RETHINKING PREEMPTION AND CONSTITUTIONAL PARAMETERS IN BANKRUPTCY.

• Author: Harner, Michelle M.

TABLE OF CONTENTS INTRODUCTION 150 I. HISTORICAL BOUNDARIES: CONSTITUTIONAL AND 157 PREEMPTION ISSUES IN BANKRUPTCY A. The Origins of the Bankruptcy Clause 158 B. Early Bankruptcy Laws in the United States 161 C. The Supreme Court's Approach to the Bankruptcy Clause 163 1. Cases Under Early Federal Bankruptcy Laws 165 2. Cases Under the 1898 and 1978 Federal Bankruptcy Laws 166 D. The Preemption Doctrine, Bankruptcy, and State Debtor-Creditor Laws 170 1. The Supreme Court and the Preemption Doctrine 171 2. Lower Courts' Application of the Preemption Doctrine in the Bankruptcy Context 175 II. BLURRING BOUNDARIES BETWEEN FEDERAL AND STATE BANKRUPTCY LAWS 179 A. Chapter 11 of the Bankruptcy Code 180 B. State Debtor-Creditor Laws 185 C. Potential Implications of Changes to State Debtor-Creditor Laws 193 III. THE NEED TO RETHINK BOUNDARIES TO ACHIEVE THE OBJECTIVES OF THE BANKRUPTCY CLAUSE 194 A. Congress's Intended Purpose in Enacting Chapter 11 195 1. Implied Field Preemption 196 2. Implied Conflict Preemption 199 3. The Contract Clause 202 B. Historical Police Powers of the States and the Bankruptcy Clause 204 C. Modernizing Preemption Analysis Under the Bankruptcy Clause 208 D. Why the Status Quo Is Unacceptable 211 CONCLUSION 213 INTRODUCTION

The concept of federal preemption is easy to articulate: laws enacted by Congress supersede similar or conflicting state laws under the Supremacy Clause of the U.S. Constitution. (1) It often is, however, difficult to implement. For example, Congress has the power under the Bankruptcy Clause of the U.S. Constitution to enact uniform laws governing bankruptcy. (2) Nonetheless, the U.S. Supreme Court has held that certain state laws governing debtors' and creditors' rights may coexist with legislation enacted by Congress under the Bankruptcy Clause. (3) Some state and lower federal courts have extended this rationale to state laws that mimic, and in some instances conflict with, various provisions of the U.S. Bankruptcy Code. These provisions include the automatic stay of section 362 of the Bankruptcy Code; (4) a trustee's ability to assume or reject executory contracts and unexpired leases under section 365 of the Bankruptcy Code; (5) and a trustee's ability to sell a debtor's assets as an operating entity (or going concern) free of all liens and interests under section 363 of the Bankruptcy Code. (6) Are these extensions warranted? Are they consistent with the Bankruptcy Clause, the Contract Clause, and Congress's intent in enacting the Bankruptcy Code?

Although states are increasingly refining their debtor-creditor laws to look more like mini Bankruptcy Codes, few scholars have analyzed the legitimacy or policy implications of this trend. (7) But these issues have never been more relevant or important to financially distressed companies and their creditors. (8) As even the smallest of businesses now conduct operations on an interstate and global basis, through the Internet and online platforms, parties need uniform and consistent bankruptcy laws. (9)

Consider the following scenario: a company experiences a liquidity crisis--it simply cannot pay its ongoing obligations from current cash flows, and creditors' demands for payment or security of payment are increasing by the day. Traditionally, that company had several options: it could file a federal bankruptcy case, (10) seek to achieve an out-of-court consensual workout with its creditors, (11) or subject itself to a state law remedy (such as an assignment for the benefit of creditors or a receivership) that would liquidate the company's assets to satisfy creditors' claims. (12) Each option provided slightly different advantages and disadvantages to the company and its creditors, as discussed more fully in Part II. Nevertheless, these distinctions have essentially disappeared, as companies exercise different means for reorganizing under federal bankruptcy laws, and as states have refined their debtor-creditor laws to mimic the relief available to companies under the Bankruptcy Code. (13) Consequently, the company in our hypothetical could file a federal bankruptcy case, commence an assignment for the benefit of creditors, or consent to the filing of a state law receivership and achieve the same result. All options would result in a sale of the business free of all creditors' claims with the assumption, assignment, and rejection of contracts and leases on a nonconsensual basis. This result allows a continuation of the distressed company's business free of legacy costs and other pre-filing obligations. (14)

