773
Unit Six
Focus on Ethics:
Creditors’ Rights and Bankruptcy
See Separate Lecture Outline System
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.
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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.
ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
The following video supplements relate to topics discussed in this feature—
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips on topics covered in this chapter include the following.
• Ask the Instructor
Secured Transactions: More than One Creditor Can Claim—How is it that more than one creditor can claim a
security interest in a particular piece of collateral? Are debtors allowed to grant more than one lien on the same
collateral?—Yes, debtors frequently grant more than one lien on the same collateral. For example, one creditor might
be granted a purchase money security interest in collateral that is also covered by a prior creditor’s floating lien on
after-acquired property. This conflict is resolved by Article 9’s lien priority rules.
Secured Transactions—The Loan Is Past Due, Is the Editing Machine Lost?—Since the advertising company is in
Field of Dreams—Default/ creditor rights; (Scene in which Kevin Costner’s character’s brother-in-law tries to talk
him into selling his property.).
FOCUS OUTLINE
I. “Self–Help” Repossession
The rationale for the UCC’s “self–help” provision [UCC 9–503] is that it 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.
UNIT SIX: FOCUS ON ETHICS—CREDITORS’ RIGHTS AND BANKRUPTCY 775
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
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
honest debtor a fresh start. Article 9 simplified what had become a morass of law. Under the Bankruptcy Reform Act
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.
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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 pur–
chaser 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
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,
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
2. What is the rationale behind the law giving creditors a right of “self–help” repossession? The rationale for the UCC’s
“self–help” provision—under which creditors may take possession of collateral on a debtor’s default 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
3. How are creditors’ interests protected in a debtor’s sale of collateral? Creditors’ interests are protected by the law’s
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 interest are mixed with other goods
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
6. What does bankruptcy law attempt to do for creditors? 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. What 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
7. Do interest rates affect the numbers of bankruptcies? Before the recession, some observers argued that bankruptcies
8. Is it fair to increase the costs for debtors seeking bankruptcy relief? The Bankruptcy Reform Act of 2005 increased the
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 debtors through the procedures, potentially
slowing the process. It remains to be seen whether the intended consequences of bankruptcy reform—fewer filings, less debtor
fraud, more payments of debts—will actually happen. With more debtors filing pro se, or with the limited help of pro bono
attorneys, there may not be fewer filings, but there may be more unintentional, error-based fraud. Also, considering that about
80 percent of debtors filing under Chapter 13 default on their payment plans and that this is the direction towards which
bankruptcy reform pushes petitions, the number of defaults may not decrease.
UNIT SIX: FOCUS ON ETHICS—CREDITORS’ RIGHTS AND BANKRUPTCY 779
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 benefits 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 DISCUSSION 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
always raise questions of fairness and justice. Suggestions to achieve a better balance may focus on such factors as the
2. So long as a breach of the peace does not result, a lender may repossess goods on the debtor’s default under the
self-help provision of Article 9. Do you think that debtors have a right to be told in advance about a planned
repossession? Some observers argue that the self-behind remedy under Article 9 should be abolished. Do you agree?
Why or why not? The rationale for the UCC’s “self–help” provision—under which creditors may take possession of
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proceedings. But creditors too can suffer from unplanned violence, either from a debtor’s resistance during
repossession or from a later determination that the repossession amounted to a breach of the peace.
But it is difficult to see how requiring a debtor to be notified before a repossession would protect anyone’s
interest. The debtor might be no less likely to resist a creditor’s actions—and might do so with more violence, having
been given the opportunity to prepare. The creditor might be no less likely to rely on the element of surprise by
might be argued that the remedy should be abolished. That is, preventing the risk of abuse and injury to the parties on
3. Is it unethical to avoid paying one’s debts by going into bankruptcy? Does a person have a moral responsibility to
pay his or her debts? Discuss. Bankruptcy is not easy for debtors (and seems to have become even less easy with the
Bankruptcy Reform Act of 2005). Many debtors feel a sense of shame and failure when they file a petition. And there
are certainly more concrete consequences—blemished credit ratings for up to ten years, higher interest charges for
new debts, and so on. A debtor may find it difficult to get a job because an employer may refuse to hire an applicant
who filed for bankruptcy. Because of these consequences, debtors do not always get the “fresh start” promised by the
law.
Some might argue that this is as it should be. Others might contend that debts should not be discharged at all, but
should be paid, even if according to an extended schedule. Some debtors themselves have agreed with these
sufficiency, and a duty to honor one’s obligations and pay one’s debts may lie beneath these attitudes.
benefit from it. Individuals who have obtained a discharge in bankruptcy can continue to earn, spend, and prosper.
Businesses that have filed for bankruptcy can continue to do business, pay their employees, and contribute to the
their contributions to society and the economy.
4. Are borrowers better off as a result of the bankruptcy reform legislation? Why or why not? The text posits that
when the number of bankruptcies increases, creditors incur higher risks in making loans—because bankruptcy shifts
the cost of the debt from the debtor to the creditor. To compensate for these higher risks, creditors increase the
interest rates charged to everyone, require additional collateral, or become more selective in granting credit. Thus,
Under this reasoning, most debtors are better off as a result of the bankruptcy reform legislation because the law
makes it more difficult for individual debtors to obtain a discharge of their debts in a personal bankruptcy. This shifts
5. How does minimizing business or personal debt help prevent bankruptcies in a recession? Overdependence on
credit and overconfidence in investment contributed to the most recent U.S. recession and global economic crisis.
