Insolvency and Bankruptcy Law; D. Bechara

352 Insolvency and Bankruptcy Law by Dennis Bechara A tone time in history, society regarded those who applied for bankruptcy relief as defrauders, and, in some instances, as criminals. Bankrupts were the object of so cial sanctions, and in many cases they had to leave their area of employment for fear of fur ther societal punishments. The origin of the word bankruptcy itself is indicative of the atti tude toward bankrupts. In medieval Venice, merchants conducted their business affairs in public places, and they usually brought their own benches where they could rest during the course of the day. If a merchant were unable to pay his debts, his creditors would proceed to break down his bench, symbolizing the bank rupt's exclusion from the business community. The word bankrupt comes from the Italian banca rotta, or broken bench. Governmental attitude toward bankruptcy has evolved over the years to the point where today many no longer consider it a socially objection able form of behavior. Perhaps reflecting America's more permissive values, filing for bankruptcy protection has become a growth in dustry. Consumers and corporations have dis covered the advantages of bankruptcy relief.

Many individuals who overextended their credit and no longer can meet their obligations have filed bankruptcy petitions. Some corporations have also obtained bankruptcy protection as a means of unilaterally breaking executory con tracts or of dealing with a variety of pending lawsuits. Mr. Bechara, an attorney, is a frequent contributor to The Freeman. Recent developments in the area of bank ruptcy, however, indicate that the boom in bankruptcy filings may already have reached its limits. Before analyzing the nature of these changes, however, it will be instructive to take a brief look at the development of bankruptcy in the United States. At the time the Constitution of the United States was adopted, bankruptcy law differed among the various states. The framers of the Constitution felt that it would benefit the coun try if these differences were eliminated, so they inserted in section 8 of Article I of the Constitu tion a clause granting Congress the power to es tablish "uniform laws on the subject of bankruptcies throughout the United States."

This delegation of authority to Congress, how ever, did not require the enactment of a bank ruptcy code nor the discharge of debts. In fact, although having the power to enact a bank ruptcy statute, Congress did so only sporadi cally during the nineteenth century. Most of the bankruptcy statutes enacted during this time were motivated by financial panics. After the effects of these business cycles had subsided, the statutes usually were repealed. Overall, prior to 1898, Federal bankruptcy statutes were in effect for less than a total of twenty years. It has been said that the Panic of 1893 was ultimately responsible for the enactment of the Bankruptcy Act of 1898. This statute dealt with liquidations, and provided the mechanism for bankrupts to place their nonexempt ass~ts in the hands of a trustee who, in turn, was charged with liquidating them and paying off the debts in accordance with a priority schedule. The 1898 Act, in turn, was amended in 1938 by the Chandler Act, which introduced the reorganiza tion aspect to bankruptcy. Reorganization is the method by which a going concern restructures itself so as to continue in business after the clos ing of the bankruptcy case. This bankruptcy statute was left in effect until the Bankruptcy Reform Act of 1978.

During the 1960s and 1970s a number of fac tors led Congress to conclude that the existing Bankruptcy Code was inadequate to meet the needs of the country. The growth in consumer credit had led to an increase in bankruptcy fil ings. To grasp the magnitude of this expansion, one should consider that in 1960 total consumer credit was $56 billion, whereas by 1977 it had increased to $289 billion. This expansion was partly responsible for a record 224,354 con sumer bankruptcy filings in 1975. The increase in the number of bankruptcies tested the ability of the bankruptcy court system as it was then organized. As a result of these developments, Congress enacted the Bankruptcy Reform Act of 1978. This statute restructured the organization of bankruptcy courts, and contained substantive amendments which liberalized the ability of consumers and corporations to file for bank ruptcy relief. Perhaps symbolic of the changing attitude toward bankruptcy, the new statute re ferred to bankrupts as debtors, in an attempt to remove part of the stigma of being a bankrupt.

An Increase in Bankruptcies There is considerable controversy over the ef fects of the 1978 amendments. There is no ar gument, however, that after enactment of the Bankruptcy Reform Act of 1978, the country experienced an increase of bankruptcy filings of historic proportions. The number of consumer bankruptcies, in particular, mushroomed. In fiscal 1980, the first year the 1978 statute was in effect, there was a 60 per cent increase of filings over the previous year, to a total of 314,856. By 1982, the number of individual bankruptcy cases exceeded 500,000. The credit industry, alarmed at this develop ment, commissioned a study of consumer bank ruptcy. The study, commonly referred to as the 353 Purdue Study, concluded that a significant num ber of consumers who had filed for bankruptcy relief could repay part of their debt out of future earnings. The study estimated that the amount of repayable debt discharged by the Bankruptcy Courts exceeded $1 billion per year. The credit industry faulted the 1978 amendments because of the newly acquired ability of many debtors to choose a no-asset Chapter 7 liquidation.

