Fake and Real People in Bankruptcy

• Publication year: 2023
• Citation: Vol. 39 No. 3

Fake and Real People in Bankruptcy

Melissa B. Jacoby

FAKE AND REAL PEOPLE IN BANKRUPTCY

Melissa B. Jacoby^*

Abstract

This essay explores the bankruptcy system's structural bias in favor of artificial persons—for-profit companies, non-profit enterprises, and municipalities given independent life by law—relative to humans. The favorable treatment extends to foundational issues such as the scope and timing of debt relief, the conditions to receiving any bankruptcy protections, and the flexibility to depart from the Bankruptcy Code by asserting that doing so will maximize economic value. The system's bias also contributes to the "bad-apple-ing" of serious policy problems, running counter to other areas of law that have deemed harms like discrimination to be larger institutional phenomena rather than merely the product of individual wrongdoing. The bankruptcy system cannot fully internalize the consequences of these choices. These factors make bankruptcy a less effective partner in the broader policy project of deterring, remedying, and punishing enterprise misconduct.

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Table of Contents

Introduction..........................................................................................498

I. Fake Bankrupt People...............................................................499

II. Bankruptcy's Bias......................................................................502

A. Debt Cancellation................................................................... 502

B. Protections of Solvent Third Parties........................................ 508

C. Govern Thyself....................................................................... 509

D. Flex in the Joints .................................................................... 512

E. Exceptions .............................................................................. 515

III. From Binary to Spectrum..........................................................516

IV. Implications of the Binary and Spectrum for Bad Apple-ism......................................................................................517

V. What Now?..................................................................................521

Conclusion.............................................................................................521

Introduction

Ronald Tamecki's run of good fortune ran dry. His income plummeted due to health problems and irregular work opportunities.¹ He paid expenses using live checks sent in the mail by a credit card issuer. He and his spouse were estranged, living apart in different towns. Ronald had no assets to speak of other than a house of modest value that he built with his own hands years before. Creditors had no rights to the house or its value because Ronald and his wife owned the property in a form known as tenancy by the entirety.²

When Ronald filed a chapter 7 bankruptcy owing about $35,000, his credit card lender lodged no complaints.³ Believing that Ronald was strategically delaying a divorce to retain the protection of the tenancy by the entirety and thus the home, a trustee assigned to the case asked a court to throw out the bankruptcy for lack of good faith. Ronald testified under oath that he did not wish to be divorced, that he sought to reconcile with his wife. Nonetheless, the bankruptcy court dismissed Ronald's case. Ronald appealed all the way up to the United States Court of Appeals for the Third Circuit, and a majority of the panel upheld the dismissal.⁴ Ronald's modest house built with his own hands and picture-

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imperfect personal life disqualified him from a fresh start in the American bankruptcy system.

When enterprises use bankruptcy, they count on a reception dissimilar to that greeting Ronald Tamecki, one that exalts economics and value maximization. Indeed, a subsidiary of Johnson & Johnson, deemed not to be in financial distress by the Third Circuit and thus ineligible for bankruptcy, refiled a second chapter 11 case mere hours after its first case was dismissed.⁵ Companies repurpose bankruptcy—a public system designed for debt cancellation and restructuring voluntary loans—hoping to say goodbye to the civil justice system and jury trials. Whereas tort law reflects objectives of deterrence, behavior modification, and expression of particular social values, the bankruptcy system makes different choices, at least when it comes to artificial persons. other enterprises use bankruptcy to sell themselves quickly, hoping to insulate savvy buyers from the consequences of prior bad acts.

When a company uses bankruptcy in the aftermath of scandal and widespread wrongdoing, bankruptcy runs the risk of contributing to a "bad apple-ing" effect: allocating fault to a small number of humans while functionally cleansing other people, fake and real. In so doing, bankruptcy can disrupt the project of deterring, remedying, and punishing serious corporate misconduct. Are the benefits of bankruptcy worth these costs?

