BANKRUPTCY

BANKRUPTCY. Bankruptcy is formally understood as the condition in which a debtor, upon voluntary petition or one invoked by his or her creditors, is judged legally insolvent and whose remaining property is administered by those creditors or distributed among them. The condition seems relatively straightforward: bankruptcy is legally recognized insolvency. In early modern Europe, however, it was a far more ambiguous state, freighted with the suspicion of fraud, distinguished from simple indebtedness, and, in some places, limited in its prosecution to certain trades or professions.

BANKRUPTCY AND THE INDIVIDUAL

Some of the earliest criminal codes make these associations and distinctions clear. The Discipline Ordinance, promulgated in Augsburg in 1537, ordered arrest and imprisonment of any individual unable to pay debts in excess of two hundred guldens. Should the defaulter flee—a generally recognized indication of fraudulent intent—his creditors were authorized to seize his property and person by whatever means necessary. The results were often acrimonious and violent free-for-alls, as in the infamous Höchstetter bankruptcy of 1527, in which the bankrupts languished and died in prison. While the creditors scrambled to recover what they could, a few, like the Höchstetters' partners the Fuggers, profited handsomely, but many others were ruined in the process.

Were a more mutually agreeable settlement reached, the bankrupt still faced a humiliating loss of status, a fatal derogation in an economy that functioned largely on the basis of personal relationships and reputation. The ordinance prescribed that he be stripped of his membership in the merchants' corporation, that his stall be removed from the privileged position of honest merchants at the base of Augsburg's watchtower, that he be prohibited from bearing arms in public, and that he be compelled to take his place with the women at the rear of public processions. Even his children could not escape his stigma: those born after the bankruptcy would be forbidden to wear the gold chain that was the emblem of established Augsburger merchants. Bankruptcy ordinances in 1564, 1574, and 1580 retained this emphasis on punishing economic crime.

The presumed connection between bankruptcy and fraud was echoed in other sources and other places. The Imperial Discipline Ordinance of 1548 spoke of "ruined merchants" who engaged in insecure—and, hence, fraudulent—credit transactions and suffered bankruptcy because of carelessness or waste. They were to be treated as common thieves. In England, the Tudor Act Touching Orders for Bankrupts of 1571 limited the term to indicate "traders" or "merchants" who "craftily obtaining into their hands great substance of other men's goods, do suddenly flee to parts unknown, or keep their houses, not minding to pay or restore to any their creditors, their debts and duties, but at their wills and pleasures, consume the substance obtained by credit of other men, for their own pleasure and delicate living, against all reason, equity and good conscience. . . ." Thus, bankruptcy existed in relationship to credit (which was considered a morally ambiguous entity), competence, and crime, all indicators of a crisis in the conduct and conception of business.

The passage of these laws constitutes a first response to the growing frequency of bankruptcies in early modern Europe. Beginning in the early sixteenth century, bankruptcy became a social evil that affected all levels of society and had extraordinary implications for both large and small economies. State profligacy, coupled with the unpredictable nature of economic growth, created conditions in which even the greatest commercial houses were not safe from default and failure. For the less well-connected or well-provided-for, insolvency and bankruptcy were common facts of life, the litigation of which left an unmistakable trail in most European archives. In 1560, the chronicler Paul Hektor Mair would record the names of twenty-six prominent Augsburg merchants who "became bankrupt and because of debts, sought sanctuary, fled the city, or suffered arrest until they settled and were released." Between 1529 and 1580, that number would rise to at least sixty-three and perhaps as many as seventy of the "great and famous commercial houses" of that city. Over the entire early modern period, Augsburg witnessed over 250 bankruptcies and countless insolvencies. Nor was the problem geographically limited. In England, according to one historian, "debt litigation dominated pleading in the courts of King's Bench and Common Pleas" from the mid-sixteenth to the mid-seventeenth century. From the mid-seventeenth to the mid-eighteenth century, no fewer than fifty-eight French merchants engaged in transatlantic trade suffered bankruptcy. Studies of the Parisian credit market for the same period reveal a noteworthy expansion of private borrowing coupled with periodic government defaults and interventions that would have resulted in waves of bankruptcies.

BANKRUPTCY AND GOVERNMENT

The relationship between public and private finance remains dimly understood, but the numbers and patterns of commercial or domestic failures in early modern Europe relate, in part, to a series of spectacular state bankruptcies. In an age when most princes struggled to live within their means, the monarchs of Spain and France, despite rising prices and ambitions, seemed to rule in virtual freedom from such limitations and developed extraordinary debts in pursuit of their policies. France declared bankruptcy in 1559 and defaulted on its short-term debts repeatedly during the reign of Louis XIV, subsisting otherwise on a fiscal system noted particularly for its corruption. Spain suffered bankruptcies in 1557, 1560, 1575, and 1596. The most spectacular, that of 1575, may be taken as emblematic of all. The decision of Philip II to suspend payments to his bankers can be seen as a watershed in his reign (and in Spanish power). The causes are not far to seek: the costs of political and military policies in the Mediterranean and the Netherlands during the 1560s and 1570s outstripped the crown's financial resources. Rather than effect economies, renegotiate terms, or redistribute the burden, Philip and his financial advisers opted to default, forcing a conversion of short-term debt to long-term debt that involved favorable interest rates and the forgiveness of certain obligations. This was a favorite tactic not only of the Spanish crown but also of the French in the early modern period. But in dealing with the bankruptcy of 1575, Spain's bankers (the Genoese above all) did not mildly concede as they did in 1560 (and, later, in 1596) but instead firmly resisted. They suspended all commercial credit to Castile, the fiscal heartland of Spain, and rejected the king's proposed terms. Although the immediate consequences were not fatal, the bankruptcy may be said to mark the beginning of Spanish decline. The suspension of commercial credit within Spain, and especially within Castile, permanently affected trade and, consequently, taxes. The loss also impinged on the effectiveness of Spanish armies in Italy and the Netherlands and led, most immediately, to the sack of Antwerp in 1576, likely rendering any suppression of the Dutch Revolt of 1568–1648 impossible. As important as this bankruptcy may be for the political history of the period, its economic consequences reach far beyond Spain's borders. In the 1577 settlement that ended the bankruptcy and restored Spanish credit, the bankers managed to avoid the worst consequences by recouping or transferring their losses (by calling in other debts). This became apparent in a wave of private failures that mark the interconnections between public and private finance and between larger and smaller commercial enterprises. In Augsburg, for example, 39 of the 63 sixteenth-century bankruptcies cluster around the Spanish defaults: 13 between 1559 and 1561, 14 between 1573 and 1576. Though it is impossible to attribute these and many other failures strictly to the fiscal chicanery of Philip II, their timing cannot be purely coincidental. Bankruptcies marked a shortage of credit—a crisis in money markets—that potentially reached from state treasuries to commercial countinghouses and from powerful bankers to humble artisans.

FINANCIAL RELATIONSHIPS

Of course, bankruptcies illuminate much more than the interconnections of early modern finance; they reveal some aspects of business practice. Early modern merchants, entrepreneurs, and financiers operated in an age of money scarcity and relied, therefore, to a very large extent on credit. Indeed, these men often traded within systems of interlocking credit, owing money to their suppliers or lenders and owed money by their customers and clients. Such systems could be quite fragile; one default could cause others, rippling across the entire network of relationships. In addition, they operated in an economy that lacked legal and fiscal institutions to ensure and enforce credit transactions. As a result, merchants, entrepreneurs, and financiers relied upon personal relationships and personal knowledge to reduce the risk of default. Being a close-knit community in most places, they often knew who was or was not a good credit source or credit risk. Where personal knowledge would not serve, intermediaries, such as notaries or goldsmiths, often arose, and used their own knowledge of persons (and their means) to mediate and facilitate credit exchange. Questions of reputation and risk, to say nothing of the issue of fraud, were a function of the transmission of information and touch the boundaries between economic and cultural history. They also touch the social history of economic life in early modern Europe. Merchants also depended on a wide range of organizations to reduce risk and reinforce reputations: they formed partnerships among themselves; they entered into collective agreements; they drew upon the resources of their families; they strengthened business agreements with confessional ties (by doing business with people of the same Christian creed). Finally, bankruptcies testify not just to the failures but also to the successes of early modern enterprise, a varying combination of fortune and misfortune, competence and incompetence, honesty and dishonesty. Bankruptcies give us a mirror image of business success; by showing us how merchants and manufacturers assessed risk and managed assets, we learn not only the circumstances of failure but also the conditions of success.

The early modern period supposedly witnessed what scholars have for more than a century generally described as the transition to modern capitalism. Insofar as this is true, bankruptcy reveals some of the continuities and discontinuities in an age of change. Credit played a central role in early modern bankruptcies, and the vitality and ubiquity of early modern money markets is one area in which modern capitalism differs less than expected from its pre-modern model. The personal nature of credit relations, given the institutional underdevelopment of early modern economies, constitutes a less well understood distinction from modern capitalistic practice. The interpretation of bankruptcy as a criminal act requiring restitution—which remained unaltered until the nineteenth century—raises fundamental questions about business reorganization and capital accumulation on the eve of the Industrial Revolution. The adversarial relationship between private and public finance, revealed strikingly in early modern state bankruptcies, may suggest that their modern symbiotic relationship had not developed. Bankruptcy teaches, finally, that "transition" may be too simple a term for what was a multifaceted, complex, and gradual process.

By the eighteenth century, the bankrupt replaces the monopolist as the quintessential image of ruthless, exploitative capitalism. Bankruptcies were common occurrences against which integrity offered no necessary protection. Yet moralizing tracts and popular periodicals elevated the bankrupt to the level of arch-villain of the local economy. It was a perfect measure of the ways economic principles had and had not caught up with economic practices. Given the importance of bankruptcy not only for the economic history of early modern Europe but also for its political, social, and cultural history, it is surprising that so little scholarship has been devoted to the topic.

See also Banking and Credit ; Capitalism ; Commerce and Markets ; Economic Crises ; Interest ; Taxation .

BIBLIOGRAPHY

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Dent, Julian. "An Aspect of the Crisis of the Seventeenth Century: The Collapse of the Financial Administration of the French Monarchy (1653–61)." The Economic History Review 20 (1967): 241–256.

