978-1285770178 Lecture Note Unit 5

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Focus on Ethics:

Creditors’ Rights and Bankruptcy

INTRODUCTION

Today, debtors are in a more favorable position than when debtors’ prisons existed. A debtor may accuse a

creditor of fraud, negligence, breach of contract, breach of the duty of good faith, or some other claim that may render

a debt uncollectible. A debtor can file for protection under bankruptcy law. Some say, however, that it is too easy to

avoid paying debts. Discharging a debt on a creditor’s technical violation, many would claim, is unfair to the creditor.

What also seems unfair is the ease with which debtors can enter into bankruptcy.

Some of these criticisms were addressed in the Bankruptcy Abuse and Consumer Protection Act (BACPA) of

2005. But it is difficult to ensure the rights of debtors and creditors simultaneously, and the law is still sometimes seen

as unfair to debtors. Critics of BACPA claim that the pendulum is swinging too far in towards favoring the rights of

creditors. There is no way in which the law can protect debtors and creditors at all times under all circumstances.

Tradeoffs are made to balance the rights of both groups, and tradeoffs often lead to questions of fairness and justice.

2 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

FOCUS OUTLINE

I. “Self–Help” Repossession

The UCC’s “self–help” provision [UCC 9–503] simplifies the process of repossession for creditors and reduces

the burden on courts. Because the UCC does not define “breach of the peace,” it is not always easy to predict

what will or will not constitute a breach of the peace. Occasionally, confrontation between debtor and creditor

can lead to a distressful situation (the text provides an example), but debtors are exposed to occasional

abuse and violence resulting from self-help repossessions so that the rights of creditors to collect on their

debts quickly and without legal proceedings may be protected.

II. Ethics and Bankruptcy

Bankruptcy law is a balancing act between providing debtors’ a fresh start and ensuring that creditors get “a

fair shake.” The total number of bankruptcies has increased dramatically over the last thirty years. From the

point of view of a creditor, once a debtor is in bankruptcy, the asset that secures the debt often has a

diminished value, or no value. The easier it becomes for debtors to use bankruptcy laws, the greater may be

the incentive to do so. BACPA was intended, in part, to change this situation.

III. Bankruptcy and Economics

Bankruptcy shifts the cost of a debt from a debtor to a creditor (creditors rarely recover their money once a

debtor files for bankruptcy). To compensate, creditors increase their interest rates, require more security

(collateral), or are more selective in granting credit. Thus, debtors who will never be in bankruptcy may be

worse off. Ethical concerns must be tempered with economic concerns.

A. CONSEQUENCES OF BANKRUPTCY

Bankruptcy is never easy for debtors. Many feel a sense of shame and failure when they petition for it.

There are more concrete consequences—blemished credit ratings for up to ten years, higher interest

charges for new debts, and so on. Debtors may find it difficult to get jobs. A private employer may refuse

to hire an applicant who has filed for bankruptcy. Because of these consequences, debtors do not

always get the “fresh start” promised by bankruptcy law.

B. INVESTMENT RISK MANAGEMENT AND BANKRUPTCY

Before the recession, some investors chose to invest a significant amount of their funds in risky

propositions with a potential for extraordinary gains. Without diversifying their portfolios or holding funds

in reserve—and sometimes borrowing additional funds—these investors were unable to pay their debts

when the market fell during the recession and filed for bankruptcy. The overdependence on credit and

overconfidence in investments contributed to the global economic crisis that followed. This situation

underscores the importance of self-sufficiency and minimizing debt as a hedge against market

fluctuations and bankruptcy.

TEACHING SUGGESTIONS

1. Discuss the historic and policy reasons behind debtor-creditor law, including the drafting of the UCC’s

Article 9, and the development of bankruptcy law in the United States. Mention the problems of debtors under

English law in the eighteenth and nineteenth centuries, including debtors’ prisons, and explain that in this

country the goal was to give an honest debtor a fresh start. Article 9 simplified what had become a morass of

UNIT FIVE: FOCUS ON ETHICS—CREDITORS’ RIGHTS AND BANKRUPTCY 3

law. Under the Bankruptcy Reform Act of 1978 and the Bankruptcy Reform Act of 2005, bankruptcy is not

now seen as a debtor’s right, but is interpreted as a process to meet debtors’ needs while preserving the

rights of creditors.

2. Point out that questions of fairness often arise when two or more creditors claim rights in the same

collateral. Article 9, by establishing the order of priorities that apply in such situations, has attempted to

resolve priority disputes as equitably as possible. Still, situations arise in which there appears to be no way to

avoid seemingly unjust results. For example, imagine that a dishonest debtor defrauded a seller to obtain

possession of jewelry that he then sold to a pawnbroker. The jeweler filed a financing statement to perfect its

interest in the goods, but the pawnbroker took possession of the jewels to protect its interest. This would give

the pawnbroker’s interest priority (the debtor would have had voidable title under UCC 2–403(1), and a

person with voidable title can transfer good title to a good faith purchaser for value).

3. Students may be interested to know that unless repaying government-guaranteed student loans creates

an undue hardship, the loans are not dischargeable in bankruptcy. The policy is that the public should not

have to bear the burden of covering, through taxes, these loans. In effect, this shifts the burden of student-

loan default to other creditors (for whom there may not be enough assets to pay). Some courts have held that

giving student loans priority unfairly discriminates against unsecured creditors.

