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Chapter 30
Bankruptcy Law
See Separate Lecture Outline System
INTRODUCTION
Bankruptcy law is designed to accomplish two main goals: to provide relief and protection to debtors who have “gotten in
over their heads” and to provide a fair means of distributing a debtor’s assets among creditors. Thus, the law attempts to
protect the rights of debtor and creditor, with an emphasis on requiring debtors to pay as many of their debts as they can.
ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
The following video supplements relate to topics discussed in this chapter—
718 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
PowerPoint Slides
To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for
Chapter 30.
ADDITIONAL BACKGROUND—
Bankruptcy—A Creditor’s Remedy?
Originally, bankruptcy represented a creditor’s remedy, not debtor’s relief. In Great Britain, in the sixteenth
century, creditors used the bankruptcy laws to obtain all of the property of a merchant behind in the payment of debts.
At the time, only merchants were subject to the bankruptcy laws. Creditors could seize a debtor’s property, have the
ADDITIONAL BACKGROUND—
Bankruptcy Abuse and Consumer Protection Act (BACPA) of 2005
The most significant changes to bankruptcy law in nearly thirty years occurred in 2005, with the enactment of the
Bankruptcy Abuse and Consumer Protection Act (BACPA) of 2005.
For individual debtors, key changes from previous law included—
• Subject to a means test, many debtors must file for bankruptcy under the Bankruptcy Code’s Chapter 13
instead of the more commonly used Chapter 7, which often provided an almost complete discharge of all debts.
Under Chapter 13, as amended by BACPA, a debtor must comply with a repayment plan for up to five years,
according to a strict budget.
• Debtors’ attorneys may be liable for inaccurate, incomplete, or other erroneous information in documents
filed with the court.
• Creditors can review a debtor’s federal tax filings, to compare them against court-filed documents and to
challenge discrepancies.
• Creditors who have not been properly notified of a bankruptcy filing may be able to foreclose on a debtor’s
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• Debtors must seek credit counseling.
• Fewer debts can be discharged under Chapter 13. Notable limits include fraudulently obtained credit-card
debt, fraudulently-unpaid tax debt, fraudulently-incurred fiduciary debt, and debts related to criminal fines and
victim restitution, and civil liability for willful and malicious injury or death.
• Under Chapter 13, the entire amount of a secured claim, such as a car loan, must be repaid (instead of, for
example, reducing the amount to o current value).
• Spousal and child support debts have top priority (except for a trustee’s expenses). The automatic stay can be
lifted to collect child support debts.
• The amount of a homestead exemption was limited in a variety of ways, which were focused primarily on
attempts to defraud creditors or avoid crime-related or tort-based liability.
• Protection was extended on retirement and college-savings plans (see an ADDITIONAL BACKGROUND elsewhere
in this chapter).
For small-business debtors, key changes from previous law included—
• Small-business debtors are those with $2 million or less in debt on the date they file for bankruptcy.
extended to 180 days.
• For small-business debtors, the grounds on which a court can convert a Chapter 11 case to a Chapter 7 case
were specified and expanded.
• A U.S. Trustee can inspect the premises and the books of a small-business debtor.
• Small-business debtors must include copies of balance sheets, income statements, cash-flow statements,
federal tax returns, and other documents with their bankruptcy petitions. Such debtors must also file periodic
financial reports with information on profitability and cash receipts. Forms that debtors must submit to creditors
before their approval of a Chapter 11 plan or reorganization were simplified.
The U.S. Small Business Administration is expected to monitor the impact of BACPA on small businesses and inform
Congress of any needed changes.
CHAPTER OUTLINE
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I. Bankruptcy Proceedings
A. BANKRUPTCY COURTS
Bankruptcy proceedings are held in federal bankruptcy courts under the authority of the federal district courts, to
which rulings can be appealed.
B. TYPES OF BANKRUPTCY RELIEF
The Bankruptcy Code is in Title 11 of the U.S.C. and has eight chapters. Chapters 1, 3, and 5 include definitions
and provisions governing case administration, creditors, debtors, and estates. Chapter 7 provides for liquidation.
Chapter 9 governs the adjustment of municipal debts. Chapter 11 governs reorganizations. Chapters 12 and 13
provide for the adjustment of debts by parties with regular incomes (family farmers under Chapter 12).