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Ehrenberg, Richard. Das Zeitalter der Fugger: Geldkapital und Creditverkehr im 16. Jahrhundert. 2 vols. Jena, 1896.

Häberlein, Marc. Brüder, Freunde und Betrüger: Soziale Beziehungen, Normen und Konflikte in der Augsburger Kaufmannschaft um die Mitte des 16. Jahrhunderts. Berlin, 1998.

Hoffman, Philip T., Gilles Postel-Vinay, and Jean-Laurent Rosenthal. "Information and Economic History: How the Credit Market in Old-Regime Paris Forces Us to Rethink the Transition to Capitalism." The American Historical Review 104 (February 1999): 64–99.

——. "Redistribution and Long-Term Private Debt in Paris, 1660–1726." The Journal of Economic History 55, no. 2 (1995): 256–284.

Hoppit, Julian. "Financial Crises in Eighteenth-Century England." The Economic History Review 39 (1986): 39–58.

——. Risk and Failure in English Business, 1700–1800. Cambridge, U.K., 1987.

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Kerridge, Eric. Trade and Banking in Early Modern England. Manchester, U.K., 1988.

Lamoreaux, Naomi R. Insider Lending: Banks, Personal Connections, and Economic Development in Industrial New England. Cambridge, U.K., 1994.

Lovett, A. W. "The Castilian Bankruptcy of 1575." Historical Journal 23 (1980): 899–911.

——. "The General Settlement of 1577: An Aspect of Spanish Finance in the Early Modern Period." Historical Journal 25 (1982): 1–22.

Marriner, Sheila. "English Bankruptcy Records and Statistics before 1850." The Economic History Review 33 (1980): 351–366.

Muldrew, Craig. "Credit and the Courts: Debt Litigation in a Seventeenth-Century Urban Community." Economic History Review 46 (1993): 23–38.

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Neal, Larry. The Rise of Financial Capitalism: International Capital Markets in the Age of Reason. Cambridge, U.K., 1990.

Safley, Thomas Max. "Bankruptcy: Family and Finance in Early Modern Augsburg." The Journal of European Economic History 29 (2000): 53–73.

Tracy, James D. A Financial Revolution in the Habsburg Netherlands: Renten and Renteniers in the County of Holland, 1515–1565. Berkeley, 1985.

Van der Wee, Hermann. "Money, Credit, and Banking Systems." In The Cambridge Economic History of Europe, vol. 5, edited by E. E. Rich and C. H. Wilson, pp. 290–392. Cambridge, U.K., 1977.

Welbourne, E. "Bankruptcy before the Era of Victorian Reform." Cambridge Historical Journal 4 (1932/34): 51–62.

Thomas Max Safley

BANKRUPTCY

A federally authorized procedure by which a debtor—an individual, corporation, or municipality—is relieved of total liability for its debts by making court-approved arrangements for their partial repayment.

Once considered a shameful last resort, bankruptcy in the United States is emerging as an acceptable method of resolving serious financial troubles. A record one million individuals filed for bankruptcy protection in the United States in the peak year of 1992, and between 1984 and 1994 the number of personal bankruptcy filings doubled. Corporate bankruptcies are commonplace, particularly when corporations are the target of lawsuits, and even local governments seek debt relief through bankruptcy laws.

The goal of modern bankruptcy is to allow the debtor to have a "fresh start," and the creditor to be repaid. Through bankruptcy, debtors liquidate their assets or restructure their finances to fund their debts. Bankruptcy law provides that individual debtors may keep certain exempt assets, such as a home, a car, and common household goods, thus maintaining a basic standard of living while working to repay creditors. Debtors are then better able to emerge as productive members of society, albeit with significantly flawed credit records.

History of U.S. Bankruptcy Laws

U.S. bankruptcy laws have their roots in English laws dating from the sixteenth century. Early English laws punished debtors who sought to avoid their financial responsibilities, usually by imprisonment. Beginning in the eighteenth century, changing attitudes inspired the development of debt discharge. Courts began to nullify debts as a reward for the debtor's cooperation in trying to reduce them. The public increasingly viewed debtors with pity, as well as with a realization that punishments such as imprisonment often were useless to creditors. Thus, a law that was first designed to punish the debtor evolved into a law that protected the debtor while encouraging the resolution of outstanding monetary obligations.

England's eighteenth-century insight did not find its way into the first U.S. bankruptcy statutes; instead, laws based largely on England's earlier punitive bankruptcy statutes governed U.S. colonies. After the signing of the Declaration of Independence, individual states had their own laws addressing disputes between debtors and creditors, and these laws varied widely.

In 1789, the U.S. Constitution granted Congress the power to establish uniformity with a federal bankruptcy law, but more than a decade passed before Congress finally adopted the Bankruptcy Act of 1800. This act, like the early bankruptcy laws in England, emphasized creditor relief and did not allow debtors to file for relief voluntarily. Great public dissatisfaction prompted the act's repeal three years after its enactment.

Philosophical debates over whom bankruptcy laws should protect (i.e., debtor or creditor) had Congress struggling for the next forty years to pass uniform federal bankruptcy legislation. The passage of the Bankruptcy Act of 1841 offered debtors greater protections and for the first time allowed them the option of voluntarily seeking bankruptcy relief. This act lasted eighteen months. A third bankruptcy act passed in 1867 and was repealed in 1878.

The Bankruptcy Act of 1898 endured for eighty years, thanks in part to numerous amendments, and became the basis for current bankruptcy laws. The 1898 act established bankruptcy courts and provided for bankruptcy trustees. Congress replaced this act with the Bankruptcy Reform Act of 1978 (11 U.S.C.A. § 101 et seq.), which, along with major amendments passed in 1984, 1986, and 1994, is known as the Bankruptcy Code.

Federal versus State Bankruptcy Laws

In general, state laws govern financial obligations such as those involving debts created by contracts—rental leases, telephone service, and medical bills, for example. But once a debtor or creditor seeks bankruptcy relief, federal law applies, overriding state law. This is because the U.S. Constitution grants Congress the power to "establish … uniform Laws on the subject of Bankruptcies throughout the United States" (U.S. Const. art. I, § 8). Federal bankruptcy power maintains uniformity among the states, encouraging interstate commerce and promoting the country's economic stability. States retain jurisdiction over certain debtor-creditor issues that do not conflict with, or are not addressed by, federal bankruptcy law.

Types of Federal Bankruptcy Proceedings

Federal bankruptcy law provides two distinct forms of relief: liquidation and rehabilitation, also known as reorganization. The vast majority of bankruptcy filings in the United States involve liquidation, governed by chapter 7 of the Bankruptcy Code. In a chapter 7 liquidation case, a trustee collects the debtor's nonexempt assets and converts them into cash. The trustee then distributes the resulting fund to the creditors in order of priority described in the Bankruptcy Code. Creditors frequently receive only a portion, and sometimes none, of the money owed to them by the bankrupt debtor.

Gambling WITH Bankruptcy Exemptions

In bankruptcy cases, individual debtors have the privilege of retaining certain amounts or types of property that otherwise would be subject to liquidation or seizure by creditors in order to satisfy debts. Laws protecting these forms of property are called exemptions.

Consistent with the goal of allowing the debtor a "fresh start," exemptions in bankruptcy cases help ensure that the debtor, upon emerging from bankruptcy, is not destitute. Exemption statutes generally permit the debtor to keep such things as a home, a car, and personal goods like clothes. Although exemptions inhibit the creditor's ability to collect debts, they relieve the state of the burden of providing the debtor's basic needs.

The bankruptcy code provides a list of uniform exemptions but also allows individual states to opt out of (override) these exemptions (11 U.S.C.A. § 522 [1993 & Supp. 2003]). Thus, the types and amounts of property exemptions differ greatly and depend upon the debtor's state of residence.

A debtor residing in a state that has not opted out is entitled to the exemptions described in the bankruptcy code. Examples of code exemptions are the debtor's aggregate interest of up to $15,000 in a home; up to $2,400 in a motor vehicle; up to $8,000 in household furnishings, household goods, clothes, appliances, books, animals, crops, and musical instruments; up to $1,000 in jewelry; up to $1,500 in professional books or tools of the debtor's trade; and certain unmatured life insurance policies owned by the debtor. The debtor also may claim an exemption for professionally prescribed health aids, such as electric wheel-chairs.

The majority of states have chosen to opt out of the uniform federal exemptions, replacing them with exemptions created by their own legislatures. Homestead exemptions, which excuse all or part of the value in the debtor's home, are the most common state-mandated exemptions. These are not uniform across states. For instance, Missouri mimics the federal government by placing a dollar limit on the exemption, but at $8,000, its cap is meager in comparison (Mo. Ann. Stat. § 513.475 [Vernon 2002]). The bordering state of Iowa limits the homestead exemption by acreage rather than dollar amount (Iowa Code Ann. §§ 561.1, 561.2 [West 1992]). Florida allows a homestead exemption without limits (Fla. Const. art. X, § 4(a)(1)). This lack of uniformity raises the question of fairness: bankruptcy laws are federal in nature, yet a debtor in Florida may have a significant financial advantage over a debtor in Missouri, owing to different exemption laws.

Despite the broad variance among states when it comes to bankruptcy exemptions, critics charge that even the uniform federal system can be grossly unfair. For example, assume two debtors, Arlene and Ben, each have estates valued at $28,000. Arlene, a dentist, has $15,000 of equity in her home. She has $8,000 worth of furniture and household goods. Her car is worth $4,000, and she owns dental tools valued at $1,000.

Ben is an art lover. He owns no car, no furniture, and no house, having chosen instead to spend his money on paintings and sculptures that are now worth $26,000. His clothes, musical instruments, and other household goods are worth $2,000.

Arlene and Ben have states of equal value, but when the federal exemption statute is followed, Arlene can claim $27,200 in exemptions, whereas Ben can claim only $16,300. Arlene receives exemptions worth $15,000 for her homestead, $8,000 for her household goods, $2,400 for her car, and $1,000 for her dental tools, and an $800 general exemption for property not covered by other exemptions. Ben may claim an $8,000 exemption for his art and other household goods, as well as a general exemption worth $8,300, which replaces his unused homestead exemption.

