Insolvency and Bankruptcy Law

Mr. Bechara, an attorney, is a frequent contributor to The Freeman.

At one time in history, society regarded those who applied for bankruptcy relief as defrauders, and, in some instances, as criminals. Bankrupts were the object of social sanctions, and in many cases they had to leave their area of employment for fear of further societal punishments. The origin of the word bankruptcy itself is indicative of the attitude toward bankrupts. In medieval Venice, merchants conducted their business affairs in public places, and they usually brought their own benches where they could rest during the course of the day. If a merchant were unable to pay his debts, his creditors would proceed to break down his bench, symbolizing the bankrupt’s exclusion from the business community. The word bankrupt comes from the Italian banca rotta, or broken bench.

Governmental attitude toward bankruptcy has evolved over the years to the point where today many no longer consider it a socially objectionable form of behavior. Perhaps reflecting America’s more permissive values, filing for bankruptcy protection has become a growth industry. Consumers and corporations have discovered the advantages of bankruptcy relief. Many individuals who overextended their credit and no longer can meet their obligations have filed bankruptcy petitions. Some corporations have also obtained bankruptcy protection as a means of unilaterally breaking executory contracts or of dealing with a variety of Pending lawsuits.

Recent developments in the area of bankruptcy, however, indicate that the boom in bankruptcy filings may already have reached its limits. Before analyzing the nature of these changes, however, it will be instructive to take a brief look at the development of bankruptcy in the United States.

At the time the Constitution of the United States was adopted, bankruptcy law differed among the various states. The framers of the Constitution felt that it would benefit the country if these differences were eliminated, so they inserted in section 8 of Article I of the Constitution a clause granting Congress the power to establish “uniform laws on the subject of bankruptcies throughout the United States.” This delegation of authority to Congress, however, did not require the enactment of a bankruptcy code nor the discharge of debts. In fact, although having the power to enact a bankruptcy statute, Congress did so only sporadically during the nineteenth century. Most of the bankruptcy statutes enacted during this time were motivated by financial panics. After the effects of these business cycles had subsided, the statutes usually were repealed. Overall, prior to 1898, Federal bankruptcy statutes were in effect for less than a total of twenty years.

It has been said that the Panic of 1893 was ultimately responsible for the enactment of the Bankruptcy Act of 1898. This statute dealt with liquidations, and provided the mechanism for bankrupts to place their nonexempt assets in the hands of a trustee who, in turn, was charged with liquidating them and paying off the debts in accordance with a priority schedule. The 1898 Act, in turn, was amended in 1938 by the Chandler Act, which introduced the reorganization aspect to bankruptcy. Reorganization is the method by which a going concern restructures itself so as to continue in business after the closing of the bankruptcy case. This bankruptcy statute was left in effect until the Bankruptcy Reform Act of 1978.

During the 1960s and 1970s a number of factors led Congress to conclude that the existing Bankruptcy Code was inadequate to meet the needs of the country. The growth in consumer credit had led to an increase in bankruptcy filings. To grasp the magnitude of this expansion, one should consider that in 1960 total consumer credit was $56 billion, whereas by 1977 it had increased to $289 billion. This expansion was partly responsible for a record 224,354 consumer bankruptcy filings in 1975. The increase in the number of bankruptcies tested the ability of the bankruptcy court system as it was then organized.

As a result of these developments, Congress enacted the Bankruptcy Reform Act of 1978. This statute restructured the organization of bankruptcy courts, and contained substantive amendments which liberalized the ability of consumers and corporations to file for bankruptcy relief. Perhaps symbolic of the changing attitude toward bankruptcy, the new statute referred to bankrupts as debtors, in an attempt to remove part of the stigma of being a bankrupt.

An Increase in Bankruptcies

There is considerable controversy over the effects of the 1978 amendments. There is no argument, however, that after enactment of the Bankruptcy Reform Act of 1978, the country experienced an increase of bankruptcy filings of historic proportions. The number of consumer bankruptcies, in particular, mushroomed. In fiscal 1980, the first year the 1978 statute was in effect, there was a 60 per cent increase of filings over the previous year, to a total of 314,856. By 1982, the number of individual bankruptcy cases exceeded 500,000.

