. Fredricks failed to respond to the court order to sell
property and to provide a new reorganization plan. The court appointed Brandt, to be the debtor
in possession. Fredricks refused to recognize Brandt’s authority so Brandt fired Fredricks. The
debtor in possession has “full and exclusive power … to employ [and] discharge … all
managers, officers, directors, agents, employees, and servants of the debtors, as he may deem
necessary and advisable ….” Fredricks persuaded Gaslight’s board of directors to ask the court
to replace Brandt with Fredricks. They refused, leaving control with Brandt. Fredricks appealed.
Decision. Affirmed. The court may appoint a new trustee to replace the debtor in possession for
cause. “For cause would include fraud, dishonesty, incompetence, or gross mismanagement of
the affairs of the debtor by current management … or if such an appointment is in the interest of
the creditors.” The majority owners of a firm, executives, and directors are not allowed to
remain in control under reorganization if their actions jeopardize the company and creditors’
rights.
Add. Case: Bank of America v. 203 LaSalle St. Partnership (1999)–A partnership owned a
building that was mortgaged. The bank that made the mortgage was the sole creditor when the
debtor filed for relief under Chapter 11. The debtor proposed a reorganization plan under which
the partners would contribute new capital and continue operation. The bank objected, but the
court imposed a cramdown, imposing the plan on the dissenting debtor. The bank appealed the
plan.
Decision: Reversed. A debtor’s pre-bankruptcy equity holders may not, over the objection of a
senior class of impaired creditors, contribute new capital and receive ownership interests in the
Add. Case: In re Haas (11th Cir., 1998)–Haas owed the IRS $617,000 for income taxes and
$68,000 for employment taxes at the time Chapter 11 bankruptcy. The reorg plan approved by
the bankruptcy court classified the employment tax liability as a secured claim to be paid in full,
and the income tax liability as an unsecured claim. The IRS appealed this classification.
Decision: Reversed. The plan improperly changes the priorities of claims against assets. By
treating the employment “tax debt as a secured claim, rather than as a priority unsecured claim,
Add. Info.: Nonbankruptcy Alternatives—Because bankruptcy is costly and injures the
reputation of the company within the business community, financial distress is often handled
without going to bankruptcy. The options available are contractual, so they must be agreed to by
the parties involved.
Debt Composition or Extension—A business in difficulty may bargain with its creditors for relief
in the form composition (an agreement to repay some percentage of the total amount due to
relieve the debt) or extension (an agreement to allow more time to repay). Because it falls
outside the Code, any debt can be included.
Bank Workout—If debt is with a bank, extensions are often referred to as bank workouts. The
primary creditor often works with other creditors to keep the debtor in operation in hopes of
turning operations around. Additional credit may be arranged.
Assignment—Under an assignment, the debtor assigns all nonexempt assets to an assignee who
acts as a fiduciary for the benefit of the creditors. Upon assignment, the business is terminated.
The assignee liquidates the assets and distributes the proceeds to the creditors according to their
agreement. Creditors voluntarily accept partial payment of the sums they are owed as
satisfaction for their debts.
Discussion Question
Under the bankruptcy law, individual and company debtors may discharge debts in bankruptcy
courts. Debtors may chose to liquidate their assets under Chapter 7, reorganize their finances
under Chapter 11, or adjust their debt under Chapter 13 of the Bankruptcy Code.
(a) Bankruptcy under Chapter 7—A debtor may initiate a voluntary bankruptcy proceeding (the
most common approach; called straight bankruptcy) or creditors may initiate an involuntary
proceeding. To initiate a voluntary proceeding, a consumer files a bankruptcy petition in federal
court and is declared bankrupt. Creditors meet to determine the state of finances of the debtor,
such as, who is owed money, what property the debtor owns, and what the current income and
expenses of the debtor are. Creditors file bankruptcy petitions in involuntary bankruptcies. Total
claims must be more than $5,000. If the petition is unchallenged by the debtor, the debtor’s
property is subject to the jurisdiction of the court.
(b) Chapter 13 Option—Chapter 13 proceedings are less costly than Chapter 7 proceedings and
are used by about 30 percent of persons filing for bankruptcy, but that should be rising sharply.
Chapter 13 is available to individuals only, not corporations. Debtors file a plan to pay these
debts within three to five years. A court-appointed trustee supervises the pay off.
(c) Chapter 11 Bankruptcy—Chapter 11 bankruptcies are filed by businesses for the most part.
Chapter 11 allows businesses to stay in operation, and pay some portion of their debt, while they
reorganize. Remaining debts are discharged. The same hierarchy of creditors as is used in
Chapter 7 proceeding is used here. The theory behind this proceeding is that more debts will be
paid if businesses are allowed to stay in operation, than if forced to liquidate all assets and shut
down.