Critics suggest that one problem with exemption laws is that legislators must determine the property that will best enable the average debtor to remain self-sufficient following a bankruptcy. Unconventional debtors, such as Ben, frequently are penalized as a result. In addition, laws that place monetary limits on exemptions often do nothing to help the debtor achieve a fresh start. When the value of certain property is worth more than the exemption, it is said to be only partially exempt and must be completely liquidated. Following liquidation, the debtor receives the value of the exemption in cash from the liquidation proceeds. Thus, in the case of Arlene's $4,000 car, the bankruptcy trustee would sell the car and from the sale proceeds give Arlene $2,400, the amount of the exemption. Arlene could then spend the money on a tropical vacation instead of a replacement car, rendering the vehicle exemption law virtually meaningless.

Debtors may also take advantage of exemption laws by transferring assets before filing for bankruptcy protection. For example, Ben could sell nonexempt artwork and, with the proceeds, purchase a small condominium. He could then file for bankruptcy and claim a homestead exemption, increasing by $7,500 his post-bankruptcy estate.

Congress actually supports this type of pre-bankruptcy planning, permitting the debtor "to make full use of the exemptions to which he is entitled under the law" (S. Rep. No. 989, 95th Cong., 2d Sess. [1978]). Still, courts view some pre-bankruptcy asset transfers as fraudulent, particularly when they involve large dollar amounts and there is evidence of intention to hinder, delay, or defraud creditors. Upon a finding of fraud, the bankruptcy court may deny discharge of the debtor's debts. But what constitutes a fraudulent transfer is often unclear and seemingly arbitrary.

Two bankruptcy cases from Minnesota exemplify the confusion surrounding fraudulent and nonfraudulent pre-bankruptcy transfers. The debtors in both cases were doctors who lost money in the same investment and who hired the same attorney to help them with their pre-bankruptcy planning. The outcomes of the cases differed significantly.

Before filing for bankruptcy, Omar Tveten liquidated most of his nonexempt assets, including his home. With the proceeds, he purchased life insurance and annuities valued at almost $700,000. Both the life insurance and the annuities were considered exempt under Minnesota law; however, the bankruptcy court held that the large amount converted was an indication of fraud and therefore refused to discharge Tveten's bankruptcy debts (Norwest Bank Nebraska v. Tveten, 848 F.2d 871 [8th Cir. 1988]).

Robert J. Johnson also transferred assets before filing for bankruptcy. Johnson converted nonexempt property into property exempt under Minnesota law: he purchased $8,000 in musical instruments, $4,000 in life insurance, and $250,000 in annuities from fraternal organizations, and he retired (paid off) $175,000 of the debt on his $285,000 home. The court focused on Johnson's claim for homestead exemption and in particular on the $175,000 mortgage payment made just before filing for bankruptcy. As the court in Tveten demonstrated, an unusually large asset transfer can indicate fraud. But in Johnson, the court held that the homestead exemption was valid, stating that the value of an asset transfer to homestead property, unlike the value of an asset transfer to property in another exemption category, is of little relevance because "no exemption is more central to the legitimate aims of state lawmakers than a homestead exemption" (Panuska v. Johnson, 880 F.2d 78 [8th Cir. 1989]).

Legal commentators have criticized the Tveten and Johnson decisions as being arbitrary and as providing no clear lines to assist debtors in pre-bankruptcy planning. Critics charge that the different outcomes are simply a result of different judges presiding at the initial bankruptcy court level, because the facts of the cases were so similar. Bankruptcy attorneys are frustrated by a lack of uniformity among court decisions that apply similar principles but reach different results, and also a lack of uniformity in exemption laws among states.

Indeed, forum shopping (searching for the most advantageous jurisdiction in which to file bankruptcy) is prevalent because of the wide diversity of state exemption laws. In re Coplan, 156 B.R. 88 (Bankr. M.D. Fla. 1993), illustrates the problem. The debtors, Lee Coplan and Rebecca Coplan, incurred substantial debt in their home state of Wisconsin before moving to Florida. After residing in Florida for one year and purchasing a house for $228,000, they sought bankruptcy relief and a homestead exemption under Florida law (West's F.S.A. Const. Art. 10, § 4(a)(1)), which allows an exemption for the full value of the homestead. The court found that the Coplans had engaged in a systematic conversion of assets by selling their home in Wisconsin and paying cash for their new home in Florida. This action was conducted, according to the court, solely for the purpose of placing the assets out of the reach of creditors. As a result, the bankruptcy court in Florida allowed a homestead exemption of only $40,000, the extent provided by Wisconsin law (W.S.A. § 815.20(1)). Yet other bankruptcy decisions have held that a conversion of nonexempt property to exempt property for the purpose of placing such property out of reach of creditors will not alone deprive the debtor of the exemption (see, e.g., In re Levine, 139 B.R. 551 [Bankr. M.D. Fla. 1992]).

Exemption is an integral part of bankruptcy law but a difficult area to navigate. Courts and legislatures must constantly determine whether exemptions constitute fair and just vehicles by which debtors can achieve a fresh start without getting a head start at the expense of creditors. Unfortunately for attorneys, debtors, creditors, and trustees, the laws regarding exemptions are inconsistent. Attempting to maximize the benefits granted by bankruptcy exemptions can be more of a gamble than a science.

further readings

Epstein, David G. 2002. Bankruptcy and Related Law in a Nutshell. St. Paul, Minn.: West Group.

Resnick, Alan N. 2002. Bankruptcy Law Manual. Eagan, Minn.: Thompson West.

cross-references

Creditor.

When the debtor is an individual, once the liquidation and distribution are complete, the bankruptcy court may discharge any remaining debt. When the debtor is a corporation, upon liquidation and distribution, the corporation becomes defunct. Remaining corporate debts are not formally discharged, as they are with individuals. Instead, creditors face the impossibility of pursuing debts against a corporation that no longer exists, making formal discharge unnecessary.

Rehabilitation, or reorganization, of debt is an option that courts usually favor because it provides creditors with a better opportunity to recoup what is owed to them. Rehabilitative bankruptcies are governed most often by chapter 11 or chapter 13 of the Bankruptcy Code. Chapter 11 typically applies to individuals with excessive or complex debts, or to large commercial entities such as corporations. Chapter 13 typically applies to individual consumers with smaller debts.

Unlike liquidation, rehabilitation provides the debtor with an opportunity to retain nonexempt assets. In return, the debtor must agree to pay debts in strict accordance with a reorganization plan approved by the bankruptcy court. During this repayment period, creditors are unable to pursue debts beyond the provisions of the reorganization plan. This gives the debtor the chance to restructure affairs in the effort to meet financial obligations.

To be eligible for rehabilitative bankruptcy, the debtor must have sufficient income to make a reorganization plan feasible. If the debtor fails to comply with the reorganization plan, the bankruptcy court may order liquidation. A

debtor who successfully completes the reorganization plan is entitled to a discharge of remaining debts. In keeping with the general preference for bankruptcy rehabilitation rather than liquidation, the goal of this policy is to reward the conscientious debtor who works to help creditors by resolving his or her debts.

Farmers and municipalities may seek reorganization through the Bankruptcy Code's special chapters. Chapter 12 assists debt-ridden family farmers, who also may be entitled to relief under chapters 11 or 13. When a local government seeks bankruptcy protection, it must turn to the debt reorganization provisions of chapter 9.

Orange County Bankruptcy and Chapter 9 Seldom used, chapter 9 attained notoriety in late 1994 following the bankruptcy of Orange County, California, the largest municipal bankruptcy in history. A county of 2.6 million people with one of the highest per capita incomes in the United States, Orange County held an investment fund that was composed largely of derivatives that were based on speculation on the direction of interest rates. The problem was made worse because the county had borrowed the money it was investing. When interest rates began to climb in 1994, Orange County's leveraged investments drained the investment fund's value, prompting lenders to require additional collateral. The only way to raise the collateral was to sell the investments at the worst possible time. The result was a $1.7 billion loss. After consulting with finance experts and reviewing alternatives, county officials filed for chapter 9 protection on December 6, 1994.

Residents of the affluent county faced immediate repercussions. Close to 10 percent of the fifteen thousand Orange County employees lost their jobs. School budgets were slashed, infrastructure improvements were put on hold, and experts predicted that property values in Orange County would decline. Legal fees involved in a bankruptcy of this complexity are extensive, and officials did not expect Orange County to emerge from bankruptcy for several years.

Critics of current bankruptcy law argue that irresponsible debtors too frequently receive protection at the expense of noncreditors, such as the residents of Orange County. Victims who allege corporate negligence and sue for injuries from dangerous products also become unwilling creditors when a corporation files for bankruptcy. But negligent or not, corporations battling multiple lawsuits often rely on the traditional rationale supporting bankruptcy: that it offers an opportunity to pay debts that otherwise might go unpaid.

Dow Corning Corporation and Chapter 11 Dow Corning Corporation was a major manufacturer of silicone breast implants used in reconstructive and plastic surgeries. In 1991, after receiving thousands of complaints of health problems from women with silicone implants, the U.S. food and drug administration banned the devices from widespread use. Women who had obtained the silicone implants in breast reconstruction or breast enlargement surgeries complained that the implants leaked, causing a variety of adverse conditions such as crippling pain, memory loss, lupus, and connective tissue disease. Dow Corning soon became a defendant in a worldwide product liability class action suit as well as at least nineteen thousand individual lawsuits.

Citing an inability to contribute $2 billion to a $4.2 billion settlement fund and pay for the defense of thousands of individual lawsuits, Dow Corning filed for chapter 11 bankruptcy protection in May 1995. The bankruptcy move halted new lawsuits and enabled the company to consolidate existing claims while preserving business operations. As a result of the filing, Dow Corning stalled its obligation to contribute to the settlement fund.

