Bankruptcy Act of 1978

Eric A. Posner

The Bankruptcy Reform Act of 1978 (P.L. 103-394, 107 Stat. 4106), as amended, governs the relationship between creditors and debtors when debtors can no longer pay their debts. Ordinarily, people and businesses have a legal obligation to pay their debts. If they default on a loan, their creditors can sue them and obtain some or all of their money or property, up to the value of the debt. When the debtor is a person, creditors can force a sale of the debtor's house, take away household goods, and even obtain the debtor's future wages, although in all cases federal and state law limit how much the creditor can take. When the debtor is a corporation, the creditor can seize assets even when doing so forces the shutdown of factories and the interruption of business. Bankruptcy law limits these standard legal remedies in several ways.

When the debtor files for bankruptcy, creditors must stop legal proceedings to seize the debtor's assets, and all the interested parties must come to a special bankruptcy court. The bankruptcy judge and other officials determine the extent of the debtor's debts and assets. Most of the assets will be sold and the proceeds from the sale are distributed to the creditors according to the size and legal priority of their claims. One of the main functions of bankruptcy law is to ensure the orderly sale and distribution of property, so that the maximum amount of money is raised, and to ensure that the money is distributed fairly to creditors in accordance with their legal rights.

Bankruptcy law also gives important rights to debtors. If the debtor is a person, the bankruptcy will usually result in the discharge of all of his or her debts, even though he or she does not have money to pay them. The debtor will usually be permitted to keep some assets, including furniture, clothes, sometimes his or her house, some money, and so forth. Most important, the debtor will have the right to keep future income free from the earlier claims of creditors. In this way, the debtor is given a "fresh start": he or she can begin life anew with the slate wiped clean.

If the debtor is a corporation, the bankruptcy will result either in the liquidation of the corporation or its reorganization. When a corporation is liquidated, all of its assets (which might include whole divisions or subsidiaries) are sold off, and the money that is obtained is distributed to the creditors, with nothing to the shareholders. When a corporation is reorganized, its capital structure is rearranged. For example, the original creditors become shareholders in the reorganized firm, and the original shareholders are deprived of their shares. In principle, a firm after reorganization performs the same business as it did prior to bankruptcy. Factories are kept open and workers keep their jobs. In practice, the reorganization might involve the shutting down of inefficient factories, or the reorganized firm will shed assets and workers in order to become profitable.

CONGRESSIONAL POWER

Congress has authority to issue "uniform Laws on the subject of Bankruptcies" under Article I, section 8, clause 4, of the United States Constitution. People have always understood this authority to permit Congress to regulate the creditor side of bankruptcy, that is, to create a system through which creditors' claims against a defaulting debtor are processed and liquidated. There was some controversy in the nineteenth century over whether the Constitution also authorized Congress to determine the rights and obligations of the debtor. Traditionally, the area of law governing the rights of defaulting debtors was called "insolvency law," with "bankruptcy law" used to refer only to the creditor side. Because the Constitution authorizes Congress to regulate bankruptcy but says nothing about insolvency (the inability to pay debts), some people argued that Congress had no authority to create a right to a discharge, or to regulate corporate liquidations and reorganizations. However, this view was ultimately rejected by the courts, and today it is settled that the bankruptcy clause is the constitutional basis of all aspects of modern bankruptcy law.

Congress tried several times in the nineteenth century to create a bankruptcy law, but the first lasting bankruptcy law was not enacted until 1898, with an important amendment in 1938. These earlier laws included the main elements of the modern bankruptcy system: the procedure for collectively resolving claims; the discharge for the debtor; and provisions for reorganizing or liquidating insolvent corporations.