The credit industry, alarmed at this development, commissioned a study of consumer bankruptcy. The study, commonly referred to as the Purdue Study, concluded that a significant number of consumers who had filed for bankruptcy relief could repay part of their debt out of future earnings. The study estimated that the amount of repayable debt discharged by the Bankruptcy Courts exceeded $1 billion per year. The credit industry faulted the 1978 amendments because of the newly acquired ability of many debtors to choose a no-asset Chapter 7 liquidation.

It is no secret that the vast majority of consumer bankruptcies are “no-asset” cases. This means that after all property that is exempt from liquidation is accounted for, there usually are no assets remaining for the benefit of creditors. In a typical Chapter 7 case, a trustee is appointed by the Bankruptcy Court to liquidate the debtor’s nonexempt property and to distribute it in accordance with statutory priorities. Unsecured creditors share proportionately in the assets that may remain after the creditors who enjoy the statutory priority have received payment. In return for this, the debtor, provided he has not committed fraud or otherwise waived the right, will be discharged from most of his liabilities, even though the creditors received only a fraction of their claims. Any assets that the debtor may acquire after the filing of the bankruptcy petition, including wages, are beyond the reach of most pre-petition creditors. The Purdue study found that many of the debtors who filed for Chapter 7 liquidation were employed and could have paid off a substantial amount of their outstanding liabilities over a period of several years.

In view of the growing concern over the expansion of bankruptcy cases, Congress began to consider whether further amendments were needed. The movement toward reform, however, was delayed by another development. This was the Supreme Court’s decision in the case of Northern Pipeline Construction Co. v. Marathon Pipeline Co.[1] The Supreme Court held that the 1978 amendments violated the Constitution because bankruptcy judges, while enjoying broad judicial powers, were not assured of the judicial independence mandated by the Constitution in the form of lifetime appointments and salary protection.

The controversy over the 1978 amendments was not restricted to consumer bankruptcies and judicial appointments, however. Many corporations took advantage of the new provisions of the law as well. Prior to the amendments, a company that desired to file for bankruptcy protection had to be insolvent. Finding that a showing of insolvency was too cumbersome, Congress deleted this requirement in the 1978 amendments. In addition, trustees no longer have to be appointed in every Chapter 11 case, and the management of a company that files for reorganization under Chapter 11 may remain in charge of the corporation unless it engages in reprehensible conduct. In light of these provisions, some corporations began to consider bankruptcy as a means to avoid some of their liabilities and contractual obligations.

One of the immediate effects of filing for bankruptcy is that all creditors must stop their collection actions against the debtor. If a creditor already has obtained a judgment against the debtor, the bankruptcy case prevents a creditor from enforcing this judgment. Similarly, all claims against a debtor that arose before the commencement of the bankruptcy case must be handled in accordance with the Bankruptcy Code. This is known as the automatic stay. There are exceptions to the automatic stay, however. For example, the automatic stay does not shield debtors from criminal prosecutions, from the collection of alimony maintenance and support obligations, from tax deficiencies or from the exercise of the government’s police and regulatory powers.

The Johns-Manville Case

The first company to achieve notoriety in taking advantage of the 1978 amendments was Johns-Manville Corporation. This corporation filed a petition for reorganization under Chapter 11 on August 20, 1982. At the time of filing, the corporation’s net worth exceeded $1 billion. The reason for filing for bankruptcy was that 16,500 lawsuits already had been filed against the company, alleging liability because of asbestos-related injuries. The company estimated that at the rate of 425 new lawsuits monthly, up to 52,000 lawsuits were expected to be filed, creating a potential liability of up to $2 billion. In addition, the company may be liable for unforeseen liabilities since the victims of asbestos exposure may not develop any symptoms for a prolonged period of time. Since the Bankruptcy Code requires that all unmatured claims be accelerated, and that all contingent, disputed, and unliquidated claims be liquidated, the filing of the petition will aid in putting an end to the uncertainties facing the company.

