Not Just Anna Nicole Smith: Cleavage in Bankruptcy

• Publication year: 2014

Not Just Anna Nicole Smith: Cleavage in Bankruptcy

David G. Epstein

Casey Ariail

David M. Smith

NOT JUST ANNA NICOLE SMITH: CLEAVAGE IN BANKRUPTCY

David G. Epstein^* Casey Ariail^** David M. Smith^***

Abstract

This is an essay about the unwarranted erosion of two basic bankruptcy principles: the cleavage effect of a debtor's filing of a bankruptcy petition and the equality of treatment of prepetition unsecured claims. These are two of the most fundamental bankruptcy concepts. First courts and then Congress have fashioned rules favoring the prepetition unsecured claims of vendors and lessors that are inconsistent with these concepts. We explore the origins of such favored treatment, question the commonly offered policy justifications, and argue that the prepetition unsecured claims of vendors and lessors generally should be afforded the same treatment in bankruptcy as other prepetition unsecured claims.

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Introduction

There was testimony in the litigation that gave rise to Stern v. Marshall,¹ the most cited Supreme Court decision relating to bankruptcy in the twenty-first century, that Anna Nicole Smith's stepson's² lawyer referred to Ms. Smith as "Miss Cleavage."³ Cleavage is just as important to those who pursue bankruptcy as to those who pursued Ms. Smith.⁴

All bankruptcy cases start with the filing of a bankruptcy petition,⁵ regardless of whether the bankruptcy is the chapter 7 liquidation of the limited assets of Casey Ariail or the chapter 11 restructuring of the debts of Double Dave's Pizzaworks, Inc.⁶ ("Double Dave") or a chapter 9, 12, or 13 case.⁷ The filing of that bankruptcy petition effects a cleavage, separating the debts incurred before the filing of the petition from debts incurred after the filing of the petition.⁸

As Professor Laura Bartell has observed, "The Bankruptcy Code . . . divides the universe of claims into two basic categories—those that arise at or before the order for relief concerning the debtor, and those that do not—and

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treats each class very differently."⁹ The following examples of the effect of filing a chapter 7 petition and a chapter 11 petition support Professor Bartell's observation of the cleavage resulting from a bankruptcy petition.

As an example of the cleavage effect of a bankruptcy petition in chapter 7, if Casey's chapter 7 petition was filed on January 15, and he receives a discharge on April 5, only creditors holding claims incurred before January 15 would share in any potential bankruptcy distribution or be affected by that bankruptcy discharge. Casey would have no further personal liability for his January 14 credit card charges and other prepetition debts, but he would remain personally liable for his January 16 credit card charges and other postpetition debts.¹⁰

The date of the filing of the bankruptcy petition also serves as the date of cleavage in a chapter 11 case. If Double Dave's chapter 11 petition was filed on July 13, 2014, and its chapter 11 plan was confirmed on February 18, 2015, Double Dave could not, in the interim between July 13, 2014, and February 18, 2015, make a payment on any debts incurred prior to July 13, 2014.¹¹ And Double Dave's chapter 11 plan could be confirmed even though the payments to creditors holding prepetition claims were nominal or even non-existent.¹²

In chapter 11 cases, as in chapter 7 cases,¹³ postpetition claims are treated differently from prepetition claims.¹⁴ Double Dave could, at any time prior to plan confirmation, pay debts incurred after it filed the chapter 11 petition on

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July 13, 2014. Moreover, Double Dave's chapter 11 plan could not become effective unless the postpetition debts are paid in full.¹⁵

I. Cleavage and Discharge

As the Casey hypothetical suggests, the cleavage effect of filing a bankruptcy petition—separating prepetition debts from postpetition debts—is an integral part of the basic bankruptcy policy of discharge. Recall that Casey's discharge only affects prepetition debts.

A discharge is often described as a "fresh start."¹⁶ However, that description is incomplete. It begs the question: a fresh start from what? It is more complete to say that a discharge is a fresh start from prepetition debts.¹⁷ The following statement by Judge Diane Wood, a Seventh Circuit judge and former University of Chicago law professor,¹⁸ is representative: "[B]ankruptcy is normally viewed as a process through which a debtor obtains relief from pre-petition obligations and gets a fresh start in life . . . ."¹⁹

While the concept of a fresh start is compelling, it only applies to consumer debtors. According to the leading bankruptcy scholar Thomas H. Jackson, "the fresh start policy has nothing to say about business bankruptcies."²⁰ Professor