The Dow Corning strategy was similar to that employed in the mid–1980s by A.H. Robins Company, distributor of the Dalkon Shield intrauterine device for birth control. Like Dow Corning, A.H. Robins faced financial ruin owing to thousands of product liability lawsuits filed at the same time. Also like Dow Corning, A.H. Robins sought relief under chapter 11 of the Bankruptcy Code, which allowed the company time to formulate a plan to pay the many outstanding claims. A reorganization plan approved by the courts involved the merger of A.H. Robins with American Home Products Corporation, which agreed to establish a $2.5 billion trust fund to pay outstanding product liability claims (In re A.H. Robins Co., 880 F.2d 694 [4th Cir. 1989]).

On May 22, 1995, Dow Corning filed a request to stay all litigation against its parent companies, Dow Chemical Company and Corning Incorporated, so that company lawyers could concentrate on the bankruptcy reorganization. That move further threatened the chance of recovery for the plaintiffs seeking compensation for injury.

Family Farmers and Chapter 12 In 1986, responding to an economic farm crisis in the United States, Congress designed chapter 12 to apply to family farmers whose aggregate debts did not exceed $1.5 million. Congress passed the law to help farmers attain a financial fresh start through reorganization rather than liquidation. Before chapter 12's existence, family farmers found it difficult to meet the prerequisites of bankruptcy reorganization under chapters 11 or 13, often because they were unable to demonstrate sufficient income to make a reorganization plan feasible. Chapter 12 eased some requirements for qualifying farmers.

Congress created chapter 12 as an experiment, and scheduled its automatic repeal for 1993. Determining that additional time was necessary to evaluate the effectiveness of the law, Congress in 1993 voted to extend it until 1998. It was either extended or allowed to expire—then restored—eight times between November 1998 and January 1, 2004, when it expired again.

Federal Bankruptcy Jurisdiction and Procedure

Regardless of the type of bankruptcy and the parties involved, basic key jurisdictional and procedural issues affect every bankruptcy case. Procedural uniformity makes bankruptcies more consistent, predictable, efficient, and fair.

Judges and Trustees Pursuant to federal statute, u.s. courts of appeals appoint bankruptcy judges to preside over bankruptcy cases (28 U.S.C.A. § 152 [1995]). Bankruptcy judges make up a unit of the federal district courts called bankruptcy court. Actual jurisdiction over bankruptcy matters lies with the district court judges, who then refer the matters to the bankruptcy court unit and to the bankruptcy judges.

A trustee is appointed to conduct an impartial administration of the bankrupt's nonexempt assets, known as the bankruptcy estate. The trustee represents the bankruptcy estate, which upon the filing of bankruptcy becomes a legal entity separate from the debtor. The trustee may sue or be sued on behalf of the estate. Other trustee powers vary depending on the type of bankruptcy, and can include challenging transfers of estate assets, selling or liquidating assets, objecting to the claims of creditors, and objecting

to the discharge of debts. All bankruptcy cases except chapter 11 cases require trustees, who are most commonly private citizens elected by creditors or appointed by the U.S. trustee.

The office of the U.S. trustee, permanently established in 1986, is responsible for overseeing the administration of bankruptcy cases. The U.S. Attorney General appoints a U.S. trustee to each bankruptcy region. It is the job of the U.S. trustee in some cases to appoint trustees, and in all cases to ensure that trustees administer bankruptcy estates competently and honestly. U.S. trustees also monitor and report debtor abuse and fraud, and oversee certain debtor activity such as the filing of fees and reports.

Procedures Today, debtors file the vast majority of bankruptcy cases. A bankruptcy filing by a debtor is known as voluntary bankruptcy. The mere filing of a voluntary petition for bankruptcy operates as a judicial order for relief, and allows the debtor immediate protection from creditors without the necessity of a hearing or other formal adjudication.

Chapters 7 and 11 of the Bankruptcy Code allow creditors the option of filing for relief against the debtor, also known as involuntary bankruptcy. The law requires that before a debtor can be subjected to involuntary bankruptcy, there must be a minimum number of creditors or a minimum amount of debt. Further protecting the debtor is the right to file a response, or answer, to the allegations in the creditors' petition for involuntary bankruptcy. Unlike voluntary bankruptcies, which allow relief immediately upon the filing of the petition, involuntary bankruptcies do not provide creditors with relief until the debtor has had an opportunity to respond and the court has determined that relief is appropriate.

When the debtor timely responds to an involuntary bankruptcy filing, the court will grant relief to the creditors and formally place the debtor in bankruptcy only under certain circumstances, such as when the debtor generally is failing to pay debts on time. When, after litigation, the court dismisses an involuntary bankruptcy filing, it may order the creditors to pay the debtor's attorney fees, compensatory damages for loss of property or loss of business, or punitive damages. This reduces the likelihood that creditors will file involuntary bankruptcy petitions frivolously or abusively.

One of the most important rights that a debtor in bankruptcy receives is called the automatic stay. The automatic stay essentially freezes all debt-collection activity, forcing creditors and other interested parties to wait for the bankruptcy court to resolve the case equitably and evenhandedly. The relief is automatic, taking effect as soon as a party files a bankruptcy petition. In a voluntary chapter 7 case, the automatic stay gives the trustee time to collect, and then distribute to creditors, property in the bankruptcy estate. In voluntary chapter 11 and chapter 13 cases, the automatic stay gives the debtor time to establish a plan of financial reorganization. In involuntary bankruptcy cases, the automatic stay gives the debtor time to respond to the petition. The automatic stay terminates once the bankruptcy court dismisses, discharges, or otherwise terminates the bankruptcy case, but a party in interest (a party with a valid claim against the bankruptcy estate) may petition the court for relief from the automatic stay by showing good cause.

The Bankruptcy Code allows bankruptcy judges to dismiss bankruptcy cases when certain conditions exist. The debtor, the creditor, or another interested party may ask the court to dismiss the case. Petitioners—debtors in a voluntary case, or creditors in an involuntary case—may seek to withdraw their petitions. In some types of bankruptcy cases, a petitioner's right to dismissal is absolute; other types of bankruptcy cases require a hearing and judicial approval before the case is dismissed. Particularly with voluntary bankruptcies, creditors, the court, or the U.S. trustee has the power to terminate bankruptcy cases when the debtor engages in dilatory or uncooperative behavior, or when the debtor substantially abuses the rights granted under bankruptcy laws.

Recent Developments in Federal Bankruptcy Law

Brought about by a surge in bankruptcy filings and public concern over inequities in the system, the Bankruptcy Reform Act of 1994 is one illustration of Congress's continuing effort to protect the rights of debtors and creditors. Consistent with Congress's goal of promoting reorganization over liquidation, the legislation made it easier for individual debtors to qualify for chapter 13 reorganization. Previously, individuals with more than $450,000 in debt were not eligible to file under chapter 13, and instead were forced to reorganize under the more complex and expensive chapter 11 or to liquidate under chapter 7. The 1994 amendments allow debtors with up to $1 million in outstanding financial obligations to reorganize under chapter 13.

The new law helps creditors by prohibiting the discharge of credit card debts used to pay federal taxes, or those exceeding $1,000 incurred within sixty days before the bankruptcy filing. In this way, the law deters debtors from shopping sprees and other abuses just before filing for bankruptcy. Creditors also benefit from new provisions that set forth additional grounds for obtaining relief from the automatic stay, and require speedier adjudication of requests for relief from the stay.

It looked as though the bankruptcy system would see more reform with the introduction of the Bankruptcy Reform Act of 1998. The act was a response to a report issued by the National Bankruptcy Review Commission, which recommended that the existing code be fine-tuned in order to provide incentives to debtors to file chapter 13 reorganization and to increase debt repayment. The report was issued in response to concern that debtors were taking advantage of the bankruptcy system, evidenced by the fact that a record number of consumers filed for bankruptcy during a time of economic prosperity.

But the Bankruptcy Reform Act of 1998 was never enacted, and it turned out to be only the beginning volley in one of the most tortuous paths any legislation has seen. The House of Representatives has passed a bankruptcy reform bill no fewer than seven times since 1998, with the Senate close behind, and yet bankruptcy reform has yet to be passed into law as of the time of this writing, despite the fact that President george w. bush and the majorities in the current House and Senate all currently favor some sort of bankruptcy reform.

All of the bankruptcy reform legislation introduced since 1997 shares the same main thrust. Individual debtors would be discouraged from filing under chapter 7, which allows them to liquidate their debts, and would be encouraged to file under chapter 13 instead. The filing under chapter 7 will be presumed abusive if the debtor is deemed able to pay a portion of his debts under a formula set forth in the Reform Act. Debtors who have an ability to repay a portion of their debts out of future income will be forced to reorganize under chapter 13.

The main criticism of all the bankruptcy reform acts that have been passed since 1997 is that they favor creditors at the expense of debtors who truly might not be able to pay, but who technically fail the means test that is used to determine whether they can make some form of repayment. But this criticism has not been the only reason why bankruptcy reform has not passed. For example, the Bankruptcy Reform Act of 2001 failed because a provision was included to prevent anti-abortion protesters from avoiding criminal fines by claiming bankruptcy. Anti-abortion legislators who otherwise would have supported the bill joined forces with opponents of the bill to defeat it. Another bankruptcy reform act passed in the House of Representatives by a vote of 315–113 in March 2003.

While Congress was considering bankruptcy reform, the U.S. Supreme Court handed down two decisions that further defined the limits of bankruptcy law. In Cohen v. De La Cruz 523 U.S. 213, 118 S. Ct. 1212, 140 L. Ed. 2d 341, a unanimous court held that where a debtor committed actual fraud and was assessed punitive damages, the debt would be not dischargeable because the Bankruptcy Code's prohibition against the discharge of fraudulently incurred debts is not restricted to the value of the money, property, or services received by the debtor. In Young v. U.S., 535 U.S. 43, 122 S. Ct. 1036, 152 L. Ed. 2d 79. The court held that three-year lookback period allowing IRS to collect taxes against a debtor was tolled during pendency of a debtor's earlier chapter 13 proceeding.

