U.S. Constitution’s “Bankruptcies” and “Contracts” Clauses: How They Work Together (In re Klein)

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Working together (photo by Pauline Norman)

By: Donald L Swanson

The U.S. Constitution has two provisions on bankruptcy subjects:

  1. Bankruptcies Clause — “The Congress shall have Power . . . To establish . . . uniform Laws on the subject of Bankruptcies throughout the United States” (Art. 1, Sec. 8, Cl. 4); and
  2. Contracts Clause — “No State shall enter into any . . . Law impairing the Obligation of Contracts” (Art. 1, Sec. 10, Cl. 1).

Nearly two centuries ago, the U.S. Supreme Court explains—in In re Klein [Fn. 1]—how these two clauses fit together and why they exist as drafted. Here’s how.

Federal Bankruptcy Laws Predominate

The starting point — and foundational rule — is that federal bankruptcy laws will always predominate.

That’s because the U.S. Constitution’s Bankruptcies Clause is “general and unlimited” and “gives unrestricted authority to Congress over the entire subject.”

State Bankruptcy Laws — Back In 1843

In re Klein explains that State bankruptcy laws can exist, if they satisfy both the Constitution’s (i) Contracts Clause, and (ii) Bankruptcies Clause.

The U.S. Constitution does not prohibit the states from passing bankruptcy laws; “New York, Pennsylvania, Louisiana, and others, now have them in full operation” (in 1843).

That the states had power to pass bankruptcy laws, no one ever doubted, so far as she was not restricted by the Constitution of the United States — namely, by the Constitution’s Contracts and Bankruptcies clauses.

Contracts Clause Implications. A state bankruptcy law can discharge an obligation of contract between debtor and creditor (despite the Constitution’s Contracts Clause), if:

  • the creditor and debtor are both “inhabitants of the particular state at the date of the proceeding”; and
  • the contract being discharged had been made in that state “after passing the law,” in which case “the parties contracted subject to the law” when they “entered into the contract.

Bankruptcies Clause Implications. But the states are also limited by the Constitution’s Bankruptcies Clause.

In re Klein explains this historical context:

  • Before ratification of the Constitution, “the states could frame a bankrupt law in any form they saw proper”;
  • After ratification of the Constitution, a state’s bankruptcy law is effective until Congress enacts a federal bankruptcy law; and
  • Once Congress passes a bankruptcy law, state bankruptcy laws are suspended for as long as the act of Congress continues in force.

The last of these three points is significant (both before and after 1843), because a federal bankruptcy law rarely existed during the first eighty years of the Constitution. Here is a chronology:

  • 1789 – U.S. Constitution ratified
  • 1800 – First US bankruptcy law enacted: repealed in 1803
  • 1841 – Second US bankruptcy law enacted: repealed in 1843
  • 1867 – Third US bankruptcy law enacted: repealed in 1888
  • 1898 – Fourth US bankruptcy law enacted—a federal bankruptcy law has been in effect at all times thereafter.

Why Federal Bankruptcy Laws Predominate

In the U.S. Constitution, the bankruptcy power (and the corresponding right to impair contracts) is given to the federal government—and taken away from the states. In re Klien explains the reasons like this.

–Protecting Debtors and Creditors Equally

The Constitution’s framers had in mind, equally, the rights of both debtor and creditor. That’s because the great object is to deprive the states of the dangerous power to abolish debts:

  • generally speaking, inhabitants of producing states are creditors, and inhabitants of consumer states are debtors;
  • bankrupt laws of consumer states might ruin the producers and creditors by annulling the debts of non-residents, and no remedy would exist for the grossest oppression;
  • in times of pressure by foreign creditors, such state laws are likely to be adopted;
  • if one state adopts such a measure, “it would fornish a fair occasion for others to do the same, on the plausible pretext of self-defence”; and
  • then, other states would be forced into a similar bad policy, so that “discredit and ruin would overspread the entire land, by an extinction of all debts,” along with a “prostration of morals, public and private, on the subject of contracts.”

Such an “evil” had already occurred and “was fresh in the minds of the framers of the Constitution,” who expected it to recur.

–The Uniformity Goal

By contrast, if Congress were to pass the same law, it would be “uniform throughout the United States,” so that “the entire people are equally represented” and have the collective power to (i) protect themselves against hasty and mistaken legislation being enacted, and (ii) repeal any legislation they find to be “oppressive in practice.”

–Avoiding Jurisdiction Conflicts

Moreover, In re Klein explains that a federal bankruptcy law prevents dangerous conflicts of jurisdiction among the states:

  • A discharge in one sovereignty from contracts, “is by the laws of nations not recognised as a discharge in another sovereignty, save on the grounds of comity”;
  • the states in this respect are foreign to each other, and would be little likely to extend comity to the discharge of each others; and
  • from all this, “great confusion might follow, and much ill will.”

Conclusion

The development and application of bankruptcy laws (both state and federal) in these United States has been a long, disjointed and entangled process.

Fortunately, we are in an exclusively-federal system now . . . and have been for more than a century. This federal system has served us well (its imperfections notwithstanding).

Yet, we need to recognize that our current bankruptcy system (with all its wisdom and shortcomings) is a culmination-to-date of the struggles and progress-through-imperfections of generations past.

————————–

Footnote 1. In re Klein is an opinion from the U.S. Supreme Court, 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 his 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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