It is no secret that the vast majority of con sumer bankruptcies are "no-asset" cases. This means that after all property that is exempt from liquidation is accounted for, there usually are no assets remaining for the benefit of creditors. In a typical Chapter 7 case, a trustee is appointed by the Bankruptcy Court to liquidate the debtor's nonexempt property and to distribute it in accordance with statutory priorities. Unse cured creditors share proportionately in the as sets that may remain after the creditors who en joy the statutory priority have received payment. In return for this, the debtor, provided he has not committed fraud or otherwise waived the right, will be discharged from most of his liabilities, even though the creditors received only a fraction of their claims. Any assets that the debtor may acquire after the filing of the bankruptcy petition, including wages, are be yond the reach of most pre-petition creditors.

The Purdue study found that many of the debtors who filed for Chapter 7 liquidation were employed and could have paid off a substantial amount of their outstanding liabilities over a pe riod of several years. In view of the growing concern over the ex pansion of bankruptcy cases, Congress began to consider whether further amendments were needed. The movement toward reform, how ever, was delayed by another development. This was the Supreme Court's decision in the case of Northern Pipeline Construction Co. v. Marathon Pipeline Co. 1 The Supreme Court held that the 1978 amendments violated the Constitution because bankruptcy judges, while enjoying broad judicial powers, were not as sured of the judicial independence mandated by the Constitution in the form of lifetime appoint ments and salary protection. The controversy over the 1978 amendments was not restricted to consumer bankruptcies and judicial appointments, however. Many corpora354 THE FREEMAN • SEPTEMBER 1986 tions took advantage of the new provisions of the law as well. Prior to the amendments, a company that desired to file for bankruptcy pro tection had to be insolvent. Finding that a show ing of insolvency was too cumbersome, Con gress deleted this requirement in the 1978 amendments. In addition, trustees no longer have to be appointed in every Chapter 11 case, and the management of a company that files for reorganization under Chapter 11 may remain in charge of the corporation unless it engages in reprehensible conduct. In light of these provi sions, some corporations began to consider bankruptcy as a means to avoid some of their liabilities and contractual obligations.

One of the immediate effects of filing for bankruptcy is that all creditors must stop their collection actions against the debtor. If a credi tor already has obtained a judgment against the debtor, the bankruptcy case prevents a creditor from enforcing this judgment. Similarly, all claims against a debtor that arose before the commencement of the bankruptcy case must be handled in accordance with the Bankruptcy Code. This is known as the automatic stay. There are exceptions to the automatic stay, however. For example, the automatic stay does not shield debtors from criminal prosecutions, from the collection of alimony maintenance and support obligations, from tax deficiencies or from the exercise of the government's police and regulatory powers. The Johns-Manville Case The first company to achieve notoriety in tak ing advantage of the 1978 amendments was Johns-Manville Corporation. This corporation filed a petition for reorganization under Chapter lIon August 20, 1982. At the time of filing, the corporation's net worth exceeded $1 billion.

The reason for filing for bankruptcy was that 16,500 lawsuits already had been filed against the company, alleging liability because of asbestos-related injuries. The company esti mated that at the rate of 425 new lawsuits monthly, up to 52,000 lawsuits were expected to be filed, creating a potential liability of up to $2 billion. In addition, the company may be lia ble for unforeseen liabilities since the victims of asbestos exposure may not develop any symptoms for a prolonged period of time. Since the Bankruptcy Code requires that all unmatured claims be accelerated, and that all contingent, disputed, and unliquidated claims be liquidated, the filing of the petition will aid in putting an end to the uncertainties facing the company. Other industries also have utilized the bank ruptcy route to resolve their liabilities. For ex ample, Amatex Corporation filed for bank ruptcy protection in November, 1982, in light of the fact that it was defending itself against 10,000 lawsuits. Similarly, in August, 1985, A. H. Robins filed for bankruptcy since at the time of filing there were 5,000 lawsuits pend ing, and the company estimated up to 300,000 claims to be filed.