II. Liquidation Proceedings
In a Chapter 7 liquidation (an ordinary or “straight” bankruptcy), a debtor states his or her debts and turns his or her
assets over to a trustee, who sells nonexempt assets and distributes the proceeds to creditors. With exceptions, the
rest of the debts are discharged.
A. VOLUNTARY BANKRUPTCY
Within 180 days of receiving credit counseling from an approved nonprofit agency, a debtor can file a voluntary
petition. The debtor’s attorney must verify the information in the petition. A debtor does not have to be insol–
vent—anyone liable to a creditor can file. A husband and wife can file jointly.
ADDITIONAL BACKGROUND—
Information and Automatic Dismissal
In the case from which the following is excerpted, In re Riddle, 344 Bankr.702 (S.D. Fla. 2006), the court held that
the information provided by the debtors was complete and, thus their case was not subject to automatic dismissal
under the BAPCPA.
SUA SPONTE ORDER DETERMINING DEBTORS’ COMPLIANCE WITH FILING REQUIREMENTS OF SECTION 521(a)(1)
A. JAY CRISTOL, Chief Judge.
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request for an order of dismissal pursuant to 11 U.S.C. § 521(i)(2). Notwithstanding, the Court feels compelled to
comment on the unusual and confusing language in this statutory provision.
I do not like dismissal automatic,
It seems to me to be traumatic.
I do not like it in this case,
I do not like it any place.
As a judge I am most keen
to understand, What does it mean?
How can any person know
what the docket does not show?
What is the clue on the 46th day?
Is the case still here, or gone away?
And if a debtor did not do
what the Code had told him to
and no concerned party knew it,
Still the Code says the debtor blew it.
Well that is what it seems to say:
This kind of law is symptomatic
of something very problematic.
For if the Trustee does not know
then which way should the trustee go?
Should the trustee’s view prismatic
continue to search the debtor’s attic
and collect debtors’ assets in his fist
for distribution in a case that stands
dismissed?
After a dismissal automatic
would this not be a bit erratic?
The poor trustee cannot know
the docket does not dismissal show.
What’s a poor trustee to do—
except perhaps to say, “Boo hoo!”
And if the case goes on as normal
and debtor gets a discharge formal,
what if a year later some fanatic
claims the case was dismissed automatic?
Was there a case, or wasn’t there one?
How do you undo what’s been done?
Debtor’s property is gone as if by a thief,
and Debtor is stripped but gets no relief.
I do not like dismissal automatic.
On this point I am emphatic!
I do not wish to be dramatic,
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but I can not endure this static.
Dismissal automatic is not understood.
Something more in 521 is needed
for dismissal automatic to be heeded.
For all concerned this is not good.
Before this problem gets too old
it would be good if we were told:
What does automatic dismissal mean?
And by what means can it been seen?
Are we only left to guess?
Oh please Congress, fix this mess!
Until it’s fixed what should I do?
How can I explain this mess to you?
If the Code required an old fashioned order,
that would create a legal border,
with complying debtors’ cases defended
and 521 violators’ cases ended,
from the unknown status of dismissal automatic,
to the certainty of a status charismatic.
The dismissal automatic problem would be gone,
and debtors, trustees and courts could move on.
As to this case, how should I proceed?
Review of the record is warranted, indeed.
A very careful record review,
tells this Court what it should do.
Was this case dismissed automatic?
It definitely was NOT and that‘s emphatic.
Based upon the Court’s review, the Court has determined that the debtors have complied with the information
requirements of 11 U.S.C. § 521(a)(1).
Accordingly, it is ORDERED:
1. This case is not subject to automatic dismissal under 11 U.S.C. § 521(i)(1) or (2).
2. If any party in interest has any reason to contest the Court’s finding that the debtors have filed all information
required by 11 U.S.C. § 521(a)(1), that party shall file a motion for reconsideration not later than 20 days from the date
3. Nothing in this Order shall excuse the debtors’ duty to cooperate with the United States Trustee and the trustee
1. Chapter 7 Schedules
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A voluntary petition must contain—
2. Additional Information May Be Required
3. Tax Returns during Bankruptcy
A tax return must be filed each year while a case is pending, with a copy provided to the court.