Other industries also have utilized the bankruptcy route to resolve their liabilities. For example, Amatex Corporation filed for bankruptcy protection in November, 1982, in light of the fact that it was defending itself against 10,000 lawsuits. Similarly, in August, 1985, A. H. Robins filed for bankruptcy since at the time of filing there were 5,000 lawsuits pending, and the company estimated up to 300,000 claims to be filed.

Another provision of the Bankruptcy Code that aids corporations in their reorganization efforts is the ability to unilaterally reject certain executory contracts which are burdensome. Subject to court approval, it is generally left to the debtor to decide whether or not those contracts should be assumed or rejected. A lease is an example of a contract that a debtor may wish to cancel. A debtor may reduce the scope of its operations and therefore may not need as much leased space as it is obligated to pay for under the rental agreement. This provision of the Bankruptcy Code permits adjustments in these contracts.

In light of the fact that insolvency was no longer required for a business entity to file for bankruptcy protection, some corporations that were saddled with what they considered to be burdensome contracts considered the possibility of filing for bankruptcy relief in order to cancel those contracts. The one area that created the most controversy was the rejection of collective bargaining agreements. Wilson Foods Corporation, the fifth largest meat packer in the United States, filed a Chapter 11 reorganization petition on April 22, 1983. It then rejected its collective bargaining agreement which covered 6,000 employees, and reduced wages between 40 to 50 per cent. The company’s net worth at the time of filing exceeded $67 million. Similarly, on September 24, 1983, Continental Air Lines filed for bankruptcy relief, rejected its collective bargaining agreement, and laid off 12,000 employees. Two days later, 4,200 employees were reinstated at half their salaries. The Supreme Court, in the 1984 case of NLRB v. Bildisco & Bildisco,[2] agreed with the interpretation that collective bargaining agreements may be rejected “if the debtor can show that the collective bargaining agreement burdens the estate, and that after careful scrutiny, the equities balance in favor of rejecting the labor contract.”

Because of the expansion in consumer bankruptcies, the Supreme Court’s decisions in Marathon and Bildisco, and the proliferation of business bankruptcies to avoid liabilities, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984, which went into effect on July 10, 1984. The 1984 statute re formed some aspects of consumer and business bankruptcies, and also took care of the constitutional objections to the structure of the Bankruptcy Courts.

Consumer Bankruptcies

One of the amendments enacted by the 1984 statute relates to consumer bankruptcies. Under the new provisions, Bankruptcy Courts are empowered to dismiss Chapter 7 petitions where the debts are primarily consumer debts if it is determined that the filing of those petitions constitutes a substantial abuse. The purpose of this new provision is to eliminate the previous unfettered discretion debtors had of filing for protection under Chapter 7, and to encourage those debtors who still want to file for bankruptcy protection to do so under Chapter 13 of the Bankruptcy Code. Under Chapter 13, the debtor must propose a debt adjustment plan under which payments out of future earnings will be made to creditors. The plan must, however, be approved by the Bankruptcy Court and the payment period may last from three to five years. The discharge of debts, after completion of the plan, is broader than under Chapter 7. The 1984 statute also requires that in making payments, a debtor must use all his disposable income, unless the unsecured creditors are paid in full. The 1984 amendments eliminate the past practice of Chapter 13 plans where debtors paid a minimal amount.

Although the thrust of the 1984 amendments is to encourage debtors to pay as much as possible, there are some troubling aspects to the law. For example, only the court, and not the creditors, may raise the issue of whether a debtor is committing a substantial abuse in filing a Chapter 7 petition. This can deprive the court of the information creditors may be able to bring forth. In addition, given the large number of consumer bankruptcies, it is doubtful if a court always will have the time to gather the information needed to decide if Chapter 7 is the appropriate mechanism. Finally, a question may be raised as to the court’s appearance of fairness, since the debtor would have to present evidence to refute the court’s assertion of substantial abuse, and the court would have the power to decide the issue.

The 1984 amendments also tightened some other areas. For example, the amount of exempt property has been restricted. A waiting period has been added to prevent an immediate refiling of a petition when the previous case had been dismissed either voluntarily or by the court. Similarly, in order to prevent shopping sprees prior to the filing of a petition, no more than $500 in credit for luxury goods and services owed to a single creditor may be incurred by debtors if such debts were incurred within 45 days before the filing of the bankruptcy petition. In addition, there are now time limits during which unexpired leases of nonresidential real property may be assumed or rejected.

