Dividing Secured Claims from Under-Secured Claims: A History

There are things we take for granted in bankruptcy cases: like concepts of fresh start and of absolute priority and of adequate protection. But the source of such concepts is often murky.

One of those take-for-granted things is this: the division of a secured claim into, (i) an allowed secured claim that gets paid in bankruptcy, and (ii) an allowed under-secured claim that, typically, does not. And the division can be based on an appraised value.

This division happens in bankruptcy all the time. And we take it for granted.

But taking it for granted hasn’t always been the case. Here is some history.

Dividing Under-Secured Claims from Secured Claims

The source for dividing under-secured claims into an allowed secured claim and a general unsecured claim is this:

a U.S. Supreme Court opinion arising out of the Great Depression, Wright v. Union Central Ins. Co., 311 U.S. 273 (1940).

The debtor in Wright v. Union Central is a financially strapped farmer who owns a 200 acre tract of farmland at bankruptcy filing. His case is filed under § 75 of the Bankruptcy Act of 1898.

The “narrow issue” considered by the Supreme Court in Wright v. Union Central is this:

“whether under § 75(s)(3)” of the Bankruptcy Act, “the debtor must be accorded an opportunity, on his request, to redeem the property” at “a value fixed by the court before the court may order a public sale.”

Bankruptcy Court and Appellate Court

The debtor asks, under § 75, to (i) have the land appraised, (ii) redeem the land at the appraised value, and (ii) discharge any deficiency.

The bankruptcy court holds a trial. Then, it finds: (i) the amount owed by debtor to respondent is $15,903.68, and (ii) the value of the property securing that debt is $6,000. The bankruptcy court also finds that debtor provided no evidence of an ability to refinance the property at the appraised value. So, it orders that the property be sold at public sale to the highest bidder, that respondent be allowed to credit bid at the sale, and that debtor be barred from all equity of redemption.

Debtor appeals, and the U.S. Circuit Court of Appeals affirms.

U.S. Supreme Court Reversal

Debtor appeals again. The U.S. Supreme Court grants certiorari and reverses. Here’s why:

“We think that the denial of an opportunity for the debtor to redeem at the value fixed by the court before ordering a public sale was error.”
§ 75(s)(3) of the Bankruptcy Act provides two seemingly inconsistent things—(i) it allows a debtor to pay into court the appraised amount to redeem the property, and (ii) it provides that “upon request in writing by any secured creditor or creditors, the court shall order the property upon which such secured creditors have a lien to be sold at public auction.”
The granting of a request for a public sale, under this statute, is mandatory—but so is the granting of a request for a valuation at which the debtor may redeem.
Yet a reconciliation of these seemingly inconsistent remedies is not difficult because of the purposes of the Act—(i) the Act effectuates “a broad program of rehabilitation of distressed farmers,” and (ii) the Act provides safeguards “to protect the rights of secured creditors . . . to the extent of the value of the property.”
“There is no constitutional claim of the creditor to more than that.”
And so long as the value of the collateral is protected, the creditor is in no position to insist that doubts or ambiguities in the Act be resolved in its favor and against the debtor.
“Rather, the Act must be liberally construed to give the debtor the full measure of the relief afforded by Congress . . . lest its benefits be frittered away by narrow formalistic interpretations which disregard the spirit and the letter of the Act.”
“Equal protection to debtor and creditor alike can be afforded only by holding that the debtor’s request for redemption pursuant to the procedure prescribed in the first proviso of § 75(s) (3) cannot be defeated by a request of a secured creditor for a public sale under the second proviso.”
Under our construction—(i) “the debtor will be given the benefit of an express mandate of the Act,” and (ii) “the creditor will not be deprived of the assurance that the value of the property will be devoted to the payment of its claim.”

Today’s Bankruptcy Code

Accordingly, when the drafters of the Bankruptcy Code of 1978 crafted provisions like 11 U.S.C. § 506 (“Determination of secured status”), they did two things:

They embraced and enacted the appraised value / redemption concepts articulated by the U.S. Supreme Court in Wright v. Union Central; and
They articulated a liberal construction concept that gives the debtor “the full measure of the relief afforded by Congress” and rejects “narrow” and “formalistic interpretations” that might jeopardize such rights.

Conclusion

Here’s wishing the U.S. Supreme Court, over the past four decades, had spent more time relying on opinions like Wright v. Union Central to effectuate Congress’s efforts, instead of acting to restrict and stifle such efforts.

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Dividing Secured Claims from Under-Secured Claims: A History