Chapter 1 What, Who

• Jurisdiction: United States

Chapter 1 What, Who

§ 1.1 ~ a Good Story

A good story needs a plot and characters. Bankruptcy has both. In this chapter, we begin by sketching the plot. We provide an overview of the purposes of bankruptcy, and a brief sketch of a bankruptcy case. Then we describe the main characters.

§ 1.2 ~What Bankruptcy Is About: a Short Description

Bankruptcy is about debtors who cannot, or will not, pay their debts. It offers some relief to debtors from the burden of their obligations. It offers some protection to creditors who want an efficient and convenient means to liquidate claims. It allows society to prioritize obligations when there's not enough value to pay everyone. It seeks to preserve the value of the debtor and its assets. These goals often conflict with one another. In some cases, it will be possible to reconcile the conflicts; often, it will not be.

§ 1.3 ~ The Purposes of Bankruptcy

"Bankruptcy" is not a single concept. It is a set of loosely connected, more or less overlapping concepts that have to do with the relationship between a debtor and its creditors. Some of these serve the interests of creditors, some of debtors, and some may serve both at once.

For a long time — specifically, from 1898 to 2005 — and for most people, "bankruptcy" meant "the discharge." Most cases were filed by individual debtors who sought to wipe out their past debts, and most of them got what they came for. They had to turn over their nonexempt assets, but most of them had no nonexempt assets, so it wasn't a barrier. Perhaps most important, they got to insulate their post-bankruptcy earnings from pre-bankruptcy claims.

Traditionally, the U.S. has been unique in regards to the extent of its bankruptcy protection, and the ease with which you could get it. That has been changing lately, in two ways. For one, other countries have been catching up and liberalizing their bankruptcy laws, perhaps in imitation of the American model. Secondly, and far more important for our purposes, Congress amended the Bankruptcy Code in 2005, passing the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which resulted in the barrier to entry being raised for individuals seeking chapter 7 bankruptcy protection. Specifically, in an attempt to minimize abuse of the bankruptcy system, Congress imposed a "means test" that creates a presumption of abuse in certain circumstances.¹

The "means test" requires the court to dismiss the chapter 7 cases of some debtors if their income is above the median amount in their state and, after deducting allowable expenses, it would leave a sufficient surplus to service past debt.² At the time that the means test was enacted, it was quite controversial. Banks, credit card companies and their political supporters had been claiming that there was significant abuse in the bankruptcy system. They said that debtors who had the ability to pay their debts were instead filing for bankruptcy and getting a discharge, and that doing this was too easy. They claimed that this was not only unfair to the creditors, it also increased the cost of credit for other consumers.

Consumer advocates, and many bankruptcy law professors and bankruptcy lawyers, contended that abuse was rare. The overwhelming majority of debtors were in dire straits, they argued — often resulting from a job loss, a health care crisis, or some other unfortunate circumstances — and really needed relief. They argued that bankruptcy discharge had only a trivial impact on the cost of credit. They expressed fear that the means test would do violence to the discharge, which has been a fundamental tenet of our bankruptcy system since (at least) the nineteenth century.

With the benefit of a decade or so of experience, it seems they were both largely wrong. It turns out there was not so much abuse. Of course, there are cases of it. But for the most part, debtors who elect to file for chapter 7 bankruptcy have below-median incomes and really do need relief. As a result, the means test — which was intended to create a hurdle for abusers — does not appear to have barred very many debtors. For the same reason, the prediction that the means test would create a sea change in the availability of the bankruptcy discharge has proved to be overblown. It seems to us that most people who need chapter 7 and the discharge can still get it. There are exceptions, of course. But for the most part, relief for the honest-but-unfortunate debtor still exists.³

While the discharge for individuals may be the reason most debtors file for bankruptcy, it is far from bankruptcy's only purpose. Creditors also use the bankruptcy process to liquidate their claims. Think of it as a kind of "class action," where the creditors get together and appoint a representative to collect the property of the debtor, sell it, and distribute the proceeds. As a matter of history, this "collect and distribute" purpose of bankruptcy precedes "discharge" by several hundred years. It survives today in cases where there are assets to distribute.