Apart from developments in the law, bankruptcy was much in the news during the opening years of the twenty-first century as an economic downturn forced many of American's most prominent companies into chapter 11 bankruptcy. In 2001, the energy-trading firm Enron filed for the biggest corporate bankruptcy in history, with $64 billion in assets. Less than a year later, telecommunications firm World-Com topped that record when it listed $104 billion in assets in its bankruptcy filing. Other prominent American companies filing for bankruptcy included retailer K-Mart, financial services firm Conseco, and United Airlines parent company UAL.

further readings

Anderson, Nick. 2003. "House Passes Bankruptcy Reform Bill For the 7th Time."Los Angeles Times (March 20).

Hubler, James T. 2002. "The End Justifies the Means: The Legal, Social, and Economic Justifications for Means Testing Under the Bankruptcy Reform Act of 2001." American University Law Review (October).

Jewell, Mark. 2002. "Conseco Bankruptcy Ranks Third in U.S." Associated Press (December 19).

Reid, Linda. 2001."Bankruptcy Reform Legislation"Arkansas Lawyer (fall).

cross-references

Petition in Bankruptcy.

Bankruptcy

Bankruptcy is a legal proceeding, guided by federal law, designed to address situations where a debtor—either an individual or a business—has accumulated obligations so great that he or she is unable to pay them off. Bankruptcy law does not require filers to be financially insolvent at the time of the filing. Rather, it applies a criterion in which approval is granted if the filer is "unable to pay debts as they come due." Once a company is granted bankruptcy protection, it can terminate contractual obligations with workers and clients, avoid litigation claims, and explore possible avenues for reorganization.

Bankruptcy laws are designed to distribute the debtor's assets as equitably as possible among his or her creditors. Most of the time, with some exceptions, bankruptcy also frees the debtor from further liability. Bankruptcy proceedings may be initiated either by the debtor—a voluntary process—or may be forced by creditors.

According to the Administrative Office of the U.S. Courts, in Fiscal Year 2005, 1.637 million bankruptcies were filed in federal courts, up from 1.277 million in FY 2000. Of these 32,406 were business bankruptcies (down from 36,910 in FY 2000). Bankruptcy statistics are dominated by personal filings; these have been increasing sharply in recent years due in large part to rapidly increasing levels of personal indebtedness.

This phenomenon has been responsible for a major overhaul of bankruptcy law in 2005. The legislation, known as The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) was signed into law on April 20, 2005 and became effective October 17 of the same year. The law was designed, in part, to eliminate the practice of serial bankruptcy filings by individuals to escape carelessly accumulated debt.

Types of bankruptcy are named after chapters of the bankruptcy code. Individuals may file under the provisions of Chapter 7 or Chapter 13.

CHAPTER 7 BANKRUPTCY

Under Chapter 7 bankruptcy law, all of the debtor's assets—including any unincorporated businesses that he or she may own—are fully liquidated. Assets deemed necessary to support the debtor and his/her dependents, such as a residence, may be exempted. This "liquidation bankruptcy" is the most common filing for business failures, accounting for about 75 percent of all business bankruptcy filings.

The federal bankruptcy court develops a full listing of the debtor's assets and liabilities. The court identifies assets deemed to be exempted, such as a family home, and then divides remaining assets among the various creditors; a trustee is appointed to oversee distribution of proceeds. Unpaid taxes receive top priority; secured creditors are usually considered next. After all assets are liquidated and distributed, the debtor is freed of all further obligations. John Pearce II and Samuel DiLullo note the pluses and minuses of this procedure in Business Horizons as follows: "This type of filing is critically important to sole proprietors or partnerships, whose owners are personally liable for all business debts not covered by the sale of the assets unless they can secure a Chapter 7 bankruptcy allowing them to cancel any debt in excess of exempt assets. Although they will be left with little personal property, the liquidated debtor is discharged from paying the remaining debt." The debts thus discharged exclude certain items which the debtor is required to pay despite the Chapter 7 filing. These include child support, alimony, recent income taxes, and student loans guaranteed by government.

The recently passed BAPCPA limits the ability of a debtor to file under Chapter 7. The debtor can only file for "liquidation bankruptcy" if his or her median income is below the state median income; if it is higher, and the person can afford to pay out $100 monthly to liquidate debt, he or she may only file under Chapter 13. The new law also mandates credit counseling ahead of filing in a government-approved program.

CHAPTER 13 BANKRUPTCY

An individual or business filing under Chapter 13 turns over his or her finances to the bankruptcy court and is then obliged to make payments at the court's direction. Whereas Chapter 7 is characterized by full discharge of debt, Chapter 13 results in a repayment plan. Debtors prefer Chapter 7 because it usually allows them to hold on to their equity but, after a brief time, all obligations except such as listed above (child support, alimony, etc.) are eliminated. Courts prefer filings under Chapter 13 if the individual has any ability to satisfy the debt over time, and BAPCPA now codifies this leaning of the courts by defining a "threshold"—the state median income and an ability to pay $100 a month toward the indebtedness.

Provisions of BAPCPA have made Chapter 13 filings more burdensome for filers. Under the old dispensation, Chapter 13 filers enjoyed more protection against legal actions by litigants intending to recover funds or to impose new costs. Filers were protected against evictions; under BAPCPA they no longer are. They may lose their driver's licenses. They must continue to respond to divorce and child-support actions. BAPCPA has also moved family members with financial claims (e.g., for child support, alimony) to the first rank of recipients, ahead of secured creditors. Like Chapter 7 filers, Chapter 13 filers are also required to participate in mandatory financial management education.

CHAPTER 11 BANKRUPTCY

In a bulletin titled Corporate Bankruptcy, the U.S. Securities and Exchange Commission summarizes why corporations file for bankruptcy under Chapter 11: "Most publicly-held companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 provides a process for rehabilitating the company's faltering business. Sometimes the company successfully works out a plan to return to profitability; sometimes, in the end, it liquidates. Under a Chapter 11 reorganization, a company usually keeps doing business and its stock and bonds may continue to trade in our securities markets."

Companies generally turn to Chapter 11 protection after they are no longer able to pay their creditors. Once a company has filed under Chapter 11, its creditors are notified that they cannot press suits for repayment (although secured creditors may ask the court for a "hardship" exemption from the general debt freeze that is imposed). Creditors are, however, permitted to appear before the court to discuss their claims and provide data on the debtor's ability to reorganize. In addition, unsecured creditors may appoint representatives to negotiate a settlement with the debtor company. Finally, creditors who feel that the debtor company's financial straits are due to mismanagement or fraud may ask the court to appoint an examiner to look into such possibilities.

Once a company asks for Chapter 11 protection, it provides the court, lenders, and creditors with a wide range of financial information on its operations for analysis even as it continues with its day-to-day operations; during this period, major business expenditures must be approved by the court. The business will also prepare a reorganization plan, which, according to CPA Journal contributor Nancy Baldiga, "details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection." Another important component of this plan is the disclosure statement, which presents projected business fortunes, proposed financial settlements with creditors and equity holders, and estimates of the liquidation value of the company. "The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation," wrote Baldiga.

The reorganization plan, if approved by the court and a majority of creditors, becomes the blueprint for the company's future. Principal factors considered in determining the feasibility of reorganization proposals include:

• Status of the company's capital structure
• Availability of financing and credit
• Potential earnings of the company after reorganization
• Ability to make creditor payments
• Management stability
• General economic conditions in the industry
• General economic conditions in geographic regions of operation

BAPCPA has also introduced a number of changes governing Chapter 11 filings related to leases, payments made immediately prior to the bankruptcy filing, improved ability of creditors to reclaim products, caps on wage claims applicable to the pre-filing period, and other matters.

SMALL BUSINESS CREDITORS

Small businesses facing a bankrupt client have few options to protect themselves. If the debtor is engaged in questionable or fraudulent business activities, the small business may use legal actions beyond simply waiting patiently for a bankruptcy court to act. In situations where the debtor has incurred debt only a short time before filing before bankruptcy, creditors can sometimes obtain judgments that put added pressure on the debtor to make good on that liability. In addition, noted the Entrepreneur Magazine Small Business Advisor, "the law provides for a '60-day preference' rule. This rule is designed to prevent debtors from paying off their friends right before they file bankruptcy while leaving others stiffed. The 60-day rule allows the court to set aside any payments made up to 60 days before the actual filing of bankruptcy. Creditors who have been paid must return the money to the bankruptcy court for it to be placed in the pot. Business owners should keep in close contact with their ongoing customers so that they will have a good enough relationship to know far in advance to avoid being caught up in this rule." Indeed, small business owners in particular should always be watching for clients/customers who show signs of being in financial distress. If such indications become present, the owner needs to determine the depth of that distress and whether his or her small business can withstand the likely financial repercussions if that client/customer declares bankruptcy. If a bankruptcy declaration would be a significant blow, then the business owner should weigh various alternatives to protect his/her business, such as cutting back on business dealings with the endangered company or tightening up credit arrangements with the firm.

Finally, advisors typically counsel small business creditors to file confirmations of debt with the court even if it seems highly unlikely that they will ever be compensated. This filing allows creditors to write off bad debts on their taxes.

ALTERNATIVES TO BANKRUPTCY

A company that runs into serious financial difficulties has alternatives to bankruptcy. It can liquidate the business on its own and make payments to its creditors. "Such action may be achieved efficiently if [the business's] creditors … are few … and the assets … can readily be converted to cash," wrote Pearce and DiLullo. "If the number of creditors is large and the assets are numerous and difficult or time-consuming to sell (such as real estate), the protection, structure, and authority of the court may be needed."

Another option is for the company to place liquidation of assets in the hands of a trustee who subsequently pays creditors. The principal advantage of this avenue, say Pearce and DiLullo, is that the assets are thus protected from individual creditors who might otherwise file liens on the assets. "Composition agreements," meanwhile, can be used in situations where creditors agree to receive proportional (pro rata) payments of their claims in return for freeing the debtor company from the remainder of its debts.

These alternative strategies may enable some business owners to avoid the stigma of bankruptcy. But Pearce and DiLullo note that pursuing these options involves considerable risk: "astute creditors will recognize such actions as precursors to bankruptcy and may modify their relationships with [the company], which could precipitate a bankruptcy filing. If creditors believe that continuing in business will result in reduced assets, they may force a bankruptcy in order to stop operations and preserve the existing assets to pay outstanding debts."

see also Business Failure/Dissolution

BIBLIOGRAPHY

Administrative Office of the U.S. Courts. "Number of Bankruptcy Cases Filed in Federal Courts." Press Release, 24 August 2005.