4. Substantial Abuse—Means Test
A grant of relief cannot be “substantial abuse” of Chapter 7. If a debtor’s family income is greater than the
5. Additional Grounds for Dismissal
6. Order for Relief
The filling of the petition constitutes an order for relief (a discharge of debts). Creditors must be notified
within twenty days.
B. INVOLUNTARY BANKRUPTCY
Creditors can force most debtors (not farmers or charitable institutions) into involuntary bankruptcy. If the
debtor challenges the petition, he court will enter an order for relief if it finds: (1) the debtor is generally not pay–
ing debts as they become due, or (2) a general receiver, assignee, or custodian took possession of or was
ANSWER TO VIDEO QUESTION LTR. A
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Before this scene, the movie makes clear that Ray (Kevin Costner) is unable to pay his bills, but he has not filed a
voluntary petition for bankruptcy. What would be required for Ray’s creditors to force him into an involuntary
bankruptcy? Ray is a farmer. Farmers cannot be involuntarily petitioned into bankruptcy. Under Chapter 7 or Chapter
C. AUTOMATIC STAY
The automatic stay protects a debtor’s property from creditors’ actions. A creditor’s willful violation of the stay
may entitle a party to recover compensatory and punitive damages, costs, and attorneys’ fees.
CASE SYNOPSIS—
Case 30.1: In re Kuehn
Stefanie Kuehn, an art teacher, obtained a master’s degree at Cardinal Stritch University in Wisconsin. But when
Kuehn asked for a transcript—which was required to receive an increase in salary from her school district—the
university refused because she owed more than $6,000 in tuition. Kuehn offered to pay the nominal transcript fee but
not the tuition. She then filed a petition in a federal bankruptcy court, listing the university as her only creditor, and
while the case was pending, again asked for a transcript. The university again refused unless she paid the tuition. Kuehn
complained to the court, which ordered the university to provide a transcript. A federal district court affirmed the
order. The university appealed.
The U.S. Court of Appeals for the Seventh Circuit affirmed. Kuehn had a right to a copy of her transcript, and the
university’s refusal to honor that right until she paid her tuition was an act to collect a debt in violation of the
automatic stay. Property interests are created and defined by the law. Nothing in the Bankruptcy Code or other federal
law creates or affects property rights in grades or the right to a transcript. No Wisconsin statute applies either, but
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Notes and Questions
What actions might a college take to collect unpaid tuition that would not violate the Bankruptcy Code? The court
reasoned that “the University is unable to collect Kuehn’s tuition only because it was careless. When Kuehn failed to
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pay her mounting bills the University could have refused to let her enroll in new classes. It could have refused to let her
take exams. It could have refused to award a degree. Or the University could have required Kuehn to borrow from a
third party to pay for her education. Student loans are not dischargeable unless a debtor can show undue hardship, and
it is unlikely that Kuehn could have shown undue hardship. She was gainfully employed, and her debt to the University
was substantially less than the extra income the master’s degree afforded. Presumably the University will protect itself
in one or more of these ways in the future.”
consistently provided transcripts at or around cost, however. Along the line of reasoning in this case, it could be argued
ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?” IN CASE 30.1
Suppose that instead of offering to pay for a transcript, Kuehn had tried to obtain one on credit. Would the
university’s refusal to provide one on that basis have led to the same result? Why or why not? If Kuehn had tried to buy
a transcript on credit—in other words, to borrow more than she already owed—the university could refuse without
violating the automatic stay. The automatic stay applies only when a creditor acts to collect a debt. A creditor can
consider a debtor’s creditworthiness in deciding whether to extend more credit.
ANSWER TO “THE ETHICAL DIMENSION” QUESTION IN CASE 30.1
Some might say that higher education institutions should be able to use all methods possible to collect unpaid
tuition, including withholding certified grade transcripts. What ethical issues would this approach raise? This is an “end
1. The Adequate Protection Doctrine
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Secured creditors can ask the court to protect them from losing the value of their security as a result of the
stay. Debtors can be required to make cash [payments or provide additional collateral to offset any loss in
value.
