The Constitution’s Bankruptcy Clause — A Struggle for Judicial Recognition

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Judicial Recognition

By: Donald L Swanson

Bankruptcy laws in these United States have always struggled for acceptance by the judiciary.

Judicial Restrictions on Congress’s Bankruptcy Power

Federal courts, in many respects since 1800, have tried to restrict the bankruptcy power granted to Congress by the U.S. Constitution [Fn. 1]. For example:

–In the 1800s and early 1900s, courts did so by using, (i) the Fifth Amendment prohibition against depriving persons of property “without due process of law,” and (i) the Art. I, Sec. 10, prohibition of a State “impairing the Obligation of Contracts”; and

–From the late 1900s to the present, courts have been using Article III, and its “public rights” exception, to limit Congress’s bankruptcy power.

Why?

Why has this happened for more than two centuries? Here’s why:

1. Congress has been trying to keep pace with explosions in magnitude and complexities of business and credit activity—and with financial failures that inevitably occur; yet

2. Courts look to historical precedents for their bankruptcy rulings—but each new economic reality that Congress attempts to address is unprecedented.

Think of it this way:

Back in the early 1800s, we still had debtor’s prisons, people could still be hanged for bankruptcy crimes, and a “voluntary” bankruptcy was unthinkable; so

If we are to get from there to the 1978 Bankruptcy Code, a judicial focus on historical precedents is the long road home.

Judicial Reaction to the 1841 Bankruptcy Act–In re Klein

Here’s an illustration of how the explanation above almost worked to prevent bankruptcy progress, involving Congress’s 1841 Bankruptcy Act. The case is In re Klein [Fn. 2], with opposing opinions from the District and Appellate courts.

In re Klein: Circumstances

The 1841 Bankruptcy Act is “a sharp departure from” both the “prior English bankruptcy law” and Congress’s “1800 federal bankruptcy act”: the 1841 Act, (i) helped debtors as well as creditors, (ii) allowed voluntary bankruptcies, (iii) was no longer limited to debtors engaged in trade, and (iv) discharged debts without creditor consent.

In re Klein: District Court Ruling

Judge Wells of the U.S. District Court held the 1841 Act unconstitutional on two grounds:

First, “English practice defined the scope of the bankruptcy power and confined it to creditors’ relief measures”; and

Second, “the 1841 Act violated the (U.S. Constitution’s) contracts clause.”

Judge Wells regarded the contracts clause as applying to “the federal government as well as to the states” and viewed a discharge in a voluntary bankruptcy as “impairing the obligation of contracts.”

Fortunately for us today, the Circuit Court did not agree.

In re Klein: Circuit Court Reversal

U.S. Supreme Court Justice Catron, sitting on circuit, reversed. He rejected the idea of “tying the bankruptcy power to prior English practice” and “adopted an expansive view of the power conferred by the bankruptcy clause.” He ruled:

The Constitution’s bankruptcy power “extends to all cases where the law causes to be distributed the property of the debtor among his creditors; this is its least limit”;

The greatest limit of the bankruptcy power “is a discharge of the debtor from his contracts”;

“And all intermediate legislation, affecting substance and form, but tending to further the great end of the subject – distribution and discharge – are in the competency and discretion of congress”; and

Of the 1841 Act’s innovative approach, “the courts have no concern; it belongs to the law makers.”

Justice Catron’s view “was simply that the [Constitution’s] bankruptcy clause confers on Congress the authority to enact legislation that has the effect of impairing the obligation of contracts”:

The contracts clause the U.S. Constitution “has no independent significance in the context of bankruptcy legislation”; and

If the 1841 Act “falls within the scope of the bankruptcy power, no question of unconstitutional impairment of the obligation of contracts is presented.”

By 1935, Justice Catron’s opinion had been “cited frequently” by the U.S. Supreme Court “as the leading statement of the scope of the bankruptcy power.”

1978 Bankruptcy Code

Fast forward to Congress’s enactment of the Bankruptcy Code in 1978 and the Supreme Court’s Northern Pipeline and Granfinanciera rulings that followed.

The same type of In re Klein restriction on bankruptcy law happened again—only there was no Justice Catron to bail us out:

Granfinanciera’s majority described the new Bankruptcy Code as creating “radical reforms” and “sweeping changes”;

Northern Pipeline’s plurality opinion squeezed the new Code into a historically-recognized Article III exception—where it, simply, does not fit; and

What resulted is an unworkable and disastrous focus on “public rights” doctrine for the next four decades.

Conclusion

Fortunately, it appears that the U.S. Supreme Court, in the present day, is becoming familiar and comfortable with the Bankruptcy Code and more-open in recent times to allowing the system to work, rather than continuing to create a drag on its operation.

The Supreme Court’s struggles, over the past four decades, with Article III and  bankruptcy seem to mirror the judicial struggles that occurred under the 1841 Bankruptcy Act. And, hopefully, we are near the end of the “public rights” disaster that resulted.

Footnote 1: Art. I, Sec. 8, of the U.S. Constitution provides: “The Congress shall have Power … To establish … uniform Laws on the subject of Bankruptcies throughout the United States.”

Footnote 2: Citations for the In re Klein cases are: District Court – 14 F. Cas. 719 (D. Mo. 1843) (No. 7866), and the reversing Appellate Court — 88 14 F. Cas. 716 (C.C.D. Mo.) (No. 7865). All information and quotes about In re Klein are from this article by Prof. James Steven Rogers: “The Impairment of Secured Creditors’ Rights in Reorganization: A Study of the Relationship Between the Fifth Amendment and the Bankruptcy Clause,” published at 96 Harvard Law Review, 973-1031 (March 1983).

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