Baldiga, Nancy R. "Practice Opportunities in Chapter 11." CPA Journal. May 1998.

"Checklist of Key Changes." FindLaw. Available from http://bankruptcy.findlaw.com/bankruptcy/bankruptcy-basics/key-changes.html. January 2006.

Pearce II, John A., and Samuel A. DiLullo. "When a Strategic Plan Includes Bankruptcy." Business Horizons. September/October 1998.

U.S. Securities and Exchange Commission. "Corporate Bankruptcy." Available from http://www.sec.gov/investor/pubs/bankrupt.htm. 8 December 2005.

                                Hillstrom, Northern Lights

                                updated by Magee, ECDI

Bankruptcy

Sections within this essay:

Background

Bankruptcy is a procedure, authorized under federal law, that relieves an individual or corporation of debts. With bankruptcy, debtors rarely escape completely from liability for their debts; instead, they partially or completely repay creditors under an arrangement that is court approved and authorized and in exchange, any remaining debt is forgiven.

Once considered shameful, bankruptcy still is a method of last resort for relieving financial obligations, but in recent decades bankruptcy in the United States has become more common and more acceptable. Individuals can seek the protection of the bankruptcy courts for personal debts such as credit cards, home mortgages, and medical bills, among others. Corporations, farms, and even local governments also can find themselves lacking enough financial resources to pay their debts and can turn to the bankruptcy law for help.

Bankruptcy exists to allow debtors to have a "fresh start," so that they can settle their debts and return to being productive members of society. The goal is to prevent individual debtors from becoming destitute and to prevent corporate debtors and other entities from becoming non-existent. At the same time, it is the goal of bankruptcy to repay creditors, at least partially. This is done by having the bankruptcy court liquidate, or sell, the assets of the debtor or restructure the debtor's finances so that creditors are paid at least part of what is owed. The bankruptcy court protects the debtor from further debt-collecting actions by the creditor so long as the debtor complies with the court's liquidation or restructuring plan. Bankruptcy thereby allows the debtor to emerge from the debt and move forward. This is why bankruptcy is sometimes referred to as "bankruptcy protection" or "bankruptcy relief." A significant deterrent to bankruptcy is the damaged credit rating that results. An individual who files for bankruptcy may have a difficult time obtaining credit for up to seven years or more.

Although federal law generally governs bankruptcies in the United States, states still govern issues and disputes over financial obligations such as rental leases, utility bills, and other contracts involving finances. Federal law concerning these issues overrides state law once a debtor files for bankruptcy protection. This is warranted by the Constitution and ensures economic stability and uniformity among the states.

History

The evolution of bankruptcy laws in the United States began in England in the sixteenth century. At that time, debtors who would not, or could not, pay their debts unhappily found themselves in debtors prison. By the eighteenth century, public sentiment was shifting with the realization that imprisoning debtors was not only cruel, it also prevented creditors from ever getting paid. New laws developed that allowed debts to be reduced or forgiven in exchange for the debtor's efforts to repay them.

Before the signing of the Declaration of Independence, colonies in the United States followed the earlier, punitive English laws that imprisoned debtors. States developed their own laws regarding debtors after 1776, but these laws lacked uniformity. The U.S. Constitution in 1789 charged Congress with enacting laws concerning bankruptcy and the Bankruptcy Act of 1800 became the country's first uniform bankruptcy law.

But three years after its enactment, Congress repealed the 1800 law over public sentiment that disfavored its emphasis on creditor rights. Congress struggled during the next century to strike the delicate balance between protecting debtors and repaying creditors. In 1841, Congress for the first time permitted debtors to choose whether to obtain bankruptcy relief rather than being forced to do so. Other bankruptcy laws came and went, but the Bankruptcy Act of 1898 and its many amendments lasted for eighty years and became the model for current bankruptcy laws in the United States. The 1898 act established special bankruptcy courts and bankruptcy trustees, charged with the duty of overseeing bankruptcy liquidations and financial restructuring. The Bankruptcy Reform Act of 1978 replaced the 1898 act and, along with amendments passed in 1984, 1986, 1994, and 2005, this act is known as the bankruptcy code. The 2005 changes, which fall under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), introduced what many experts consider to be among the most sweeping changes to personal bankruptcy law, particularly for those who seek to liquidate their debts.

Types of Bankruptcies

There are generally two types of bankruptcy relief. Liquidation, governed by chapter seven of the bankruptcy code and commonly referred to as chapter seven bankruptcy, involves converting the debtor's assets into cash and using the cash to pay the creditors. The bankruptcy code defines how bankruptcy courts and trustees are to prioritize creditors. Some creditors receive only partial satisfaction, or in some cases no satisfaction, of the debt. Once the liquidation and distribution of assets to the creditors is complete, in the case of an individual debtor, the court will forgive any remaining debt. In the case of a corporation, the corporation is rendered defunct upon liquidation and distribution. There is no need to forgive remaining debts of a corporation since the corporation is no longer a legal entity for creditors to pursue.

The second type of bankruptcy relief is called rehabilitation or reorganization. This type of bankruptcy usually gives creditors a better chance of being repaid, although the duration of repayment may be extended. In a reorganization bankruptcy, the debtor may keep assets but must strictly abide by a reorganization plan that the bankruptcy court authorizes. The reorganization plan defines when and how much each creditor will be repaid, but allows the debtor to continue to function as normally as possible. While the reorganization plan is in place the court prevents creditors from pursuing additional payments from the debtor. Over time and with diligence, the debtor repays the creditors according to the reorganization plan. Once the plan is completed, remaining debts are discharged, or forgiven. If the debtor does not comply with the reorganization plan, the court may order that the debtor's assets be liquidated to pay the debts.

The most common forms of reorganization bankruptcies are chapter eleven bankruptcy, which normally applies to individuals and corporations with large and complex debts, and chapter thirteen bankruptcy, which normally applies to individual consumers. The bankruptcy code has a special chapter for family farmers, chapter twelve, but family farmers may opt to file under chapters eleven or thirteen instead. Municipalities seeking bankruptcy protection do so under chapter nine, which mandates reorganization.

Sweeping Changes in 2005

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was signed into law in April 2005 and went into effect on October 17, 2005. This act, designed to curb instances of bankruptcy fraud, had a direct impact on chapter seven bankruptcies. The most significant change was a requirement for chapter seven filers to pass a means test to determine whether they might be able to file chapter thirteen and pay back their debts over a five-year period. Debtors whose income was above the state median (variable based on the number of people in the debtor's household) would be required to file chapter thirteen. Even those deemed eligible to file for chapter seven would still face stricter requirements. Mandatory debt counseling must be completed within 180 days prior to filing for bankruptcy and the debtor must provide a certificate of counseling. The debtor must also supply additional proof of assets, including the most recent year's tax return, evidence of payment from employers made 60 days before filing, and other forms and documents (including a photo ID). The amount of time before a debtor can file again for chapter seven bankruptcy has risen from six years to eight years.

Banks and credit card agencies hailed the new act as a much-needed check on an easy way out of paying legitimate debts (in 2003 there were 1.6 million filings for personal bankruptcy). Consumer advocates claimed that the new act punished those who were legitimately seeking relief and who now would have a harder time trying to get a fresh start. One development that could have an impact on this issue was a change in regulations regarding minimum monthly payments on credit card accounts. The federal government compelled banks and other credit card issuers to raise the minimum monthly payments, in some cases to double what they had been. While such a change could be a hardship on borrowers who may have trouble making higher payments, ultimately it could help lower outstanding debt by getting people to pay their credit card bills down more quickly.

In October 2005, the U.S. Department of Justice announced that it would grant temporary waivers to chapter seven filers who were affected by Hurricane Katrina, which devastated Louisiana and Mississippi. Victims of the hurricane were given additional time to get the necessary paperwork and debt counseling requirements completed before filing for bankruptcy.

Jurisdiction and Procedure

Federal statute requires that federal district courts maintain jurisdiction over bankruptcy matters. District court judges do not preside over bankruptcy cases, however. Instead, units within the district courts manage bankruptcy cases. Federal appellate court judges appoint bankruptcy judges to these units, and these judges, with their specialized knowledge of the bankruptcy laws and rules, preside over bankruptcy cases. Thus, the federal district courts technically have jurisdiction over bankruptcy filings but in practice refer the matters to the bankruptcy judges.

Most bankruptcy cases require that the bankruptcy court appoint a trustee. The bankruptcy trustee's job is to impartially administer the bankruptcy estate, which includes the assets of the debtor. Once a debtor files for bankruptcy protection, the debtor's assets—savings, houses, cars, jewelry, stocks, and bonds are examples of assets—become the bankruptcy estate, and the bankruptcy estate becomes a distinct legal entity separate from the debtor. The trustee represents the bankruptcy estate and at the direction of the bankruptcy judge may sell assets, or otherwise oversees if, when, and how the assets will be distributed to pay the debts.

In 1986, Congress permanently established a central office to oversee the work of bankruptcy trustees throughout the country. The office of the U.S. trustee has trustees, appointed by the U.S. attorney general, in each region of the United States. These appointed U.S. trustees, in turn, appoint and supervise additional trustees, ensuring that trustees do their jobs competently and honestly. U.S. trustees also have the responsibility to monitor and report fraud by debtors and abuse by creditors.

One important aspect of the bankruptcy laws is the "automatic stay." As soon as a debtor files the proper legal documents requesting bankruptcy protection, the automatic stay takes effect. This means that all efforts by creditors to collect from the debtor are, by law, frozen, and a creditor who ignores the automatic stay faces severe penalties. The automatic stay gives the debtor, the trustee, and the court time to determine the proper course of action in getting the debts repaid. A party who has a claim against the bankruptcy estate and shows good cause for not being included in the requirements of the automatic stay may ask the bankruptcy judge for "relief from the automatic stay."