ADDITIONAL BACKGROUND—
Adequate Protection
TITLE 11. BANKRUPTCY
CHAPTER 3—CASE ADMINISTRATION
SUBCHAPTER IV—ADMINISTRATIVE POWERS
§ 361. Adequate protection
(1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay
(3) granting such other relief, other than entitling such entity to compensation allowable under section 503(b)(1) of this
title as an administrative expense, as will result in the realization by such entity of the indubitable equivalent of such
2. Exceptions to the Automatic Stay
3. Limitations on the Automatic Stay
A creditor may be granted relief from the stay sixty days after requesting it. A stay on a secured debt may be
lifted thirty days after the petition is filed (the text explains), or forty–five days after the first creditors’
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D. BANKRUPTCY ESTATE
Commencement of a Chapter 7 proceeding creates an estate in property, which consists of all the debtor’s legal
and equitable interests in property.
E. THE TRUSTEE
A trustee’s principal duty is to collect and reduce to money the property of the debtor’s estate and to close up the
estate as fast as is compatible with the parties’ best interests.
1. Duties for Means Testing
Within ten days of the first creditors’ meeting, the trustee must review the debtor’s filing and determine
2. The Trustee’s Powers
a. The Right to Possession of the Debtor’s Property
The trustee also can require persons holding a debtor’s property when a petition is filed to give the
property to the trustee.
b. The Strong-Arm Power
The trustee’s position is equivalent in rights to that of certain other parties. A trustee has strong-arm
power—the same right as a lien creditor who could have levied execution on the debtor’s property.
c. Avoidance Powers
A trustee has specific powers to set aside a transfer of the debtor’s property. These powers include
any voidable rights and the power to avoid preferences, certain statutory liens, and fraudulent
transfers.
3. Voidable Rights
4. Preferences
A trustee can recover a debtor’s payment or transfer of property made to a creditor within ninety days
before the petition in preference to others.
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a. Preferences to Insiders
Transfers to insiders within a year of the petition can be recovered, but the debtor’s insolvency at the
time of the transfer must be proved.
5. Fraudulent Transfers
A trustee may avoid fraudulent transfers made within two years of the filing of the petition or made with
intent to hinder, delay, or defraud a creditor. Transfers made for less than reasonably equivalent
consideration are vulnerable if by making them the debtor became insolvent, was left in business with a
small amount of capital, or intended to incur debts that he or she could not pay.
CASE SYNOPSIS—
Case 30.2: In the Matter of TransTexas Gas Corp.
TransTexas Gas Corp. was involved in the exploration, production, and transmission of natural gas when the firm
filed for bankruptcy under Chapter 11. The plan provided that John Stanley would serve as chief executive officer and
as a member of the board for a limited time under an agreement that would entitle him to $1.5 million if he were
dismissed for cause and nothing if he resigned. Later, when an independent review concluded that he could be
dismissed for cause, the parties entered into a new agreement under which he would resign and the company would
pay him $3 million in installments. Within the year, TransTexas filed a second Chapter 11 petition. The court held that
the payments to Stanley were avoidable fraudulent transfers. Stanley appealed.
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Notes and Questions
Why would the trustee in this case seek to recover the payments to the company’s founder, chief executive officer,
and member of the board? The trustee is in the position of the debtor, which is the company in this case. The company
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under employment contracts within two years of a petition. The payments to Stanley fell under the law.
ANSWERS TO QUESTIONS AT THE END OF CASE 30.2
1. What might have Stanley have meant when he said that by agreeing to “go quietly” he provided a benefit to the
company? Stanley might have meant that he would not challenge the company’s decision to seek his resignation from
the firm. This could have the cost the company legal fees and other expenses when it could least afford them.
2. Stanley argued that he was not an insider because he was no longer employed by the company when the
severance payments were made. How did the court respond to this argument? The court held that “it is enough that
Stanley was an insider . . . at the time the company incurred such obligation. The language of the statute makes that
evident.” It clearly states that a trustee can avoid “any transfer to or for the benefit of an insider under an employment
contract” if the debtor “received less than a reasonably equivalent value in exchange for such . . . obligation.”
F. EXEMPTIONS
A debtor can exempt certain property from bankruptcy, choosing between exemptions provided under state law
and federal law. (States may bar the use of federal exemptions.) The Bankruptcy Code’s exemptions are set out
in the text. The Bankruptcy Abuse and Consumer Protection Act (BACPA, or 2005 act) of 2005 lowered the dollar
amounts and set out specific items that qualify as household goods and other personal property.
