How the Bankruptcy Stay Passed Constitutional Muster — A Depression-Era Opinion that’s a Model for Today

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A path to follow

By: Donald L Swanson

The automatic stay is one of the basics of our bankruptcy laws. It’s a foundational rule for the entire bankruptcy system.

But that hasn’t always been the case.

In fact, the U.S. Supreme Court, in a Depression-era case, had to decide whether a bankruptcy stay is constitutionally permissible. And, fortunately, the Supreme Court ruled that it is. The opinion is here: Continental Illinois National Bank v. Chicago, Rock Island & Pacific Railway, 294 U.S. 648 (1935).

You’re gonna’ love this opinion and its rationale.

The Case

On June 7, 1933, the Chicago, Rock Island & Pacific Railway Co. filed a bankruptcy petition to reorganize under § 77 of the Bankruptcy Act. Then, it asked that secured creditors be enjoined from liquidating their collateral—i.e., Debtor wanted the Court to impose a bankruptcy stay.

[Note: § 77 was enacted on March 3, 1933. It allowed an insolvent railroad corporation to reorganize through a plan approved by creditor and equity classes, if secured creditors were adequately protected.]

Secured creditors objected, arguing that “the due process clause of the Constitution is infringed” by the injunction/stay.  But the district court granted the stay.

On appeal, the Supreme Court rejected the due process argument, saying that “§ 77, in its general scope and aim” and as applied in this case, “is within the power conferred by the bankruptcy clause of the Constitution.”

What follows is from the Supreme Court’s rationale.

The Bankruptcy Clause and Bankruptcy Developments

“Article I, § 8, cl. 4, of the Federal Constitution vests Congress with the power ‘to establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.’”

“From the beginning”:

legislation under the bankruptcy clause and judicial interpretations thereof have “been uniformly in the direction of progressive liberalization” of “the operation of the bankruptcy power”; and

that’s because older laws were unduly restrictive for current needs and treated the individual debtor as “an offender.”

–Limitations on the Bankruptcy Clause

Limitations on the Constitution’s bankruptcy clause “have never been explicitly defined” but can be understood “by the gradual process of historical and judicial inclusion and exclusion.’” Here are illustrations of the gradual process:

English law was confined to traders, but by 1935 in the U.S. “practically all classes of persons and corporations are included”;

The 1800 Act in the U.S. was “exclusively in the interest of the creditor” and presumed the debtor’s dishonesty, but the 1841 Act added a voluntary petition and a discharge of debts and introduced the concept of “fresh start” for an “honest but unfortunate” debtor; and

In 1874, the U.S. debtor was allowed, for the first time, to reorganize with the consent of creditor classes.

–Flexibility of the Bankruptcy Clause

Such developments, though “fundamental and radically progressive” have all been judicially accepted as “falling within the power conferred by the bankruptcy clause of the Constitution.”

“Taken altogether,” they strikingly demonstrate “the capacity of the bankruptcy clause to meet new conditions” that arise from “the tremendous growth of business and development of human activities from 1800 to the present day.”

Such acts, “far-reaching though they be,” have not “gone beyond the limit of congressional power, but rather have constituted extensions into a field whose boundaries may not yet be fully revealed.”

–Application to a Railroad Debtor

Section 77 is “another step in the direction of liberalizing the law on the subject of bankruptcies”—this time the new step is for railroads.

Railway corporations had previously been excluded from the bankruptcy law because:

a railroad “cannot be divided up and disposed of piecemeal like a stock of goods” but “must be sold, if sold at all, as a unit and as a going concern”; and

a railroad “cannot be halted, because its continuous uninterrupted operation is necessary in the public interest.”

So, § 77 exists because reorganization came to be regarded as “the most feasible solution” for the “preservation” of the railroad and the “protection of the various private interests involved.”

–The “Spirit of Bankrupt Laws”

Here are statements from prior Supreme Court cases that are “sound in principle” and not mere dicta:

The “spirit of bankrupt laws” is “recognized by all civilized nations” and “is not in conflict with the Constitution of the United States”; and

While the U.S. Constitution may prohibit “states from passing laws impairing the obligation of contracts,” it allows Congress to establish “uniform laws on the subject of bankruptcy throughout the United States.”

“It follows” that “§ 77, in its general scope and aim, is within the power conferred by the bankruptcy clause of the Constitution, and we so hold.”

Bankruptcy Court Authority to Issue a Stay Injunction

The Supreme Court held that § 77 could be used to enjoin/stay the sale of collateral pending progression of the bankruptcy case toward a confirmed plan.

Here’s how the stay is constitutionally permissible:

Under the bankruptcy Act in question, “courts of bankruptcy” are “essentially courts of equity”;

“The power to issue an injunction” is “inherent in a court of bankruptcy, as it is in a duly established court of equity,” such that “a federal court” can enjoin parties from proceeding in a state court “where the effect of the action” would “impair the jurisdiction of the federal court”;

A proceeding under § 77 “is a special proceeding” to “bring about a reorganization” under a “satisfactory plan,” and “to prevent the attainment of that object” would “defeat the very end” that is “the sole aim of the section” and to “render its provisions futile”; and

“The bankruptcy court, in granting the injunction, was well within its power.”

Fifth Amendment’s Due Process Clause

There is “no substance” to the argument that § 77, as applied to enjoin the sale of collateral in this case, violates the Fifth Amendment’s due process clause. Here’s why:

The argument to the contrary is that, since secured creditors may promptly (upon default) sell their collateral, a stay/injunction under § 77 “deprives them of their property” (i.e., “impairs or destroys their contractual rights”) without due process of law;

Such argument fails because the Constitution does not prohibit Congress from “impairing the obligation of contracts” as it does the states;

While Congress may not “impair the obligation of contracts by laws acting directly and independently to that end,” Congress “undeniably” has authority to act under any power conferred by the Constitution, even though such action “may operate collaterally or incidentally to impair or destroy the obligation of private contracts”;

Under the Constitution’s bankruptcy clause, § 77 is valid under the Fifth Amendment, “though drawn with the direct aim and effect of relieving insolvent persons in whole or in part from the payment of their debts”;

This “necessarily results from the nature of the [bankruptcy] power” and “must have been within the contemplation of the framers of the Constitution when the [bankruptcy] power was granted”; and

The stay/injunction granted in this case “merely delays the enforcement of the contract—it “affects only the remedy”—and a court of bankruptcy has authority “to stay the enforcement of the remedy.”

Conclusion

Wow! What a refreshing read on a crucial bankruptcy issue.

Here’s a U.S. Supreme Court opinion that:

  • recognizes the huge development of business and credit over times past;
  • acknowledges the difficulties inherent in bankruptcy laws keeping pace with business and credit expansions;
  • references the evolution of judicial rulings to allow such progress under the Constitution’s bankruptcy clause; and
  • limits the effect of another clause of the Constitution when it might impinge upon the basic requirements of the bankruptcy clause.

Can we have more opinions like this one? It should be a model for today.  It’s a path for other courts to follow!

** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.

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