4. Discuss the ethics involved in reaffirmation agreements. This may be part of the motivation for bankruptcy

reform’s mandating a long list of disclosures before debtors agree to reaffirm debts and for the act’s requiring

attorneys to verify their clients’ representations in those agreements. When debtors run up credit-card bills,

anticipating that they cannot pay the charges, is this fraud? Some courts hold that this is intent, for

purposes of a fraud action. Other courts say no. If a debtor agrees to pay this credit-card debt when it

could have been discharged in bankruptcy, what ethical questions arise? If a debtor agrees to pay

this debt after it has been discharged in bankruptcy, is this illegal? Is it unethical?

Cyberlaw Link

Would it violate a debtor’s privacy to post his or her name on the Web if the debtor declares

bankruptcy? Why or why not?

ADDITIONAL QUESTIONS

1. When a debtor defaults, how does a lender recoup the loss? A lender imposes the cost on other debtors

in the form of higher average interest rates. The more loans not repaid, the larger the risk factor to add to interest

2. What is the rationale behind the law giving creditors a right of “self–help” repossession? The rationale

without judicial process—is that it simplifies the process of repossession and reduces the burden on courts. What is

the trade-off in these situations? The tradeoff here is that debtors are occasionally exposed to abuse and violence

resulting from self-help repossessions so that the rights of creditors to collect on their debts quickly and without legal

4 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

3. How are creditors’ interests protected in a debtor’s sale of collateral? Creditors’ interests are protected

by the law’s giving them a security interest in the proceeds from the sale of the collateral. Proceeds include “whatever

4. Are creditors’ interests in goods protected if the goods are mixed with other goods and cannot be

identified, or if raw materials are processed into a finished product? Yes. If goods in which there is a security in–

5. Discuss situations in which creditors’ interests in specific goods may not be protected. When the

goods in which a creditor has a security interest is feed for farm animals, the interest may be lost when the feed is

consumed. It has been held that an interest in feed ends when hogs eat the feed, because the hogs were the same

before and after feeding, and thus there were “no traceable proceeds.” Another example in which a creditors’ security

6. What does bankruptcy law attempt to do for creditors? Bankruptcy law attempts to provide a fair means

does bankruptcy law attempt to do for debtors? Bankruptcy law attempts to provide relief and protection—a “fresh

start”—to debtors who “get in over their heads.” What is the trade-off in this situation? The easier it is for debtors to

hide behind bankruptcy laws, the greater is the incentive for debtors to use those laws to avoid paying their debts and

7. Do interest rates affect the numbers of bankruptcies? Before the recession, some observers argued that

bankruptcies were caused by interest rates that were too high and the constant promotion of credit. In other words,

creditors—particularly banks and credit-card companies—were a cause of an increase in bankruptcies. These

creditors supported enactment of the Bankruptcy Reform Act of 2005 to decrease the number of discharges and force

credit-card companies thus have an ethical obligation to pass these savings to consumers by charging lower

interest rates?

8. Is it fair to increase the costs for debtors seeking bankruptcy relief? The Bankruptcy Reform Act of 2005

increased the costs to debtors of filing for bankruptcy. The filing fees were raised, but the major increase occurred in

UNIT FIVE: FOCUS ON ETHICS—CREDITORS’ RIGHTS AND BANKRUPTCY 5

9. What effect might the increased costs of attorney-assisted bankruptcy filings have on filings by

debtors? Many suggest that the bankruptcy courts will become more clogged with debtors filing pro se—that is,

without the assistance of attorneys. These debtors may fill out their own forms, possibly downloaded from a Web site

or bought in an office-supply store, and appear on their own behalf. This may place the onus on judges to guide these

ACTIVITY AND RESEARCH ASSIGNMENT

Have students research what credit is (borrowing power) and what it does (increases turnover in the sale and

purchase of commodities and the rate of the production of wealth). Ask students whether they agree that credit bene-

fits society. How would our standard of living change if we reverted to a system based solely on coins or

bartering? Credit allows businesses to speculate on the anticipated desires of consumers. What are the advantages

and disadvantages to society of permitting this speculation?

CREDITORS’ RIGHTS AND BANKRUPTCY—

 ANSWERS TO THE LEGAL REASONING QUESTIONS 

1. Do you think that the law favors debtors at the expense of creditors or vice versa? Is there any

way to achieve a better balance between the interests of creditors and those of debtors? Bankruptcy

law attempts to provide a fair means of distributing assets in the debtor’s possession to creditors, because on

a debtor’s bankruptcy, the debtor’s obligation to pay—which is the asset in the creditor’s possession—usually

has diminished value and sometimes no value. For debtors who “get in over their heads,” bankruptcy law at–

tempts to provide relief and protection—a “fresh start.”

The easier it is for debtors to file for bankruptcy, the greater the incentive for debtors to do so to avoid

paying their debts. This of course increases the creditors’ risk. To compensate for this greater risk, creditors

raise interest rates, require more security, or become more selective in granting credit. The more lenient

bankruptcy laws are, the better off debtors who find themselves in bankruptcy are, and the worse off debtors

who will never declare bankruptcy are. This was the situation as some critics described it before the

Bankruptcy Reform Act of 2005.

After the reform, other critics complained that the law had swung too far in the opposite direction, favoring

creditors’ interests at the expense of debtors. Thus, attempts to balance the rights of creditors and debtors

are likely to always raise questions of fairness and justice. Suggestions to achieve a better balance may focus

on such factors as the politics behind the making of the law—the inevitable effect of favoring one group over

whole or in part.