When the debtor complies with the bankruptcy liquidation or reorganization plan and the plan is completed, the bankruptcy judge may discharge any remaining debt and terminate the bankruptcy case. This action also terminates the automatic stay and ends the bankruptcy court's involvement with the debtor. Typically, the debtor is left without any debts since the bankruptcy plan has repaid them or the bankruptcy court has discharged them. Also typically, the debtor is left with a poor credit rating and has difficulty borrowing money, obtaining credit cards, and financing things like homes, cars, and business ventures. Credit bureaus can report a bankruptcy for ten years after the date of filing.

Sometimes creditors offer debtors the opportunity to "reaffirm" a debt—in other words, to keep the debt and agree to pay it off even if it is eligible for liquidation. Debtors often do this when they feel it would be to their advantage to maintain a good relationship with certain creditors. Reaffirming a debt does not improve the debtor's credit rating, and leaves the debtor with an undischargable debt, thus defeating the purpose of bankruptcy as a form of financial relief. Many lending institutions do allow debtors to obtain credit in the form of a"secured" credit card, in which the debtor deposits money into a bank account as collateral against the use of the card. This can be useful for people who wish to gradually rebuild their credit ratings.

Exemptions from the Bankruptcy Estate

In keeping with the goal of bankruptcy laws to rehabilitate rather than punish the debtor, the individual debtor is permitted to keep some property that otherwise would be included in the bankruptcy estate and liquidated. These are called exemptions. Exemptions ensure that the debtor is able to survive the bankruptcy process without becoming destitute and having to rely on additional government assistance once the process is complete. Property that is commonly deemed exempt from the bankruptcy estate usually includes a home, a personal car, and personal items such as clothing.

The federal bankruptcy statute lists allowable exemptions, and these are followed in some states. But the federal law also permits states to legislate their own list of bankruptcy exemptions (in fact, 35 states do not allow debtors to take the federal exemptions). This results in widely varying types and amounts of exemptions that depend on the debtor's state of residence.

State Bankruptcy Exemptions

Below are some examples of typical state exemptions. Some of the exempt items listed (sewing machines, farm tools) are a holdover from earlier days when such items would have been essential to the debtor's ability to rebuild a life.

ALABAMA: Residents may not elect federal exemptions. State exemptions include up to $5,000 in homestead equity and up to $3,000 in personal property. Personal items such as family books and photos are exempt.

ARIZONA: Residents may not elect federal exemptions. Residents may exempt up to $100,000 in homestead property and up to $4,000 in household furnishings and appliances, food and provisions for use of individual or family for six months, life insurance proceeds, retirement fund, tools or equipment used in a trade or profession.

CALIFORNIA: Residents can elect federal exemptions or California exemptions. California homestead exemptions include up to $50,000 in home equity for individuals, up to $75,000 in home equity for heads of households, and up to $100,000 for seniors or disabled individuals. Ordinarily and reasonably necessary household furnishings and clothing used by the debtor and spouse are completely exempt. Other exemptions include jewelry, heirlooms, and works of art up to $5,000, tools of trade up to $5,000 per spouse, cemetery plots.

FLORIDA: Residents may not elect federal exemptions. Homestead is completely exempt. Personal property worth up to $1,000 is exempt. Personal vehicle up to $1,000 is exempt. Professionally pre-scribed health aids are exempt.

IDAHO: Residents may not elect federal exemptions. Homestead equity of up to $50,000 is exempt. Personal property valued up to $500 per item or an aggregate of $4,000 for all items is exempt; jewelry of aggregate value up to $250 is exempt; personal vehicle up to $1,500 is exempt; professional books and tools of the trade up to aggregate value of $1,000 is exempt.

KENTUCKY: Residents may not elect federal exemptions. Real or personal property valued up to $5,000 used by the debtor as a residence is exempt. Personal property valued up to $3,000; equipment and livestock valued up to $3,000 and personal vehicle valued up to $2,500 are exempt.

MICHIGAN: Homestead exemption of up to 40 acres of land and dwelling house not exceeding $3,500 in value are exempt. Family pictures and clothing are exempt. Household goods not exceeding $1,000 are exempt. Seat or pew used by debtor in public house of worship is exempt. Individual Retirement Account is exempt.

NEVADA: Residents may not elect federal exemptions. Homestead equity up to $125,000 is exempt. Private libraries up to $1,500 in value and personal belongings up to $3,000 in value are exempt. Farm trucks, stock, and equipment not to exceed $4,500 are exempt; tools of the profession not to exceed $4,500 are exempt. Qualified retirement plans not exceeding $500,000 in present-day value are exempt.

NEW YORK: Homestead equity of up to $10,000 is exempt. Personal belongings such as family bible, pictures, school books, one sewing machine, pets and pet food, all clothing and household furniture, one television set, one refrigerator, one radio, one wedding ring, one watch up to $35 in value are exempt.

OKLAHOMA: Homestead is exempt. Exempt personal property may include all household furniture; cemetery plots; family books, portraits, and pictures; clothing valued up to $4,000; five milk cows and their calves up to six months old; 100 chickens; two horses and two bridles and two saddles; one gun; one vehicle valued up to $3,000; ten hogs; twenty sheep; and one year's supply of provisions for stock.

RHODE ISLAND: There is no exemption for homestead. Exempt personal property includes clothing up to $500; furniture up to $1,000; bibles, school books, and family books valued up to $300; cemetery plot.

UTAH: Residents may not elect federal exemptions. Homestead equity up to $10,000 is exempt. Personal property such as burial plots; necessary health aids; clothing not including jewelry and furs; one washing machine; one dryer; one microwave oven; one refrigerator; one freezer; one stove; one sewing machine; beds and bedding are exempt. Personal vehicle up to $2,500 is exempt. Household furnishings up to $1,000 in value are exempt. Heirlooms up to $500 are exempt. Animals, books, and musical instruments up to $500 are exempt. Tools of trade up to $3,500 are exempt.

WASHINGTON: Resident may elect state exemptions, federal exemptions, or both. Homestead equity up to $30,000 is exempt. Personal property that is exempt includes clothing; jewelry, and furs valued up to $1,000; private libraries valued up to $1,500 per individual; household furnishings up to $2,700; two cars; $100 in cash; and tools of the trade not to exceed $5,000 in value.

Federal Bankruptcy Exemptions

Federal bankruptcy exemptions include the following: Residence of debtor up to $17,450 in value is exempt. Personal vehicle up to $2,775 in value is exempt. Household furnishings, books, clothing, pets, and other personal items not to exceed $425 per item or $9,300 in aggregate value are exempt. Jewelry not to exceed $1,150 in value is exempt. Tools of the trade valued up to $1,750 are exempt. Benefits such as social security, disability, unemployment, alimony, and certain pensions are exempt. A "wild card" exemption of up to $925, plus up to $8,725 of unused homestead exemption funds, can be applied to any property.

Some states allow debtors to combine state and slected federal exemption items.

Additional Resources

West's Encyclopedia of American Law. West Group, 1998.

Organizations

American Bankruptcy Institute

44 Canal Center Plaza, Suite 404
Alexandria, VA 22314 USA
Phone: ((703)) 739-0800
URL: www.abiworld.org
Primary Contact: Sam Gerdano, Executive Director

Bankruptcy

A federally authorized procedure by which a debtor—an individual, corporation, or municipality—is relieved of total liability for its debts by making court-approved arrangements for their partial repayment.

Central Virginia Community College v. Katz

Since the early 1990s the Supreme Court has reexamined the scope of congressional authority to override the sovereign immunity of state governments. In a series of cases the Court has nullified various federal laws that sought to allow private parties to file civil lawsuits for damages against state governments. However, in Central Virginia Community College v. Katz, __U.S.__, 126 S.Ct. 990, __L.Ed.2d__ (2006), the Court reversed course and ruled that the Constitution's Bankruptcy Clause abrogated state sovereign immunity. In so ruling, the Court allowed a federal bankruptcy trustee to seek return of assets from state colleges so they could be redistributed to creditors.

Bernard Katz was appointed by a federal bankruptcy judge in Kentucky as the liquidating supervisor for Wallace Bookstores, Inc. The corporation had filed for Chapter 11 reorganization. Katz discovered that four Virginia publicly funded educational institutions, including Central Virginia Community College, had received rental payments from Wallace Bookstores early in the bankruptcy process. Under the Bankruptcy Code Katz had the authority to seek recovery of these payments as "preferential transfers" prohibited by law. Such transfers include those made on or within 90 days before the filing of the bankruptcy. The purpose of the provision is to create an asset pool that will give more creditors the opportunity to recover at least some of their debt. Katz filed a proceeding in Kentucky Bankruptcy Court, demanding that the four educational institutions return a total of $400,000 to the bankruptcy estate. The schools moved to dismiss the action, arguing that state sovereignty prevented them form being sued for the money. The district court disagreed and allowed the case to proceed. The decision was upheld by the Sixth Circuit Court of Appeals, concluding that Congress had abrogated the state's sovereign immunity when it enacted the Bankruptcy Code provision 11 U.S.C.A. § 106(a). The Supreme Court agreed to hear the state's appeal to resolve the sovereign immunity issue.

The Supreme Court, in a 5-4 decision, upheld the lower courts but found that the enactment of § 106(a) had not been necessary to authorize the Bankruptcy Code's jurisdiction over the preferential transfer proceedings. Justice John Paul Stevens, in his majority opinion, noted that Article I, § 8, cl. 4 of the Constitution provides that Congress shall have the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States." The Court had made clear in previous cases that bankruptcy jurisdiction is in rem. Generally, in rem actions involve a proceeding where property, rather than a person, is a party, with the bankruptcy court's jurisdiction premised on the debtor and his estate, and not on the creditors. As such, Justice Stevens concluded that it did not implicate state sovereign immunity "to nearly the same degree as other kinds of jurisdiction."

Justice Stevens placed heavy emphasis on the early history of American bankruptcy law, the drafting of the Constitution, and the first federal bankruptcy law enacted in 1800. Stevens pointed out that before the Constitution American bankruptcy law was very similar to that found in England. Debtors were imprisoned and treated harshly. Moreover, each state administered its own bankruptcy law and a discharge granted in one state was not honored in another state where a person owed money. The substantive provisions varied from state-to-state created legal uncertainties that the framers of the Constitution addressed with the Bankruptcy Clause. Justice Stevens interpreted the lack of debate over the clause to mean that there was "general agreement on the importance of authorizing a uniform federal response to the problems presented" in the state courts.