I. Fake Bankrupt People

By "fake person," I do not mean avatars or bots or artificial intelligence or people who have undergone comprehensive cosmetic surgery. I mean corporations, limited liability companies, and their near and distant cousins that exist as a privilege of American business associations law. Fake personhood is the building block of enterprise: your local butcher, a multinational conglomerate, a charity, a church, a hospital, a city, or even a sewer system. All of these entities can file for bankruptcy under some circumstances; all are treated differently from, and better than, humans to some degree.

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In many areas of the law, the term "person" encompasses more than humans.⁶ The same is true in bankruptcy.⁷ Although the great majority of filings involve humans as debtors, a wide range of people can be debtors in the American bankruptcy system. The remainder involve for-profit entities, nonprofit entities, and municipalities.⁸ These latter categories legally exist as autonomous entities by virtue of business association law, typically state law. Most of these enterprise bankruptcies do not involve publicly held companies.⁹ And although business bankruptcy is often shorthanded as "corporate bankruptcy," many enterprises are built on forms other than the corporation, such as limited liability companies.¹⁰

In other areas of law, fake people are culpable actors. Various areas of law use respondeat superior to hold companies responsible for employment discrimination or other wrongs.¹¹ Insurers issue policies for corporate tort liability.¹² Although they cannot go to prison, corporations can be accused and

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convicted of crimes.¹³ Corporations can commit tax fraud.¹⁴ That does not mean these legal fields treat fake and real people exactly the same.¹⁵ Yet these areas of law recognize that personhood is not all benefits without obligations.

Bankruptcy law and practice more fundamentally resist treating fake people as culpable actors capable of independent wrongdoing. In addition to acting as a form of bias relative to humans that is detrimental to the bankruptcy system, this attitude makes bankruptcy an unreliable partner in the broader societal project of deterring, punishing, and remedying serious corporate misconduct.

The Bankruptcy Code (the "Code") includes integrity-promoting features that are supposed to apply to large enterprises. Bankruptcy law requires extensive disclosures.¹⁶ It authorizes tools to investigate past wrongdoing, including in ways that could bring more money into the bankruptcy estate.¹⁷ The Code authorizes the subordination of the repayment rights of misbehaving claimants whose actions harmed the creditor body.¹⁸ A debtor's board is supposed to lose much of its governance authority to a trustee upon evidence of gross mismanagement or other wrongdoing.¹⁹ Businesses in bankruptcy are not supposed to be shielded from consequences for ongoing illegal activity.²⁰ Through creditor governance rights and priority rules, chapter 11 tempers the leverage of a company's equity holders.²¹ Oversight by a federal court and a government watchdog from the Department of Justice is supposed to bring a

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level of comfort to all counterparties and the public. It is no surprise that scholars have long identified some protections for tort claimants in chapter 11.²²

In real life, these integrity-promoting elements tend to get muted in large business bankruptcy cases. As discussed below, the deference shown to big businesses, and to their allies and restructuring professionals, stands in contrast with the treatment of individual debtors.

II. Bankruptcy's Bias

A. Debt Cancellation

A 1934 Supreme Court case used the term "the honest but unfortunate debtor" to identify which debtors are worthy of debt relief under bankruptcy law.²³ The debtor was a real person named William Hunt. Local Loan v. Hunt has been cited thousands of times.²⁴

Although permanently stopping debt collection is a federal bankruptcy superpower, debt cancellation has never been absolute for humans. Section 523 of the Code contains the primary list of debts that cannot be canceled under current law.²⁵ Some debts on the list are hard to explain or defend. But a core set of the exceptions reflect that the fresh start inherently must give way to deterring and remedying matters such as serious fraud, defalcation, or willful and malicious injury.²⁶

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Fresh starts are important to humans for a long list of reasons, including relief from suffering, promoting class mobility, and reducing the need for other state supports.²⁷ Artificial persons do not inherently need a fresh start. There is an unlimited supply of them, waiting to be born, via submission of a few forms and fees to the government. In Delaware alone, day in and day out, hundreds of additional LLCs are created.²⁸

Yet, for fake people like corporations, bankruptcy law tends not to condition debt relief on being honest but unfortunate. That distinction is...