Case Questions
1. (answer on Internet for students) Judgment for defendant. “As opposed to instruments such as
ordinary checks, which are typically made payable to the order of a specific person and are
therefore knows as ‘order paper,’ bearer paper is payable to the ‘bearer,’ i.e., whoever walks in
carrying (or ‘bearing’) the instrument.” As UCC § 3-111 states, “an instrument is payable to
2. Affirmed. The bank was negligent in accepting checks made out to LaCombe with forged
endorsements for deposit in the account of another person. The bank failed to follow its own
3. (answer on Internet for students) No. The surety bond, in statute and in form, specifically
states that it covers retail sales, that is, final sales to customers. Elworth bought the motorcycles
4. Pitassi is liable. UCC 3-415 states “When the instrument has been taken for value before it is
due, the accommodation party is liable in the capacity in which he has signed even though the
5. (answer on Internet for students) No, Moody was a co-maker of the notes, he was not a surety,
and so he could not claim the status of a surety. He was fully liable to the other makers who
covered his share of the payments due to the lender. His obligation was to the lender; any fight
6. No, ServiceMaster loses. “Home repair contractor who declines to pursue statutory and
constitutional lien remedies cannot recover under equitable theories [unjust enrichment] from
homeowner’s insurer for failure to include contractor’s name on a fire loss settlement check.”
There was no contract between Sentry and ServiceMaster, so there was no basis for breach of
7. “The problem with the bank’s argument … is that the debt was in fact discharged. By failing
to raise the question before the Bankruptcy Court in the original proceeding, the bank through its
“Alternatively, the bank argues that the debt was never included in the Chapter 13 Plan, and
therefore exempt from discharge. But, the Bankruptcy Court made a factual finding that all three
“The debt, therefore, falls into none of the categories of debts which are not subject to discharge,
and the bank should not have attempted to collect the claimed indebtedness after the discharge
8. (answer on Internet for students) No, the Wisconsin lien for wages is void. The bankruptcy
trustee controls the bankrupt estate under the federal bankruptcy code and will pay the debts
9. Yes, her debts were forgiven. “Undue hardship” requires a three-part showing (1) that the
debtor cannot maintain, based on current income and expenses, a “minimal” standard of living
The court found that to apply here—she had diligently sought employment but never found
Ethics Question
Under the Bankruptcy Code, a debtor’s petition in bankruptcy may be a nondischargeable debt if
the debtor’s behavior is judged to be “willful and malicious.” The court ruled that the debtor was
“At least three times since the Code of 1978 went into effect has this Court wrestled with the
term ‘willful and malicious.’ These cases each recognizes the proposition that personal ill will
towards the injured party is not a requirement of the Code. Willful means done with the will or
While drunken driving is not per se willful and malicious conduct, “the circumstances must show
a defendant’s driving to be of such a gross nature as to imply malice.” Wooten’s gross
misconduct in this case sets it apart. Jill and Kevin Prosch were not the object of specific malice,
only the victims of Wooten’s intentional misconduct. His willfulness and maliciousness lay in the
fact that he intentionally intoxicated himself and then drove a “lethal weapon” through the streets
Essay Questions from Cases
Egebjerg filed a voluntary Chapter 7 bankruptcy petition on December 31, 2006. He earned a
gross income of $6,115.56 per month; was single and had no assets. He had unsecured consumer
debt of $31,000. Two years before, he had taken a loan from his retirement plan. The plan
automatically deducted $734 from his paycheck each month to repay the loan, which was
scheduled to be repaid in September 2008. According to Egebjerg’s schedule of necessary
expenses, which included the retirement fund repayment, he was left with a monthly disposable
income of $15. The trustee moved to dismiss the Chapter 7 petition, arguing that the retirement
fund repayment was not a necessary expense. With that subtracted from his expenses, Egebjerg’s
filing was an abuse of the means test. The bankruptcy court agreed and ordered Egebjerg to
convert his filing to Chapter 13. Under that, he could pay unsecured creditors $525 a month and
could make smaller payments toward repaying his retirement fund. Egebjerg appealed; does he
have the right to repay the sums into his retirement fund? [Egebjerg v. Anderson, 574 F.3d 1045,
9th Cir, (2009)]
Answer: Affirmed. Payments made on a loan from a debtor’s retirement account cannot be
deducted in performing a Chapter 7 means test. Such payments may not be classified as “other
Susan Krieger had about $25,000 in student debts. It had been 11 years since she graduated from
college. She never found work in the field for which she was trained and was destitute, living
with her aged mother in a rural area. She applied to have the student debt forgiven under the
“hardship” exception. Do you think that would apply in this case? [Krieger v. Educational Credit
Management Corp., —F.3d—, 7th Cir. (2013)]
Answer: Reversed. An above-median income Chapter 7 debtor who has no monthly vehicle loan
expense may still claim a vehicle ownership expense deduction when calculating his disposable
Internet Assignment
Texas Secretary of State:
www.sos.state.tx.us
United States Courts, Bankruptcy:
www.uscourts.gov/FederalCourts/Bankruptcy.aspx
Dun & Bradstreet:
www.dnb.com/us/
The Texas Secretary of State office as well as those of other states posts instructions for filing
financing forms that comply with the UCC. At the U.S. Courts Bankruptcy website, you can find
an overview of the Bankruptcy Court system as well as access to many bankruptcy forms, Lastly,
for an overview of some commonly used business credit services, see the Dun & Bradstreet
website. Many services are for a fee, but the site explains the services.