ADDITIONAL BACKGROUND—
Retirement & College Savings
According to a decision of the United States Supreme Court, individual retirement accounts (IRAs) could not be
seized during bankruptcy.a The Court explained that the IRAs were protected under 11 U.S.C. Section 522(d)(10)(E),
which exempted “payment under a stock plan, pension, profit sharing, annuity, or similar plan or contract on account
of . . . age.” The Court reasoned that a right to payment from an IRA “is casually connected to . . . age” and IRAs
“provide income that substitutes for wages earned as salary or hourly compensation.” Left open were questions
concerning the amount of the assets that were exempt and whether Roth IRAs—a specific type of IRA—were also
covered.
reach of creditors in a bankruptcy.
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a. Rousey v. Jacoway, __ U.S. __, 125 S.Ct. 1561, __ L.Ed.2d __ (2005).
G. THE HOMESTEAD EXEMPTION
To claim a state’s homestead exemption, the debtor must have lived in the state for two years before filing the
petition. Certain other residency and dollar limits may apply. Home equity may not be protected if a debt arose
from a crime or tort indicating substantial abuse (details in the text).
ANSWER TO VIDEO QUESTION LTR. B
If Ray did file a voluntary petition for a Chapter 7 bankruptcy, what exemptions might protect him from “losing
everything” and being evicted as the man indicated in this scene? How much equity in the farm home could Ray claim
as exempt if he filed the petition? Among the property that Ray might be able to exempt under the Bankruptcy Code is:
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H. CREDITORS’ MEETING
The U.S. trustee calls the creditors’ meeting within twenty and forty days of the petition. The debtor must attend
I. CREDITORS’ CLAIMS
Normally, creditors must file proof of their claims within ninety days of the meeting. In a disputed or unliquidated
claim, the court sets the value. Any creditor’s claim is allowed automatically unless contested by the trustee, the
debtor, or another creditor. Claims for breach of employment contracts or real estate leases for terms longer
than one year are limited to one year’s rent or wages. Filing a false claim is a crime.
J. DISTRIBUTION OF PROPERTY
1. Distribution to Secured Creditors
2. Distribution to Unsecured Creditors
K. DISCHARGE
1. Exceptions to Discharge
2. Objections to Discharge
The text lists circumstances in which a discharge will be denied. As grounds to deny a discharge, the BAPCPA
increased from six to eight years the period within which a discharge can prevent a later discharge, and
added the requirement of a completed consumer financial education course.
ANSWER TO CRITICAL THINKING QUESTION IN THE FEATURE—
INSIGHT INTO ETHICS
About six years ago, one could buy debt that had been discharged in bankruptcy for less than five cents on the
dollar. Why has the price increased to seven cents on the dollar? One reason that the price of debt discharged in
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other pressures unless the debtor agreed to pay it.
3. Effect of Discharge
4. Revocation of Discharge
A debtor may lose his or her discharge by revocation on petition by the trustee or a creditor. The court may
1. The Reaffirmation Process
A reaffirmation agreement must be filed with the court before a discharge is granted. Court approval may
2. Reaffirmation Disclosures
Creditors must disclose to the debtor certain information (examples are in the text) to “[b]e sure you can
afford the payments.” A debtor can rescind the agreement any time before discharge or within sixty days of
filing the agreement, whichever is later.
III. Reorganizations
Corporations commonly use Chapter 11, but any debtor (except a stockbroker or a commodities broker) eligible for
Chapter 7 is eligible for Chapter 11. Under Chapter 11, creditors and debtor plan for the debtor to pay some debts, be
discharged of the rest, and continue in business. The same principles cover Chapter 7 and Chapter 11 proceedings (a
A. WORKOUTS
The text notes that workouts are sometimes used in place of bankruptcies.
B. FOCUS IS ON THE BEST INTERESTS OF THE CREDITOR
After notice and a hearing, a court may dismiss a case “for cause.”
C. DEBTOR IN POSSESSION
A debtor generally continues in business as a debtor in possession. The court may appoint a trustee to operate
the business if gross mismanagement is shown or if appointing a trustee is otherwise in the estate’s best interest.
D. CREDITORS’ COMMITTEES