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Jackson's statement is of course correct,²¹ albeit somewhat misleading.²² Corporations and other business entities do not receive a fresh start in chapter 7. Section 727, entitled "Discharge," provides that "[t]he court shall grant the [chapter 7] debtor a discharge, unless (1) the debtor is not an individual . . . ."²³ There are no discharges for business entities in chapter 7 cases; therefore, there is no fresh start for a business entity in a chapter 7 case. The paradigm for business entities in chapter 7 is not the fresh start; it is "orderly death."²⁴ But business entities are not entirely denied the opportunity to discharge debt through bankruptcy; business entities can receive a discharge in chapter 11.²⁵ But the discharge effected by the confirmation of a chapter 11 plan is not exactly a fresh start. A chapter 11 discharge in essence replaces the debtor's obligations created prepetition with the new, reduced obligations created by the plan.²⁶

While the discharge of a business entity in chapter 11, unlike the discharge of an individual in chapter 7, does not result in a fresh start from prepetition debts, both reflect the cleavage effect of the filing of a bankruptcy petition. Chapter 7 and chapter 11 discharges provide the debtor relief from prepetition debts but not from postpetition debts. After his chapter 7 discharge, Casey has no personal liability on his prepetition debts.²⁷ After its chapter 11 discharge, Double Dave's only liability on its prepetition debts is what it has agreed to pay under its chapter 11 plan.²⁸

II. Cleavage and Equality of Distribution

Even more important than the cleavage effect of a bankruptcy petition on the rights of prepetition and postpetition creditors against the debtor is the

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cleavage effect of a bankruptcy petition on the relative rights of creditors. As one bankruptcy court observed, "[T]he entire bankruptcy process is based upon a division in time, with claims that arose prepetition against the debtor being treated in one manner and claims that arose against the estate postpetition being treated in a different manner."²⁹ The similar treatment of similarly situated creditors is a fundamental tenet of bankruptcy law, with the date of cleavage—i.e., the filing of a bankruptcy petition—being the most important method of grouping like with like.³⁰

The filing of a bankruptcy petition protects a prepetition creditor from other prepetition creditors. One early twentieth century commentator explained the elements of bankruptcy by stating: "All bankruptcy law . . . no matter when or where devised and enacted, has at least two general objects in view. . . . [It] seeks to protect the creditors, first, from one another and, secondly, from their debtor."³¹

Bankruptcy remains a creditor's remedy today. As Professor Thomas Jackson observed, "Bankruptcy, at first glance, may be thought of as a procedure geared principally toward relieving an overburdened debtor from 'oppressive' debt. Yet . . . most of the bankruptcy process is in fact concerned with creditor-distribution questions."³² More specifically, it is concerned with questions relating to distributions to prepetition creditors. Unlike state debt collection law, which focuses on each individual creditor's rights vis-à-vis the debtor, bankruptcy focuses on the rights of all prepetition creditors as a group.³³ That is to say, it is a collective remedy.³⁴

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Under state law, the race for the debtor's assets goes to the swiftest.³⁵ The first creditors to obtain and execute a judgment by seizing the debtor's assets are satisfied in full, while the creditors who are late to the party often get nothing.³⁶ Thus, once the debtor is perceived to be in a financially shaky position, state "grab" law encourages the piecemeal and potentially wasteful dismemberment of the debtor's property.³⁷

Federal bankruptcy law takes a different approach to debt collection. It seeks to get the most value out of the debtor's assets for the benefit of all of the debtor's prepetition creditors.³⁸ This requires that individual collection efforts be held at bay while the debtor's assets are liquidated by a neutral trustee³⁹ in an orderly fashion (chapter 7), or while the debtor has the opportunity to rehabilitate and return to some semblance of financial viability and make payments to prepetition creditors under a court-approved plan (chapters 11, 12, and 13).⁴⁰ The filing of a bankruptcy petition results in an automatic stay,⁴¹ which protects each prepetition creditor from collection initiatives by other prepetition creditors against the debtor.⁴²

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For bankruptcy's collective process to work effectively, prepetition creditors are required to be treated with substantial equality not only in terms of what they can do during the bankruptcy but also in terms of what they receive from the bankruptcy case.⁴³ Indeed, equality of distribution is consistently described as an important, even the most important, purpose of bankruptcy.⁴⁴ The Supreme Court in Bailey v. Glover stated: "It is obviously one of the purposes of the Bankrupt law, that there should be a speedy disposition of the bankrupt's assets. This is only second in importance to securing equality of...