Under Supreme Court decisions considering preemption issues in the bankruptcy context, a guiding consideration is whether the state law at issue provides the debtor with a discharge and frees "future acquired property from the obligation of existing debts." (15) An approach focused only on a statutory "discharge" ignores fundamental policies underlying the Bankruptcy Clause and arguably would validate the state law in our hypothetical scenario--a state law that has the effect of a discharge without being so labeled. That state law also may provide parties with different rights and remedies than federal bankruptcy law. (16) State law rights and processes that differ from, and conflict with, the Bankruptcy Code raise challenging practical issues for creditors and important constitutional issues for all. (17) It is time for policymakers and courts to question this overlap between a federal bankruptcy scheme whose purpose is to reorganize a debtor's business assets and free those assets from creditors' claims and state debtor-creditor laws. These state laws should focus on the collection and liquidation of a debtor's assets for the payment of creditors' claims.

The appropriate allocation of debtor and creditor rights and remedies between federal and state statutory schemes requires a delicate balancing of the interests at stake. There unquestionably is a federal interest in, among other things, protecting both debtors and creditors from discrimination, unfair or different standards for satisfying debts, and any undue burdens in invoking the protections afforded by federal bankruptcy laws. (18) These concerns affect not only interstate, but also international, trade, and business relations. States have an interest in protecting their residents and providing effective means for them to pay creditors when assets otherwise prove insufficient. (19) At some point, the interests of Congress and the states collide. Such federalism concerns are not new or novel in the bankruptcy context.

As explained more fully in Part I, the history of the federal bankruptcy laws is replete with examples of tension between federal and state concerns. Indeed, remnants of these struggles remain in the Bankruptcy Code, as the Code references state law or allows for the application of state law (as in the case of exemptions with respect to individual debtors) in several places. (20) The balance struck in the Bankruptcy Code is not, however, determinative for federal preemption purposes. (21) Moreover, the Supreme Court has not considered the federal preemption issue as it relates to general state debtor-creditor laws in any meaningful way for over eighty years. (22) Federal and state laws and the structure of business bankruptcy have changed significantly during that time. (23)

This Article suggests rethinking the scope of the Bankruptcy Clause and enforcing appropriate parameters for federal preemption in the bankruptcy context. State law does and should provide remedies for creditors against a defaulting party. Those remedies should include the traditional tools of foreclosing against the collateral securing the debt, obtaining a judgment lien to facilitate a foreclosure, or seeking the assistance of a receiver or assignee to collect and liquidate the debtor's assets for the payment of debts. (24) The latter remedy should not, however, include the power to reorganize the debtor's business through a going-concern sale. (25)

As used in this Article, a going-concern "reorganization" sale includes the orderly administration of a debtor's business by, for example, implementing an automatic stay, selling all or substantially all of the debtor's assets free from existing or successor liabilities, transferring contracts and leases without counterparty consent, (26) and allowing the business to continue as an operating entity after the closing of the sale. (27) A state law scheme that facilitates a going-concern reorganization sale presents at least two issues. First, it uses powers traditionally reserved to a bankruptcy trustee or debtor in possession to facilitate a fresh start for a debtor's business. (28) Second, it may provide creditors with rights or distributions that are different from, and conflict with, the Bankruptcy Code. (29) Accordingly, such state law schemes raise both field and conflict preemption issues under the Bankruptcy Clause, (30) and also may separately violate the Contract Clause.

Part I of this Article examines the origins of the Bankruptcy Code and the Supreme Court's historical approach to the Bankruptcy Clause and federal preemption, and the Contract Clause, in the bankruptcy context. This Part explains the nuances of federal preemption law, specifically considering field and conflict preemption. (31) It also reviews how state and lower federal courts have addressed preemption under the Bankruptcy Code, given that Supreme Court precedent exists primarily under the Bankruptcy Act of 1898 and prior federal bankruptcy laws. (32) Part II then considers the increasing similarities between federal bankruptcy law and state debtor-creditor laws and the potential implications of this trend. Part III focuses on the content and scope of the Bankruptcy Code and states' debtor-creditor laws to consider whether the two bodies of law can coexist, or whether instead certain aspects of state laws are, or should be, preempted by...