Although the ability of debtors to shield themselves from lawsuits through the use of bankruptcy was left intact, the 1984 statute did limit the ability of businesses to reject collective bargaining agreements. Bildisco was overruled by the statute, and certain procedural and substantive standards must be met prior to a court granting approval of a rejection of a collective bargaining agreement.

Although recent developments indicate that the tide has turned against the debtors’ perceived abuse of the bankruptcy system, the problems still exist. In the area of business bankruptcy, the delays in the processing of bankruptcy petitions harm creditors. It is not unusual for a reorganization plan proposed by a debtor under Chapter 11 to take one or two years before it is finally confirmed by the court. During this time, creditors cannot remove their assets or invest them in a more productive venture. Similarly, there sometimes are conflicts between secured and unsecured creditors. A secured creditor, for example, may wish to dispose of the property in which he has a security interest in order to recover the amount owed. Unsecured creditors, however, may oppose this proposal because the disposal of the property may amount to a liquidation of the business, thereby eliminating any opportunity for recovery of their debts. Or, a secured creditor may feel that the property upon which he has a security interest is depreciating or is being consumed at a rate that will reduce the value of his security interest. Although the Bankruptcy Code allows secured creditors the opportunity to obtain “adequate protection” from some of these developments, it is not altogether clear that secured creditors are able to realize the market value of their security interest.

There is no question that bankruptcy tends to reward the irresponsible and the profligate. However, a free society must have a creditor-distribution system to take insolvency into account. When a debtor becomes insolvent, that is when liabilities exceed assets, there must be a system to treat all creditors fairly. In fact, a bankruptcy system that would concern itself with creditor distribution issues is to the benefit of creditors in general. This is because in the absence of a bankruptcy system, creditors would engage in a race to the courthouse whenever they may fear that a debtor is insolvent. A system that would allow such a race would benefit some creditors at the expense of other creditors. In addition, the race to the courthouse may prematurely terminate an ongoing business, reducing the probabilities of recovery to other creditors. The absence of a bankruptcy system would be detrimental to creditors in general and would raise the cost of credit to debtors.

The present system, however, goes beyond the distribution of debtors’ assets to creditors. The Bankruptcy Code also contains provisions aimed at fostering the reorganization of failed business enterprises. As we have seen, approval of these plans takes time, and some creditors benefit at the expense of others in reorganizations. We should reassess whether it is a proper function of government to reorganize busi nesses. If a business has failed to adequately meet consumer demands, it is questionable whether the government should veto the market and keep such an entity afloat. It is one thing to set up a system which liquidates assets of insolvent debtors and distributes them to their creditors. It is altogether different when the government meddles into how a business should be structured and whether or not it should be allowed to survive.

In addition, the relief sought by those who file for protection under bankruptcy may have the effects of encouraging more bankruptcies. This, in turn, raises the cost of credit for all. Although a debtor should be allowed a fresh start after bankruptcy, a discharge of debts is too strong a remedy.

The removal of the insolvency requirement in business bankruptcies has led to the inequitable result that some companies, notably those with potential liability in the billions of dollars, may successfully shield themselves from lawsuits by filing for bankruptcy. A Bankruptcy Court may place limits on a debtor’s potential liability since it may be interested in preserving the business as an ongoing concern. This only injures the debtor’s claimants.

The 1984 amendments reveal a trend in cutting back some of the advantages debtors obtained by filing for bankruptcy relief. There is clearly a need for further revision. In a recent case, the Supreme Court has involved itself in this trend as well. In this case, it was held that a debtor may not avail himself of the Bankruptcy Code in order to violate “a state statute or regulation that is reasonably designed to protect the public health or safety from identified hazards.”[3] True bankruptcy reform, after all, may not be that far away. []

1.   458 U.S. 50 (1982).

2.   465 U.S. 513 (1984).

3.   Midlantic National Bank v. New Jersey Department of Environmental Protection, 88 LEd, 2d 859. 869 (1986),

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