We speak of bankruptcy as providing for the distribution of assets on a pro rata basis. For example, if there is enough to pay 40 percent of all unsecured claims, and those claims have the same priority, we pay 40 percent of each claim. Pro rata distribution thus supplants the "race to the courthouse" system that would apply under state law if bankruptcy did not intervene. But to speak of a pro rata distribution of assets can be misleading. In fact, the Bankruptcy Code articulates its own list of claim priorities (for administrative expenses, taxes, wages and so forth), and distributions are made pro rata to each priority creditor until all value has been exhausted. Also, bankruptcy respects the non-bankruptcy rights in collateral of a creditor with a valid and perfected security interest. This means that a secured creditor is entitled to receive the value of its collateral up to the amount of the secured debt (the debt that exceeds the collateral value is treated as an unsecured claim). Taken together, even in those cases where a debtor has assets to distribute, these priority and secured creditors often eat up most of the estate, leaving little or nothing for the residual class.

Defenders of the system offer any number of justifications for the bankruptcy "class action." Defenders frequently speak of the pro rata distribution as appealing to a generalized sense of fairness. But there are any number of more specific justifications for the bankruptcy device. In a well-known law review article, Prof. (and former university president) Thomas H. Jackson analyzed the pro rata distribution scheme as implementing a kind of "creditor's bargain," substituting the certainty of a modest recovery for the hazard of winning or losing a race.⁴

A different justification argues that the collective proceeding is more economical. Call it the "death by a thousand cuts" argument: Letting one agent act for all eliminates the duplication and outright waste that you get in a race to dismember the debtor's assets.

But there is a still more subtle justification. Consider the hypothetical business debtor IndusCo, a heavy-industry manufacturer. IndusCo owns a factory, where it has and maintains a boiler. As a going-concern business, IndusCo could be sold for $5 million. Broken up for scrap, the assets would yield $1.5 million — some $1 million from the boiler alone. The factory cannot run without the boiler.

IndusCo owes $1 million to Carlos, and $3.5 million to an array of other creditors. Carlos levies on the boiler. He puts it up for sale, and the proceeds pay his entire claim. The going-concern value of the business is lost; the liquidation value of the remaining assets is just $500,000, which the other creditors share pro rata. The other $3.5 million in going-concern value is dissipated. Creditors (except for Carlos) wind up with just 20 cents on the dollar, and the owners of the business's equity are wiped out.

What we mean is this: A business might have two different values — the liquidation value of the component assets piecemeal, and the value of the business kept together as a going concern. Sometimes, but not always, the business is worth more as a going concern than in liquidation because a going concern might have the ability to continue to operate at a profit, producing a stream of positive cash flows that can be projected and discounted to its present value. A piecemeal liquidation has the potential to destroy the value of the going concern.

Now, an individual creditor may have no incentive to care whether he destroys the value of the going concern; as far as he is concerned, if he gets paid, that is the end of it. But the creditors as a whole may have a powerful interest in preserving the going concern. So when we say that one of the goals of bankruptcy is to "protect asset values," then at least part of what we mean is "to protect going-concern value."

Part and parcel of protecting asset values, bankruptcy (chiefly through chapter 11) offers an opportunity to make and implement deals about a debtor's liabilities and their satisfaction. Sometimes, it may be in the creditors' interest to settle for less than the full amount they are owed, particularly if they can rely on others to do so as well. Nothing bars debtors and creditors from making a deal, even independent of bankruptcy. But a non-bankruptcy deal may be considerably harder to achieve and harder to enforce than one that is reached through the bankruptcy process.

Why does the bankruptcy process make the deal easier? In part, it is because the automatic stay prevents individual creditors from jumping to the head of the line. But an equally important reason is that the court may impose the terms of the deal on a dissenting minority of creditors that might otherwise hold out for better terms than the rest in a non-bankruptcy setting. This power to impose the plan on dissenters may mean the difference between a successful...