Chapter 3: The Bankruptcy System
3.1. Purposes of Bankruptcy
As we’ve seen in the previous chapters, state laws favor the swiftest creditors by granting
priority to those unsecured creditors who are first to obtain a judgment, execute on the debtor’
assets and cause them to be sold. Meanwhile, debtors can generally prefer favored creditors by
preferentially paying their claims or granting them security interests before paying other creditors,
even if the preferential payments render the debtor insolvent and unable to pay other claims. The
state law process is expensive and time consuming for creditors, and because of the holdout
problem makes it difficult for debtors to enter into consensual workouts with creditors.
The state law system also results in creditors (and, if solvent, the debtor) receiving fire sale
prices for the debtor’s non-exempt assets. Although many states have statutes allowing collective
action by creditors (assignments for the benefit of creditors and equity receiverships), these
procedures lack the nationwide organizational structure of a national bankruptcy system and also
face significant obstacles from the holdout problem.
State laws also provide no ready mechanism for debtor relief outside of the statutes of
limitation. There are generally long statutory periods for filing contractual debt collection suits
(generally 3-6 years from default), and even longer periods (generally 10 or more years) for
collecting judgments. In some states, like New York, the debtor can unwittingly revive an expired
limitations period by acknowledging the debt. New York General Obligations Law 17-101. In New
York, any payment on a debt – even one that could not be collected in court due to the expiration
of the statute of limitations - renews the entire liability and starts a new limitations period if the
court determines that the partial payment constitutes an acknowledgment of the debt. See Empire
Purveyors v. Weinberg, No. 603282/06, 2008 N.Y. Misc LEXIS 8842, 2008 Slip Op 31380U (N.Y.
Co. 2008), aff’d, 60 A.D.3d 508, 885 N.Y.S.2d 905 (1st Dept. 2009). Debt collectors often request
a small token payment, claiming that it would be a sign of good faith, when in fact they are seeking
to extend or renew a limitations period that that debtor did not know expired and was not intending
to renew. In many states the judgment limitation periods can be extended by filing renewal suits
before the limitations period expires, potentially saddling a debtor with liability for a lifetime. The
statute of limitations on the enforcement of liens can run for a decade or more. Statute of limitations
periods thus provide only limited relief for debtors.
Debtors saddled with debts that the y are unable to pay are discouraged from engaging in
gainful employment when much of the benefit would go to the debtor’s creditors, creating a cycle
of poverty. Debtors who know that they would be unable to rid themselves of debt may be unable
or unwilling to incur debt for entrepreneurial investment, hampering the growth of the economy.
For these basic reasons, successful economies have recognized that debt relief is an important
ingredient for both fairness and economic growth.
The bankruptcy system is designed to pick up where state law leaves off by providing for
orderly collective creditor action, providing for the discharge of debts that are not paid through the
bankruptcy process, and addressing the holdout problem by facilitating orderly and fair
reorganization proceedings. In liquidation cases, an independent trustee will have time to achieve
high sale process, and the distribution rules assure that similarly situated creditors will be treated
similarly. Individual debtors can receive a discharge of their debts, allowing them to receive a
fresh start and return as productive members of society. In reorganization cases, creditors are
assured of receiving more than they would receive in a liquidation, and are protected by detailed
rules designed to assure a measure of fairness to all parties. All parties are also protected by a legal
framework designed to provide full and prompt financial disclosure by the debtor, and an
expeditious hearing process before specialized bankruptcy judges who are experts in bankruptcy
law to resolve any disputes that may arise.
3.2. Structure of the Bankruptcy Code
The federal bankruptcy system is grounded on a grant of power contained in the United
States Constitution. The grant gave Congress the power to create “uniform laws on the subject of
bankruptcies.” While there were long periods during the 18th and 19th Centuries during which
Congress decided not to enact uniform bankruptcy laws, there has been a continuous federal
bankruptcy system in effect since 1898.
Congress revamped the bankruptcy laws in 1978 by passing the Bankruptcy Reform Act
of 1978 (Pub.L. 95–598, 92 Stat. 2549, November 6, 1978), which has become known simply as
the “Bankruptcy Code” or “Code,” and will be referred to as such throughout this book.