The Court dispensed with the need to interpret the scope of the bankruptcy preferential transfer provisions. Justice Stevens reasoned that framers of the Bankruptcy Clause "would have understood it to give Congress the power to authorize courts to avoid preferential transfers and to recover the transferred property." Turning to early bankruptcy law, he noted that Congress passed the first Bankruptcy Act in 1800. It gave the federal courts the power to use the writ of habeas corpus to free debtors from state prison. This "remarkable" grant of power came in the aftermath of the passage of the Eleventh Amendment, which barred citizens from one state suing another state for damages. The states at that time were sensitive to any efforts that would abrogate their sovereignty, yet the habeas provision was accepted without objection. Justice Stevens concluded that the Bankruptcy Clause gave Congress "the power to redress the rampant injustice resulting from States' refusal to respect one another's discharge orders." Therefore, the "ineluctable conclusion" was that the states agreed at the Constitutional Convention to "not assert any sovereign immunity defense" involving federal bankruptcy laws. Congress had never "abrogated" state sovereign immunity, it had merely acted within the scope of its powers when it declared that states are not immune to preferential transfer lawsuits.

Justice Clarence Thomas, in a dissenting opinion joined by Chief Justice John Roberts and Justices Antonin Scalia and Anthony Kennedy, disagreed with the majority's reading of constitutional history. Moreover, the Court had made clear in its recent opinions on sovereign immunity and the Eleventh Amendment that Article I provisions did not waive state sovereign immunity. The passage of the Bankruptcy Clause "merely established federal power to legislate in the area of bankruptcy law."

Howard Delivery Service v. Zurich

In Howard Delivery Service v. Zurich American Insurance Co., No.05-128, 547 U.S. __ (2006), the U.S. Supreme Court ruled that claims from insurance companies for unpaid worker's compensation insurance premiums were not entitled to priority status in bankruptcy proceedings. The 6-3 decision resolved a split among the circuit courts of appeal, specifically reversing rulings of the Fourth and Ninth Circuits. The case turned on statutory construction of the U.S. Bankruptcy Code, Section 507(a)(5).

Howard Delivery Service (Howard), an over-the-road freight carrier based in West Virginia, self-insured its employees through a workers' compensation policy issued by Zurich American Insurance (Zurich) rather than participate in the state workers' compensation program. In January 2002, Howard cancelled its policy with Zurich. Eight days later, Howard filed for bankruptcy, seeking protection through a Chapter 11 reorganization scheme.

Section §507(a)(4) of the Bankruptcy Code prioritizes payment for unpaid "wages, salaries, [and] commissions." Later, Congress added a new priority to the list, §507(a)(5) (one step lower than the wage priority), for "unpaid contributions to an employee benefit plan … arising from services rendered." Under this statutory scheme, because §507(a)(4) has a higher priority status, all claims for unpaid wages are paid first (up to the statutory maximum of $10,000), followed by any outstanding claims under §507(a)(5) for benefit plan contributions.

In May 2002, Zurich filed an unsecured creditor's claim seeking priority status under §507(a)(5) for unpaid premiums to "an employee benefit plan," i.e., characterizing workers compensation benefits as employee benefits. In July 2003, the bankruptcy court denied Zurich's claim, reasoning that the unpaid premiums were not bargained-for, wage-substitute-type benefits furnished in lieu of higher wages. The federal district court affirmed, similarly concluding that unpaid workers' compensation premiums do not share the priority afforded unpaid contributions to pension and health plans.

A divided Fourth Circuit Court of appeals reversed, but failed to agree on a rationale. Es-sentially, the appellate court found that a contribution to an employee benefit plan need not be made voluntarily to qualify for priority status under the Bankruptcy Code. The court noted that the statutory language was plain in that it did not require that compensation received by an employee be a wage substitute (in order to qualify for priority status).

But the U.S. Supreme Court was more precise in its ruling. Writing for the majority, Justice Ruth Bader Ginsburg concluded that insurance carriers' claims for unpaid workers' compensation premiums fell outside the purview of §507(a)(5) of the Bankruptcy Code.

Congress did not define §507(a)(5)terms. This fact contributed to Zurich's argument urging the Supreme Court to adopt the encompassing definition of "employee benefit plan" as used in the Employee Retirement Income Security Act of 1979 (ERISA): "[A]ny plan, fund, or program [that provides] its participants …, through the purchase of insurance or otherwise,… benefits in the event of sickness, accident, disability, [or] death." 29 USC 1002(1).

But the majority opinion rejected this argument. Instead, the Court relied on one of its earlier decisions, United States v. Reorganized CF&I Fabricators of Utah, Inc., 518 U.S. 213, quoting that "[h]ere and there in the Bankruptcy Code Congress has included specific directions that establish the significance for bankruptcy law of a term used elsewhere in the federal statutes." But no such directions are included in the text of §507(a)(5), and the Court refused to write them into the text.

The Supreme Court also agreed with the lower courts' reasoning relating to the essential character of workers' compensation. Unlike pension plans or group insurance—negotiated or granted to supplement or substitute for wages—workers' compensation programs substitute for liability of employers for work-related accidents.

Zurich also argued that according its claims a §507(a)(5) status would give workers' compensation carriers an incentive to continue coverage of a failing enterprise. The Court found this argument too speculative. More convincing is the Bankruptcy Code's objective of securing fair and equal distribution among creditors. The Code therefore limits the priority status of claims to ensure that some creditors (such as insurance companies) do not come out better than the workers themselves.

Justice Kennedy filed a dissenting opinion, joined by Justices Alito and Souter. He noted that the majority opinion relied on the premise that statutorily prescribed workers' compensation regimes did not run exclusively to the employees' benefit. That, in itself, did not justify the Court's holding; neither did it comport with the text or purpose of the Bankruptcy Code's prioritization under §507(a)(5).

Uniform Debt Management Services Act

In November 2005, the National Conference of Commissions on Uniform State Laws (NCCUSL) approved the final draft of the Uniform Debt-Management Services Act (UDMSA), addressing rising problems in the credit/debt counseling industry. The American Bar Association's (ABA) House of Delegates endorsed the Act in February 2006. Adoption by states is not mandatory but encouraged to effect the purpose of uniformity among states, as comparable to the Uniform Probate Code, the Uniform Commercial Code (UCC), and others. As of early 2006, adoption of the UDMSA was already pending in Colorado, Illinois, Nebraska, and Utah.

The UDMSA provides guidance to, and regulation of, two separate industries: credit counseling and debt management services. Consumer credit counseling services assist consumers with budgeting skills and help them pay off their debts. Credit counseling agencies are generally supported by fair share payments made to them by creditors, usually in the form of a percentage of the total payment made by a consumer/debtor. Because many states prohibit debt adjustment but have exemptions in their laws for nonprofit or tax-exempt organizations, most of the existing credit counseling agencies are organized as tax-exempt non-profit entities under Internal Revenue Code 501(C).

Debt management service providers, on the other hand, function as negotiators who persuade creditors to settle for less than the full amount owed by individual consumer/debtors. Such entities may or may not directly control consumers' funds, but most are organized as taxable entities that are supported by incentive-based percentages of collections and/or contract amounts.

The need for regulation and oversight of these entities is undisputed. There is no comprehensive federal law that regulates credit counseling or debt management organizations. (The federal Credit Repair Organization Act regulates entities claiming to offer "credit repair services," but the majority of credit counselors do not offer credit repair services, and are accordingly not subject to the CROA.) The 2005 amendments to the U.S. Bankruptcy Code (U.S. Code, Title 11), especially under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, added a requirement that debtors seek credit counseling assistance prior to Chapter 7 filings [§ 109(h)]. Additionally, many state laws require credit-counseling services in conjunction with high-cost mortgages and short-term payday loans. The industry goes largely unregulated, at least with respect to some of the issues addressed by the UDMSA.

Starting around 2003, several high-level investigations and reports focusing on the industry surfaced, including those from the National Consumer Law Center, Consumer Federal of America, Internal Revenue Service, Federal Trade Commission, and the Permanent Subcommittee on Investigations of the Committee on Homeland Security. The latter entity published its findings in its 2005 report, Profiteering in a Non-Profit Industry: Abusive Practices in Credit Counseling. As a result of the escalating incidence of alleged unfair and deceptive trade practices and other reported abuses, the Internal Revenue Service, by 2005, was in the process of revoking the tax exempt status of over 50 percent of the industry, based on the number of debt management plans.

The UDMSA is constructed to regulate both nonprofit/tax-exempt and for-profit organizations. For those organizations entering into agreements with consumers, the UDMSA requires certain important disclosures and terms of the agreement. A number of consumer protections are required. There is a provision specifying maximum fees. Consumer funds must be held in a trust account. With respect to consumer relations, the UDMSA requires service providers to act in good faith, to maintain toll-free communications that permit clients to speak with credit counselors during regular business hours; and to render determinations as to whether debt management plans are suitable for particular consumers. The Act provides for both private and public enforcement, and provides for the recovery of minimum, actual, and punitive damages.

To offer debt management services in a state adopting UDMSA, a provider must be registered or licensed within that state. Registration requires the applicant to provide state regulatory authorities with comprehensive background information. Additionally, applicants must show proof of liability insurance, proof of surety bond, and evidence that they meet industry competency standards.

The Consumer Federation of America (CFA), on behalf of low-income consumer clients, has opposed the UDMSA. Its chief concerns are: (1) that the Act regulates debt settlement as a valid type of debt management service, thereby legitimizing a business deemed dangerous to some consumers; and (3) the Act gives states the option of allowing for-profit firms to offer debt management and debt settlement services. This could undermine IRS efforts to weed out abuses in the industry. CFA urged states to choose the non-profit option to improve consumer protections.

The National Conference of Commissioners on Uniform State Laws (NCCUSL) drafted the text of the NDMSA. The Act's text can be found at that organization's web site, http://www.nccusl.org.