Another provision of the Bankruptcy Code that aids corporations in their reorganization ef forts is the ability to unilaterally reject certain executory contracts which are burdensome. Subject to court approval, it is generally left to the debtor to decide whether or not those con tracts should be assumed or rejected. A lease is an example of a contract that a debtor may wish to cancel. A debtor may reduce the scope of its operations and therefore may not need as much leased space as it is obligated to pay for under the rental agreement. This provision of the Bankruptcy Code permits adjustments in these contracts. In light of the fact that insolvency was no longer required for a business entity to file·for bankruptcy protection, some corporations that were saddled with what they considered to be burdensome contracts considered the possibility of filing for bankruptcy relief in order to cancel those contracts. The one area that created the most controversy was the rejection of collective bargaining agreements. Wilson Foods Corpora tion, the fifth largest meat packer in the United States, filed a Chapter 11 reorganization peti tion on April 22, 1983. It then rejected its col lective bargaining agreement which covered 6,000 employees, and reduced wages between 40 to 50 per cent. The company's net worth at the time of filing exceeded $67 million. Simi larly, on September 24, 1983, Continental Air Lines filed for bankruptcy relief, rejected its collective bargaining agreement, and laid off 12,000 employees. Two days later, 4,200 em ployees were reinstated at half their salaries.

INSOLVENCY AND BANKRUPTCY LAW 355 The Supreme Court, in the 1984 case of NLRB v. Bildisco & BildiscO,2 agreed with the inter pretation that collective bargaining agreements may be rejected "if the debtor can show that the collective bargaining agreement burdens the es tate, and that after careful scrutiny, the equities balance in favor of rejecting the labor con tract. " Because of the expansion in consumer bankruptcies, the Supreme Court's decisions in Marathon and Bildisco, and the proliferation of business bankruptcies to avoid liabilities, Con gress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984, which went into effect on July 10, 1984. The 1984 statute re formed some aspects of consumer and business bankruptcies, and also took care of the constitu tional objections to the structure of the Bank ruptcy Courts. Consumer Bankruptcies One of the amendments enacted by the 1984 statute relates to consumer bankruptcies. Under the new provisions, Bankruptcy Courts are em powered to dismiss Chapter 7 petitions where the debts are primarily consumer debts if it is determined that the filing of those petitions con stitutes a substantial abuse. The purpose of this new provision is to eliminate the previous un fettered discretion debtors had of filing for pro tection under Chapter 7, and to encourage those debtors who still want to file for bankruptcy protection to do so under Chapter 13 of the Bankruptcy Code. Under Chapter 13, the debtor must propose a debt adjustment plan un der which payments out of future earnings will be made to creditors. The plan must, however, be approved by the Bankruptcy Court and the payment period may last from three to five years. The discharge of debts, after completion of the plan, is broader than under Chapter 7.

The 1984 statute also requires that in making payments, a debtor must use all his disposable income, unless the unsecured creditors are paid in full. The 1984 amendments eliminate the past practice of Chapter 13 plans where debtors paid a minimal amount. Although the thrust of the 1984 amendments is to encourage debtors to pay as much as possi ble, there are some troubling aspects to the law. For example, only the court, and not the credi tors, may raise the issue of whether a debtor is committing a substantial abuse in filing a Chap ter 7 petition. This can deprive the court of the information creditors may be able to bring forth. In addition, given the large number of consumer bankruptcies, it is doubtful if a court always will have the time to gather the informa tion needed to decide if Chapter 7 is the appro priate mechanism. Finally, a question may be raised as to the court's appearance of fairness, since the debtor would have to present evidence to refute the court's assertion of substantial abuse, and the court would have the power to decide the issue.

The 1984 amendments also tightened some other areas. For example, the amount of exempt property has been restricted. A waiting period has been added to prevent an immediate refiling of a petition when the previous case had been dismissed either voluntarily or by the court. Similarly, in order to prevent shopping sprees prior to the filing of a petition, no more than $500 in credit for luxury goods and services owed to a single creditor may be incurred by debtors if such debts were incurred within 45 days before the filing of the bankruptcy peti tion. In addition, there are now time limits dur ing which unexpired leases of nonresidential real property may be assumed or rejected. Although the ability of debtors to shield themselves from lawsuits through the use of bankruptcy was left intact, the 1984 statute did limit the ability of businesses to reject collective bargaining agreements. Bildisco was overruled by the statute, and certain procedural and sub stantive standards must be met prior to a court granting approval of a rejection of a collective bargaining agreement.

