Updating Bankruptcy Laws To Changing Economic Realities — A Constant Struggle

By: Donald L. Swanson

The U.S. economy is constantly changing; and our bankruptcy laws must change with it.

The months of March and April, 2020, bring massive disruptions in our economy; and our bankruptcy laws must adjust. Here are a few of the needed changes:

1. Middle class debtors must be allowed to select Chapter 7 relief;
2. Student loans must not be saddled with a certainty-of-hopelessness standard for discharge; and
3. A total-debts limit on small business eligibility needs to be replaced with small business identifiers from other federal laws.

Assuring that bankruptcy laws keep pace with economic changes has always been a struggle. And the struggle occurs in two distinct places: in the U.S. Congress and in the Federal Courts.

Reviewing struggles from the past can be instructive in dealing with similar struggles of today.  So, here are examples of struggles in keeping bankruptcy laws updated—from a couple centuries ago. [Fn. 1]

Struggles in Congress

By 1790, the U.S. Constitution has been written, adopted and ratified, with its “Bankruptcies” clause intact.

–Bankruptcy Act of 1800

But it is not until 1800 that Congress adopts its first bankruptcy law: the Bankruptcy Act of 1800. Congress models this 1800 law after the bankruptcy laws of England: it is (i) harsh toward debtors, with debtors’ prisons still operative, and (ii) intended entirely for the benefit of creditors. Here’s an illustration of the creditor focus:

• Even when the Bankruptcy Act of 1800 provides some “liberality towards the debtor” by “allowing him a discharge” with the consent of a majority of his creditors, this liberality is “intended for the benefit of creditors”;
• That’s because the discharge influences debtors “to act with economy, industry, and honesty, and make a full surrender of their property, without which they could not hope to obtain the consent of their creditors.” [Id.]

Congress quickly recognizes the deficiencies in the Bankruptcy Act of 1800 and repeals it in 1803.

–Bankruptcy Act of 1841

Thereafter, Congress allows the United States to continue without a bankruptcy law, until it adopts the Bankruptcy Act of 1841.

Prior to 1841 (in the absence of federal bankruptcy laws), various states enact their own insolvency laws. Such state laws, back then, are decidedly more debtor friendly than the olde laws of England and the Bankruptcy Act of 1800: the state laws, for example, (i) eliminate debtors’ prisons, and (ii) allow a debtor to file bankruptcy voluntarily and obtain a discharge without creditor consent.

So, Congress incorporates, into its Bankruptcy Act of 1841, similarities with debtor friendly state laws.

One reason for Congress moving in a debtor friendly direction involves huge mobility advances that changed the economy. One Judge describes such changes over the prior 50 years like this:

Back in the late 1700s, the several states had “far less intercourse” than in 1843. There were, for example, “no steamboats, railroads, or Macadamized roads.” [Id.]

Struggles in the Courts

It takes time for courts to accept Congress’s bankruptcy law changes. Here’s an illustration of judicial struggles over the Bankruptcy Act of 1841.

–U.S. Supreme Court Upholds Bankruptcy Act of 1841

In 1843, the U.S. Supreme Court upholds the constitutionality of the Bankruptcy Act of 1841—by reversing a lower court ruling of unconstitutionality! In doing so, it declares foundational principals of bankruptcy law, under the U.S. Constitution’s “Bankruptcies” clause, that hold true to the present day. The case is In re Klein. [Id.]

The Klein opinion sets up its ruling like this:

1. On the “subject of bankruptcies” under the U.S. Constitution, “Congress has general jurisdiction”; and
2. The question for decision is this: “To what limits is that jurisdiction restricted?” [Id.]

The Supreme Court’s 1843 declaration of bankruptcy principals, in In re Klein, is this:

• The U.S. Constitution’s Bankruptcies clause is “general and unlimited” and “gives unrestricted authority to Congress over the entire subject”;
• Congress’s bankruptcy jurisdiction “extends to all cases where the law causes to be distributed, the property of the debtor among his creditors: this is its least limit”;
• “its greatest, is a discharge of the debtor from his contracts”;
• “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
• As to details of the 1841 Act (e.g., permitting a voluntarily filing and discharging without creditor consent), “the courts have no concern; it belongs to the lawmakers.” [Id.]

–U.S. Supreme Court Overrules Lower Court

The Supreme Court’s In re Klein opinion exists only because a lower federal court had declared the Bankruptcy Act of 1841 unconstitutional—as too debtor friendly.

Here’s the lower court’s unconstitutionality reasoning that the Supreme Court rejects in In re Klein.

1.  Bankruptcy Laws Must Be For The Sole Benefit of Creditors

A debtor friendly bankruptcy law cannot comply with the Constitution’s Bankruptcies clause. That’s because the sole purpose of such clause is to “prevent so many frauds where the parties or their property may lie or be removed into different states.”

Various states enacted debtor friendly insolvency laws. Pennsylvania’s insolvency laws, for example, are similar to Congress’s Bankruptcy Act of 1841 and “no doubt furnished some of the ideas that were incorporated” into it.

So, the lower court dismisses state law precedents by looking, instead, to creditor friendly laws of England. The Judge justifies such a choice by pointing to the Constitutional Convention of 1787:

• “The convention well knew it was making a Constitution for the whole Union”;
• “The laws of the several states could not have been generally known to the members of the convention from the different states”;
• “Ask a lawyer the meaning of a legal term, and where does he look for an answer? To the statutes of Massachusetts or Georgia—New York, Pennsylvania, or Virginia? Certainly not.” Instead, the lawyer, “will refer to Blackstone’s Commentaries, or to an English Law Dictionary, where he will readily find it”;
• “The first Continental Congress, in 1774,” and “the Supreme Court of the United States” have both adopted the statutes of England as “part of the common law of the county’; and
• The Constitutional convention “had the English statutes in view” when “the bankrupt clause was under consideration.”