The bankruptcy filing rate was low and relatively flat for the first half of the twentieth century, averaging in the low thousands per year. But with the expansion of the credit market, the number of bankruptcies increased, and by the late 1960s there were about 200,000 bankruptcy filings per year. These figures alarmed observers, who associated bankruptcy with moral or economic failure. Observers were also unhappy with the existing laws governing corporate reorganization, which seemed to be unnecessarily complex and to generate unnecessary litigation. In 1968 Congress created a bankruptcy reform commission and asked it to propose amendments to the bankruptcy law. The commission issued its report in 1973, but Watergate interrupted legislative deliberations for several years.

POLICY

By the time Congress turned its full attention to bankruptcy reform, people were no longer so worried about high bankruptcy filing rates. The consumer protection movement had intervened, and people had become more skeptical about the methods of creditors than about the motives of debtors.

Three other issues dominated discussion. First, most backers of bankruptcy reform wanted to replace the existing system of state exemptions with a uniform system of federal exemptions. State exemptions are laws that allow defaulting debtors to keep some of their property even though they do not pay off the full debt. State homestead exemptions, for example, permit debtors to keep their house (usually but not always up to a dollar ceiling). The generosity of state exemptions varied greatly, and critics of the exemption system argued that it was not fair that the residents of one state could keep their houses while the residents of another state might be able to keep no more than some clothes and furniture. Defenders of the system believed that the exemption level was properly left to the states under the principles of federalism. The complex compromise in the act created a new federal system of exemptions but gave the states the right to "opt out" and force residents to use the state exemptions laws, and about two-thirds of the states subsequently exercised this right.

Second, reformers wanted to streamline the old corporate reorganization system, which included separate procedures for large public corporations and for smaller closely held businesses. Though the rhetoric was about simplifying a complex area of the law, beneath the surface the debate focused on the amount of protection to be given creditors of large corporations. History suggested to reformers that when a large corporation is reorganized, the "insiders"—managers, large shareholders, large creditors—will give themselves large stakes in the reorganized firms, while outsiders such as small creditors and workers will be given little or nothing. A variety of mechanisms, including oversight by the Securities and Exchange Commission, had been devised to protect the small stakeholders. The act weakened these protections to some extent, but not significantly.

Third, many backers of bankruptcy reform wanted to elevate the status of bankruptcy judges and lawyers, to make bankruptcy a more respectable and normal legal proceeding than it had been in the past. One source of the low prestige of the bankruptcy bar was the suspicion that bankruptcy judges were patronage appointments enjoyed by the federal judiciary (in other words, appointments made for the political advantage of judges). Reformers sought to make bankruptcy judges as much like ordinary federal judges as possible, with appointment by the president, life tenure, and so forth. Federal judges, however, objected to what they saw as a dilution of their own status. The complex compromise subsequently ran into constitutional difficulties, which were ultimately resolved through additional legislation in 1984.

EXPERIENCE UNDER THE ACT

Experience with the Bankruptcy Reform Act has been mixed. Individual bankruptcy filings increased rapidly after passage of the act, for complex reasons. The filing rate might have increased because of the generosity of the new federal exemptions, but they probably also increased simply because consumer debt has become much more common than it was in the 1970s and before. More people borrow, so more people fail to pay their debts and file for bankruptcy. Consumer protection advocates argue that bankruptcy should be more generous than it is. Others fear that the high filing rate threatens a collapse in the credit market. These warring forces left their mark on bankruptcy amendments in 1984 and 1994, and agitation for reform has been continuing.

Corporate reorganization has also become more frequent, but again it is not clear whether the act is the cause. Major changes in the economy occurred in the 1980s, resulting in a wave of transactions in which firms borrowed money in order to finance their acquisition by investors. As corporations took on debt, they became more likely to default on loans, and bankruptcy became an increasingly attractive option.

Some critics of the act argue that it has contributed to a kind of moral decline. The act did try to destigmatize bankruptcy, and it might have succeeded. And, as noted, it might have contributed to the rise of bankruptcy filings. In the view of critics, the act has thus made people feel less responsible about paying their debts. Defenders of the act argue that most people file for bankruptcy only because of devastating and unanticipated events, such as the death of a wage-earning spouse or a divorce, severe medical problems, or loss of employment during a recession. Bankruptcy is not a cause of, or symptom of, moral decline, but an effect of larger social forces, such as the breakup of families, economic dislocation, and the decline of communities.