Although recent developments indicate that the tide has turned against the debtors' per ceived abuse of the bankruptcy system, the problems still exist. In the area of business bankruptcy, the delays in the processing of bankruptcy petitions harm creditors. It is not unusual for a reorganization plan proposed by a debtor under Chapter 11 to take one or two years before it is finally confirmed by the court. During this time, creditors cannot remove their assets or invest them in a more productive ven ture. Similarly, there sometimes are conflicts 356 THE FREEMAN • SEPTEMBER 1986 We should reassess whether it is a proper function of government to reorganize businesses. between secured and unsecured creditors. A se cured creditor, for example, may wish to dis pose of the property in which he has a security interest in order to recover the amount owed. Unsecured creditors, however, may oppose this proposal because the disposal of the property may amount to a liquidation of the business, thereby eliminating any opportunity for recov ery of their debts. Or, a secured creditor may feel that the property upon which he has a secu rity interest is depreciating or is being con sumed at a rate that will reduce the value of his security interest. Although the Bankruptcy Code allows secured creditors the opportunity to obtain "adequate protection" from some of these developments, it is not altogether clear that secured creditors are able to realize the market value of their security interest.

There is no question that bankruptcy tends to reward the irresponsible and the profligate. However, a free society must have a creditor distribution system to take insolvency into ac count. When a debtor becomes insolvent, that is when liabilities exceed assets, there must be a system to treat all creditors fairly. In fact, a bankruptcy system that would concern itself with creditor distribution issues is to the benefit of creditors in general. This is because in the absence of a bankruptcy system, creditors would engage in a race to the courthouse when ever they may fear that a debtor is insolvent. A system that would allow such a race would ben efit some creditors at the expense of other credi tors. In addition, the race to the courthouse may prematurely terminate an ongoing business, re ducing the probabilities of recovery to other creditors. The absence of a bankruptcy system would be detrimental to creditors in general and would raise the cost of credit to debtors.

The present system, however, goes beyond the distribution of debtors' assets to creditors. The Bankruptcy Code also contains provisions aimed at fostering the reorganization of failed business enterprises. As we have seen, approval of these plans takes time, and some creditors benefit at the expense of others in reorganiza tions. We should reassess whether it is a proper function of government to reorganize busi nesses. If a business has failed to adequately meet consumer demands, it is questionable whether the government should veto the market and keep such an entity afloat. It is one thing to set up a system which liquidates assets of insol vent debtors and distributes them to their credi tors. It is altogether different when the govern ment meddles into how a business should be structured and whether or not it should be al lowed to survive. In addition, the relief sought by those who file for protection under bankruptcy may have the effects of encouraging more bankruptcies.

This, in turn, raises the cost of credit for all. Although a debtor should be allowed a fresh start after bankruptcy, a discharge of debts is too strong a remedy. The removal of the insolvency requirement in business bankruptcies has led to the inequitable result that some companies, notably those with potential liability in the billions of dollars, may successfully shield themselves from lawsuits by filing for bankruptcy. A Bankruptcy Court may place limits on a debtor's potential liability since it may be interested in preserving the busi ness as an ongoing concern. This only injures the debtor's claimants. The 1984 amendments reveal a trend in cut ting back some of the advantages debtors ob tained by filing for bankruptcy relief. There is clearly a need for further revision. In a recent case, the Supreme Court has involved itself in this trend as well. In this case, it was held that a debtor may not avail himself of the Bankruptcy Code in order to violate "a state statute or regu lation that is reasonably designed to protect the public health or safety from identified haz ards."3 True bankruptcy reform, after all, may not be that far away. 0 1. 458 u.s. 50 (1982).

2. 465 u.s. 513 (1984). 3. Midlantic National Bank v. New Jersey Department of Environ mental Protection, 88 LEd. 2d 859, 869 (1986).

357 Readers' ForuDl To the Editors: J.D. Steelman's essay, "Deregulation of the Natural Gas Industry," (June 1986) interest ingly describes some of the revolutionary changes taking place as the gas industry breaks out of its decades-old regulatory straitjacket. Out of the distortions of shortage and surplus that have affected the production, transmission, and distribution phases of this industry for over a decade, new institutions and business prac tices have been developing that seen as a whole make up what EA. Hayek calls "spontaneous order." But unlike the impression given in this essay, there is still significant regulation and much to resolve before a free market can be said to reign in the gas industry. In response to growing market forces and dis tortions requiring market solutions, the Federal Economic Regulatory Commission (FERC) has faced the age-old regulatory question-more regulation or less regulation. (This is not new; the past of industry regulation has been closing one regulatory gap after another.) Beginning with self-help transportation programs in the 1970s to move gas from surplus areas to short age areas, the FERC has been pragmatically de regulating piecemeal to create a greater role for market forces. As competitive forces snow balled, propelled by the gas surpluses of the 1980s, the FERC was forced to overhaul the Natural Gas Act of 1938 with Order 436 of Oc tober 1985 which Mr. Steelman refers to. Im portantly, this overhaul is not deregulatory al though certain provisions such as relaxed certification for entry and exit tend to be. Order 436 substitutes new regulation for relaxed regulation and magnifies existing industry prob lems.