The original structure of the Code remains intact, although there have been several
significant amendments, the most significant being the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005, Pub.L. 109–8, 119 Stat. 23, known as “BAPCPA.” BAPCPA
was a poorly drafted law cobbled together by special interests without the usual vetting process by
the bankruptcy bench and bar that had been used in previous amendments. Major portions of
BAPCPA did not go into effect immediately, and the media spread alarm that bankruptcy would
no longer be available to consumer debtors, resulting in a tremendous rush by individuals to file
prior to the effective date. As a result, nearly 2 million people filed bankruptcy in 2006, with
bankruptcy lawyers serving lines of people waiting to get their cases filed before the deadline.
In fact, as we will see, while the law created a great deal of unnecessary paperwork and
complexity, and substituted rigid tests that are easily circumvented for the flexible tests that the
courts used previously, the law did not disqualify most of the people who need relief from
eligibility. However, BAPCPA’s complexity and confusion have made it more difficult for general
practitioners to handle bankruptcy cases part time. The bankruptcy bar has become smaller and
more specialized as a result of BAPCPA. We will look in this chapter at the some of the most
significant changes wrought by BAPCPA, including the dreaded “means test” and the automatic
The Bankruptcy Code is Title 11 of the United States Code. It is divided into chapters – all
odd numbers except Chapter 12. Chapters 1, 3 and 5 contain general rules applicable to each of
the remaining chapter proceedings. Cases are filed under a specific chapter proceeding:
Chapter 7: Straight bankruptcy liquidation
Chapter 9: Municipalities (government entities)
Chapter 11: Business reorganizations
Chapter 12: Family farmer and fisherman reorganizations
Chapter 13: Mostly consumer reorganizations
Chapter 15: Transnational reorganizations
Chapter 7 is what most people think bankruptcy is about. The debtor turns over all of his,
her or its non-exempt assets to an independent Chapter 7 trustee. The trustee liquidates the assets
(turns them into money usually by selling them), and uses the proceeds of the liquidation pay
claims in an order of priority: expenses of liquidation and administration first, certain priority
claims second, and then general unsecured claims. Individual debtors receive a discharge of their
debts. Entity debtors become empty shells and for all practical purposes suffer corporate death. A
better term may be corporate zombies, since the entity must technically be wound up and
terminated under state law to cease to exist, but they are empty shell entities that cannot generally
be used for any other purpose since the shells continue to owe all unpaid creditors. Chapter 7
proceedings are fast, with most cases completed within four to six months after filing.
Until recently, Chapter 9 was a sleepy and ill-defined chapter of the Bankruptcy Code.
Recently, however, it has become a hotbed of activity, with major cities like Detroit, Michigan,
filing for bankruptcy relief, and great uncertainty about what can be done to revitalize moribund
governmental entities. These cases pit former government workers relying on promised pensions
against bondholders, creditors, continuing workers and taxpayers. Many municipalities appear to
be sitting on the sidelines awaiting clarity from the courts about what can be done in a Chapter 9
Chapter 11 is the most important reorganization chapter in terms of the amount of money
at stake, but involves only a tiny fraction of the cases that are filed each year. Chapter 11 is
expensive. Even small simple Chapter 11 cases can cost $100,000 in fees, and large cases can cost
hundreds of millions of dollars in fees. Chapter 11 cases pit the largest and most expensive law
and investment firms in the country against each other. Chapter 11 is designed for flexibility,
allowing virtually limitless reorganization agreements to be reached between creditors and debtors,
and overcoming the holdout problem with a special majority voting structure. Because of its
flexibility and consequent expense, Chapter 11 is appropriate only for individuals or businesses
seeking to reorganize significant assets.
Almost anything can be done to reorganize a debtor in Chapter 11 with the requisite levels
of consent from creditors. The trick is proposing a plan which will cause as much pain to creditors
as possible while still receiving the affirmative votes of the requisite majorities. Debtor who
cannot obtain the requisite votes must “cramdown” the plan on non-consenting classes of creditors
in the limited ways allowed by the bankruptcy code.
While lawyers handling Chapter 11 cases perform legal work that is custom tailed to the
particular case, those handling Chapter 12 and 13 cases work from an off-the-rack reorganization
plan structure. Like Chapter 7, Chapters 12 and 13 are structured simply, limiting what the debtor
can do to reorganize its business. There is no voting and no need to reach agreements with the
majority of creditors – the plan either meets the requirements for confirmation or it does not, and
the bankruptcy law says what can and cannot be done to restructure creditor claims.
Chapter 15 is a new provision for foreign parties that have filed a bankruptcy or
bankruptcy-like proceeding in another country to obtain assistance through an ancillary proceeding
in the United States to deal with assets located in the United States.