These debates, however, obscure what is really at stake in bankruptcy law. A generous personal bankruptcy law that shields assets and future income has both beneficial and harmful effects. On the one hand, the law reduces the hardship experienced by individuals when circumstances prevent them from paying their debts. On the other hand, the law increases the cost of credit by making it harder for creditors to collect their debts. Bankruptcy law is like an involuntary insurance policy that protects people against the financial consequences of bad events, but also costs them money in the form of a higher interest rate than they would otherwise pay.

Corporate reorganization policy also involves tradeoffs. If the law is flexible, and makes it easy to reorganize firms, then insiders and large creditors might use corporate reorganization as an opportunity to improve their financial position at the expense of smaller creditors, workers, and other stake-holders. If the law makes it hard to reorganize firms, then sometimes a firm that has a good business plan but cannot pay its debts will be liquidated, which causes real harm. Good corporate bankruptcy law gives managers, creditors, and other stakeholders some flexibility to change the firm's capital structure, but not too much.

THE LANGUAGE OF BANKRUPTCY LAW

Bankruptcy law uses a lot of technical language, but it is not very difficult, as a few examples will show. When a person or business files for bankruptcy, the person or business is labeled the debtor (not the bankrupt, which was the term under prior law). The debtor must provide a list of assets to the court: these are any items of value, such as furniture, money, and machines. These assets are then put in the bankruptcy estate, which is a legal fiction (rather than an actual estate) that refers to the assets that will be sold off so that creditors can be paid. In the case of individuals, assets that are covered by state or federal exemptions are not included in the estate. The debtor also provides a list of debts, and the creditors are informed of the bankruptcy. Each creditor has a claim against the estate; the value of the claim is the same as the value of the original unpaid debt. An official named the trustee will, with the bankruptcy judge's approval, sell the assets in the estate, and distribute the proceeds of the sale to the creditors, with each creditor getting a pro rata share (its claim divided by the sum of all claims). The debtor than obtains a discharge, which wipes out all debts that existed prior to bankruptcy.

See also: Bankruptcy Act of 1841; Consumer Credit Protection Act.

BIBLIOGRAPHY

Jackson, Thomas H. The Logic and Limits of Bankruptcy. Cambridge, MA: Harvard University Press, 1986.

Posner, Eric A. "The Political Economy of the Bankruptcy Reform Act of 1978." Michigan Law Review 96 (1997): 47–126.

Skeel, David A., Jr. Debt's Dominion: A History of Bankruptcy Law in America. Princeton: Princeton University Press, 2001.

Sullivan, Theresa, Elizabeth Warren, and Jay L. Westbrook. As We Forgive Our Debtors: Bankruptcy and Consumer Credit in America. Cambridge, MA: Harvard University Press, 1989.

Warren, Charles. Bankruptcy in United States History. Cambridge, MA: Harvard University Press, 1935.

Enron Retirement Plans

In December 2001, the Enron energy corporation filed for bankruptcy amid one of the biggest scandals in the his tory of U.S. business. Government investigators charged that an account ing cover-up had hidden debt and overstated the company's earnings, falsely boosting its stock price to provide billions in unearned profits. Enron executives were indicted for fraud, and the company's accounting firm, Arthur Andersen, was convicted of obstructing justice and collapsed. Among the victims of the debacle were approximately 15,000 Enron employees whose retirement plans were heavily invested in Enron stock. During the weeks before the company filed for bankruptcy, Enron prohibited rank-and-file employees from selling their stock, but executives faced no such restriction. As a result, as the stock price plunged from $26 per share to complete collapse, employees lost approximately $1.2 billion of the money they had saved for retirement. In 2003 the Justice Department was expected to charge twenty executives of Enron and its retirement plan with breach of fiduciary duty.