The lower court also looked for justification to Congress’s Bankruptcy Act of 1800, which is “altogether, in its principle and material features, like the English system”—i.e., for the sole benefit of creditors.

2.  The 1841 Act Is Entirely For Debtors’ Benefit

“I will now show,” the lower Klein court declares, that the Bankruptcy Act of 1841 is, (i) “solely and entirely for the benefit of debtors,” (ii) because it enables them to “avoid their debts,” and (ii) is, therefore, “opposed to the whole intent, spirit, and object of a bankrupt law.”

Here’s what follows in the lower court’s opinion:

• Debtor selects his own time to commence proceedings—when he may have entirely squandered his property, and when nothing can be found;
• Debtor selects the state and county where he will commence proceedings and can change his residence or business to any place he may think most favourable;
• Debtor may have spent all his property in idleness, riotous living, debauchery, or gambling, in stocks, or wild speculations: it will not affect him; and he is entitled to his discharge, equally with the most prudent, industrious, and economical person;
• Even when creditors get not even one cent’s worth of property, Debtor may reserve to himself and for his own use $300 worth of property plus the wearing apparel for himself and his family, including jewelry;
• Debtor can manipulate procedures, if creditors object to his discharge, in ways that a creditor can’t;
• English bankrupt laws and the Bankruptcy Act of 1800 give appointment of the assignee to creditors, while no such privilege is given by the 1841 Act;
• There is no punishment for frauds; and
• The 1841 Act applies to debts contracted before its passage, of which creditors had no idea at the time they gave the credit.

Fortunately for the development and progress of bankruptcy laws, the U.S. Supreme Court overturns this ill-advised lower court ruling.

Today’s Bankruptcy Code (Bankruptcy Act of 1978)

The struggles of Congress and the Courts on updating bankruptcy laws have continued from In re Klein to the present time.

–Recent Struggles in Congress

In 1978 Congress did a total rewrite of the bankruptcy laws enacted in 1898, as revised by the Chandler Act in 1938. The Bankruptcy Act of 1978 is commonly known, today, as the Bankruptcy Code.

From the beginning, the Bankruptcy Code worked well to address the down-side needs of our market economy.  For two and a half decades it worked well.

But Congress became alarmed by the volume of bankruptcy filings by individual debtors (particularly by middle class debtors) and decided to revert to the debtor-averse and punishment ideas of olde.  Specifically, in 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), which keeps middle class debtors out of Chapter 7 and requires a five-years penance of such debtors in Chapter 13. BAPCPA has been a disaster for our bankruptcy system and for the many individuals who have needed, and are deserving of, efficient and effective bankruptcy relief.

Other urgent problems exist in the bankruptcy realm that Congress has been unable or unwilling to fix.  For example:

• Higher education costs have exploded since the 1970s. The Federal Government has both enabled and funded that explosion through student loans. To deal with student loan problems (and with the federal government’s exposure for defaulted loans), Congress created a certainty-of-hopelessness standard for discharging such loans. This has been a terrible problem for many hardship cases.
• Despite all the bankruptcy amendments in recent decades, Congress has failed to provide effective bankruptcy relief for small businesses and their entrepreneurs. This failure is more-than-a-little bizarre, due to the crucial role of small businesses in the U.S. economy. Fortunately, Congress made recent progress on this through the Small Business Reorganization Act of 2019. In an inexplicable twist, however, such progress has been limited to only the smallest of small businesses (to businesses with less than $2.72 total debt). This debt limitation is increased for one year to $7.5 million under the CARES Act, but even this increase omits many small businesses and their entrepreneurs from effective bankruptcy relief.

All of these deficiencies need to be remedied by Congress. The current economic crisis highlights the need for such remedies—and their urgency.

–Recent Struggles in the Courts

Under the Bankruptcy Code, and in a reversal from In re Klein, it has been the U.S. Supreme Court who viewed the Bankruptcy Code as a radical and improper departure from laws of the century past. In cases like Northern Pipeline v. Marathon Pipe Line and Granfinanciera v. Nordberg and Stern v. Marshall, the U.S. Supreme Court placed limitations on the role and authority and jurisdiction granted by Congress to bankruptcy courts.

It is the wisdom of Justices Blackmun and O’Connor proclaiming, in their Granfinanciera dissent, the importance of “permitting Congress at long last to fashion a modern bankruptcy system which places the basic rudiments of the bankruptcy process in the hands of an expert equitable tribunal.”

In more recent times (i.e., after the Stern v. Marshall debacle of 2015), the U.S. Supreme Court seems to have abandoned its disdain for the Bankruptcy Code and embarked upon a trajectory of making the Bankruptcy Code work efficiently and well.

Conclusion

Presumably, and hopefully, (i) Congress will, in the near future, make adjustments to bankruptcy laws that our current economic realities demand, and (ii) the U.S. Supreme Court will be on board with the bankruptcy changes Congress decides to make.

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Footnote 1. All information and quotes about early bankruptcy laws are from the U.S. Supreme Court’s In re Klein opinion, which is reported as the second of two opinions appearing as Nelson v. Carland, 42 U.S. 265 (1843). The In re Klein opinion is authored by Justice John Catron, who served as an Associate Justice of the U.S. Supreme Court from 1837 to 1865. The In re Klein opinion begins in volume 42 U.S. at 227, following this introductory sentence: “While this volume was in press, we received the following opinion delivered by Judge Catron in his judicial district, which we insert as being of general interest.”

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