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Business and Commercial Law

Bankruptcy Under Scrutiny

By James L. Baillie

The National Bankruptcy Review Commission has completed its eighteen-month study of the bankruptcy system. It delivered a 1,300-page report (including nearly 300 pages of dissent) to Congress, the president, and the Supreme Court on October 20, 1997. The nine-member commission was created by the Bankruptcy Reform Act of 1994 and charged with “reviewing, improving and updating the Code in ways which do not disturb the fundamental tenets of current law.” While the report is meant to guide future legislation, its format consists of 172 policy recommendations rather than draft legislation.

The chair of the commission is Brady C. Williamson, a practitioner from Madison, Wisconsin. The reporter for the commission is Elizabeth Warren, a professor at Harvard Law School. Warren has been quoted as saying that she considers the final report a fair balance between the interests of creditors and of debtors. Much of the dissent was led by Judge Edith Jones of the Fifth Circuit.

The report will be at the center of discussions of possible changes to the Bankruptcy Code for years to come. Because many of the areas in which the commission has offered policy recommendations are controversial, and because many of the recommendations were adopted by the commission on closely divided votes, it is not expected that comprehensive legislation based on the report will be adopted by Congress soon. And many of the recommendations may be rejected by Congress.

The report notes that nearly 1.3 million families will use bankruptcy this year, a sevenfold increase over 1978, the year before the current Bankruptcy Code went into effect. During the same period, business bankruptcies increased from 32,000 to 53,500. In addition to the increased number of bankruptcy cases, the commission noted other changes since 1978, suggesting the need for revisions of the Bankruptcy Code responsive to mass tort cases, international business failures, legalized gambling, credit card solicitation (at least twenty-four for every household each year), and investigations concerning forced reaffirmation of discharged debt by several major companies.

The most controversial recommendations address consumer bankruptcy law, where banks and some members of the commission have pushed for “means testing,” which would limit the availability of Chapter 7 and force some debtors with the capacity to repay debt into Chapter 13, where they would be required to make payments to creditors. The commission’s report does not contain means testing, but legislation that does has already been introduced in Congress.

Under a recommendation by the commission, the Bankruptcy Code would set national exemptions (currently in many states, debtors are able to choose either state exemptions or the exemptions specified in the Bankruptcy Code). New Code exemptions would protect homestead equities of $20,000 to $100,000 (depending on state exemptions laws), would include other specific exemptions and would allow retention of up to $20,000 in property not otherwise exempt. Student loans (except for medical school) would be dischargeable. Credit card charges made within thirty days of bankruptcy would not be dischargeable. Dischargeability of credit card charges made before that time would depend on whether the debt was incurred on the basis of a materially false financial statement or to pay nondischargeable taxes due the United States.

There would be a national database for and random audits of bankruptcy cases and there would be limitations on serial bankruptcy filings and a procedure to prevent repeat filings as to specific real property. There would be limitations on the reaffirmation of debt. Financial education programs would be available to debtors. Valuations of personal property would be based on wholesale rather than retail value, thereby reversing the effect of the recent decision of the Supreme Court in In re Rash, in which the court used retail values to determine the amount of a creditor’s secured claim.

Among the most significant recommendations regarding the structure of bankruptcy courts and the bankruptcy process are recommendations that would make bankruptcy judges (with a transition process) Article III judges, with lifetime tenure and salary protection, giving them full judicial authority to handle all matters at the trial court level in bankruptcy cases. Appeals would go directly to the court of appeals, bypassing the district court. Another recommendation would provide for expanded opportunities for interlocutory appeals.

The commission would address the “Delaware issue” by eliminating the state of incorporation as an independent basis for the venue of bankruptcy cases. Preference recovery actions seeking less than $10,000 would have to be brought in the bankruptcy court in the district where the creditor has its principal place of business. Also, there would be a $5,000 limitation on preference actions in nonconsumer cases. There would be a national admission to practice in bankruptcy courts.

Another significant change would eliminate the references to “executory” with respect to contracts that would be subject to an “election to perform” or “election to breach” with court approval. The commission also presented recommendations concerning several bankruptcy tax issues, many of which were also controversial within the commission.

A proposal that will undoubtedly receive a significant amount of attention addresses mass future claims. This recommendation, which would not address environmental claims, provides an elaborate definition to cover situations that give rise to mass future claims. In those defined situations, a representative of the class of such claims would be appointed for the bankruptcy case. The new bankruptcy law would provide estimation of these claims and for the disposition of property free and clear of the mass future claims in connection with a sale or plan of reorganization approved by the bankruptcy court.

In the business area, one proposed change that is central to how Chapter 11 bankruptcy cases actually work would create an explicit “new value” exception, which would permit members of a junior class of claims or interests to purchase a new interest in the reor-ganized debtor as part of a plan. However, such a request would result in a termination of exclusivity, so that competing plans could be filed. A proposed change concerning classifications of claims would permit a plan of reorganization to classify legally similar claims separately if based on a “rational business justification.”

Under a recommendation addressing “small business debtors,” those with secured and unsecured claims of $5 million or less, new procedures generally would provide for more active involvement by the bankruptcy court and the U.S. trustee in scheduling and monitoring the progress of the case. Among other things, this recommendation would provide new reporting requirements, clarify the circumstances under which a trustee would be appointed or the case would be converted or dismissed, provide for waiver or simplification of the disclosure statement, and provide a “safe harbor” standard-form disclosure statement. Unless extended by the court, the debtor would be required to file a plan and disclosure statement within ninety days and confirmation within 150 days after the filing of the case. There would also be changes with respect to single-asset Chapter 11 cases.

The recommendations described here and many others contained in the report will result in discussion and controversy regarding both highly technical matters for bankruptcy specialists and also fundamental issues of public policy.

The report is available through the Government Printing Office Web site at

James L. Baillie is a shareholder at Fredrikson & Byron in Minneapolis.

-This article is an abridged and edited version of one that originally appeared on page 24 in Business Law Today, Jan./Feb. 1998 (7:3).

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