A particularly onerous provision forces inter state pipelines to accept all transportation re quests by outsiders (whether producers, bro kers, pipelines, or end-users) whether or not there is capacity or whether the pipeline wishes to do so. By removing pipeline "monopoly power," it is believed, mandatory contract car riage makes the industry more competitive and lowers prices for consumers. At the same time end-user contracts are incrementally terminated (begun previously by Order 380 of May 1984 and Opinion 238 of July 1985) which leaves pipelines in the predicament of holding unmar ketable high-take, high-price producer contracts entered into on the basis of voided end-user "minimum-bill" commitments. There are many distortions in the making from the new regulation of Order 436 that cannot be pre sented here, but let it be said that pipeline regu lation (not to mention partial wellhead regula tion, conservation laws, and comprehensive distribution company regulation) remains a powerful force in the natural gas business envi ronment.

I make these points in regard to Mr. Steel man's article not as an end in itself but in the hope of interesting young "Austrian" econo mists (who are increasingly populating graduate economics programs around the country) to ex amine the insightful history of natural gas inter vention to teach us more. I single out Aus trianism for this topic for good reason. So far only neoclassical economists and industry358 related observers have interpreted the story. Yet there are many Austrian themes that are vital for understanding, such as the interrelationships (dynamics) of industry intervention, the devel opment of new market institutions and sponta neous order in relation to regulatory and market changes, and the role of integration, non access, and cooperation (as opposed to free ac cess and rivalry) in market coordination and ef ficiency. -Robert Bradley, Jr. Mr. Steelman replies: Mr. Bradley's ideas were most thought provok ing. I do not disagree with his proposition that the natural gas industry is still a regulated industry-so is every industry in the United States. Those industries not regulated by a com mission such as the FERC, FCC, FAA or the like, are subject to antitrust laws and other laws. Although I prefer the free market ap proach of Mises, Hayek, and the Austrian econ omists the issue in today' s environment is whether the regulations give one a long or short leash. Certainly regulation of the natural gas in dustry is being relaxed in comparison to the comprehensive wellhead to burner tip regula tion that had existed. Market forces are being allowed to have much more of an impact on the industry. Meaningful deregulation is a possibil ity. However, neither the FERC nor the state regulations on natural gas are being relaxed rap idly enough. The concluding paragraph of my article called for acceleration of deregulation not merely a relaxation of regulations.

At the time I wrote my article, Order No. 436 had all the makings of a comprehensive deregu lation order, as did Order No. 451 when it was first proposed by the Department of Energy; subsequently, the picture became muddled. In my opinion, Order Nos. 436 and 451, as now being finalized, are causing chaos in the indus try and the marketplace. The result among vir tually everyone I know in the industry is a preference for comprehensive legislation dereg ulating the industry (this in itself is a radical departure by the industry from past positions). Not only is the natural gas industry desirous of greater flexibility within the industry, it also must have greater flexibility to compete with energy substitutes that are less regulated than natural gas. This more than anything else was the impression I meant to convey-the market place is de facto deregulating and beginning to operate like a competitive marketplace. Entre preneurs and managers have acknowledged by their actions that the natural gas industry is sub ject to competition like any other industry and they are responding accordingly.

In summary, I believe the industry is begin ning .to function more like a competitive mar ketplace than a regulated public utility and that the industry will continue to seek the removal of marketplace barriers. Regulation will be re laxed, though it is unlikely that the FERC or state regulatory commissions will be abolished. Nor do I believe that the Natural Gas Act or even the Natural Gas Policy Act will be re pealed in the foreseeable future. However, I do believe that there will be forthcoming further relaxation in regulations and perhaps some real deregulation. This will allow a more competi tive and efficient natural gas market to evolve and will be healthy for both the natural gas in dustry and the marketplace. -J.D. Steelman Let us hear from you! We would like to share with readers the most interesting and provocative letters we receive regard ing Freeman articles, and the issues they raise. Since FEE's activities encompass much more than just publishing The Free man, we will also include reactions to other FEE programs.

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