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Bankruptcy

Types Of Federal Bankruptcy Proceedings

Federal bankruptcy law provides two distinct forms of relief: liquidation and rehabilitation, also known as reorganization. The vast majority of bankruptcy filings in the United States involve liquidation, governed by chapter 7 of the Bankruptcy Code. In a chapter 7 liquidation case, a trustee collects the debtor's nonexempt assets and converts them into cash. The trustee then distributes the resulting fund to the creditors in order of priority described in the Bankruptcy Code. Creditors frequently receive only a portion, and sometimes none, of the money owed to them by the bankrupt debtor.

GAMBLING WITH BANKRUPTCY EXEMPTIONS

In bankruptcy cases, individual debtors have the privilege of retaining certain amounts or types of property that otherwise would be subject to liquidation or seizure by creditors in order to satisfy debts. Laws protecting these forms of property are called exemptions.

Consistent with the goal of allowing the debtor a "fresh start," exemptions in bankruptcy cases help ensure that the debtor, upon emerging from bankruptcy, is not destitute. Exemption statutes generally permit the debtor to keep such things as a home, a car, and personal goods like clothes. Although exemptions inhibit the creditor's ability to collect debts, they relieve the state of the burden of providing the debtor's basic needs.

The bankruptcy code provides a list of uniform exemptions but also allows individual states to opt out of (override) these exemptions (11 U.S.C.A. § 522 [1993 & Supp. 2003]). Thus, the types and amounts of property exemptions differ greatly and depend upon the debtor's state of residence.

A debtor residing in a state that has not opted out is entitled to the exemptions described in the bankruptcy code. Examples of code exemptions are the debtor's aggregate interest of up to $15,000 in a home; up to $2,400 in a motor vehicle; up to $8,000 in household furnishings, household goods, clothes, appliances, books, animals, crops, and musical instruments; up to $1,000 in jewelry; up to $1,500 in professional books or tools of the debtor's trade; and certain unmatured life insurance policies owned by the debtor. The debtor also may claim an exemption for professionally prescribed health aids, such as electric wheel-chairs.

The majority of states have chosen to opt out of the uniform federal exemptions, replacing them with exemptions created by their own legislatures. Homestead exemptions, which excuse all or part of the value in the debtor's home, are the most common state-mandated exemptions. These are not uniform across states. For instance, Missouri mimics the federal government by placing a dollar limit on the exemption, but at $8,000, its cap is meager in comparison (Mo. Ann. Stat. § 513.475 [Vernon 2002]). The bordering state of Iowa limits the homestead exemption by acreage rather than dollar amount (Iowa Code Ann. §§ 561.1, 561.2 [West 1992]). Florida allows a homestead exemption without limits (Fla. Const. art. X, § 4(a)(1)). This lack of uniformity raises the question of fairness: bankruptcy laws are federal in nature, yet a debtor in Florida may have a significant financial advantage over a debtor in Missouri, owing to different exemption laws.

Despite the broad variance among states when it comes to bankruptcy exemptions, critics charge that even the uniform federal system can be grossly unfair. For example, assume two debtors, Arlene and Ben, each have estates valued at $28,000. Arlene, a dentist, has $15,000 of EQUITY in her home. She has $8,000 worth of furniture and household goods. Her car is worth $4,000, and she owns dental tools valued at $1,000.

Ben is an art lover. He owns no car, no furniture, and no house, having chosen instead to spend his money on paintings and sculptures that are now worth $26,000. His clothes, musical instruments, and other household goods are worth $2,000.

Arlene and Ben have states of equal value, but when the federal exemption statute is followed, Arlene can claim $27,200 in exemptions, whereas Ben can claim only $16,300. Arlene receives exemptions worth $15,000 for her homestead, $8,000 for her household goods, $2,400 for her car, and $1,000 for her dental tools, and an $800 general exemption for property not covered by other exemptions. Ben may claim an $8,000 exemption for his art and other household goods, as well as a general exemption worth $8,300, which replaces his unused homestead exemption.

Critics suggest that one problem with exemption laws is that legislators must determine the property that will best enable the average debtor to remain self-sufficient following a bankruptcy. Unconventional debtors, such as Ben, frequently are penalized as a result. In addition, laws that place monetary limits on exemptions often do nothing to help the debtor achieve a fresh start. When the value of certain property is worth more than the exemption, it is said to be only partially exempt and must be completely liquidated. Following liquidation, the debtor receives the value of the exemption in cash from the liquidation proceeds. Thus, in the case of Arlene's $4,000 car, the bankruptcy trustee would sell the car and from the sale proceeds give Arlene $2,400, the amount of the exemption. Arlene could then spend the money on a tropical vacation instead of a replacement car, rendering the vehicle exemption law virtually meaningless.

Debtors may also take advantage of exemption laws by transferring assets before filing for bankruptcy protection. For example, Ben could sell nonexempt artwork and, with the proceeds, purchase a small condominium. He could then file for bankruptcy and claim a homestead exemption, increasing by $7,500 his post-bankruptcy estate.

Congress actually supports this type of pre-bankruptcy planning, permitting the debtor "to make full use of the exemptions to which he is entitled under the law" (S. Rep. No. 989, 95th Cong., 2d Sess. [1978]). Still, courts view some pre-bankruptcy asset transfers as fraudulent, particularly when they involve large dollar amounts and there is evidence of intention to hinder, delay, or defraud creditors. Upon a finding of FRAUD, the bankruptcy court may deny discharge of the debtor's debts. But what constitutes a fraudulent transfer is often unclear and seemingly ARBITRARY.

Two bankruptcy cases from Minnesota exemplify the confusion surrounding fraudulent and nonfraudulent pre-bankruptcy transfers. The debtors in both cases were doctors who lost money in the same investment and who hired the same attorney to help them with their pre-bankruptcy planning. The outcomes of the cases differed significantly.

Before filing for bankruptcy, Omar Tveten liquidated most of his nonexempt assets, including his home. With the proceeds, he purchased life insurance and annuities valued at almost $700,000. Both the life insurance and the annuities were considered exempt under Minnesota law; however, the bankruptcy court held that the large amount converted was an indication of fraud and therefore refused to discharge Tveten's bankruptcy debts (Norwest Bank Nebraska v. Tveten, 848 F.2d 871 [8th Cir. 1988]).

Robert J. Johnson also transferred assets before filing for bankruptcy. Johnson converted nonexempt property into property exempt under Minnesota law: he purchased $8,000 in musical instruments, $4,000 in life insurance, and $250,000 in annuities from fraternal organizations, and he retired (paid off) $175,000 of the debt on his $285,000 home. The court focused on Johnson's claim for homestead exemption and in particular on the $175,000 mortgage payment made just before filing for bankruptcy. As the court in Tveten demonstrated, an unusually large asset transfer can indicate fraud. But in Johnson, the court held that the homestead exemption was valid, stating that the value of an asset transfer to homestead property, unlike the value of an asset transfer to property in another exemption category, is of little relevance because "no exemption is more central to the legitimate aims of state lawmakers than a homestead exemption" (Panuska v. Johnson, 880 F.2d 78 [8th Cir. 1989]).

Legal commentators have criticized the Tveten and Johnson decisions as being arbitrary and as providing no clear lines to assist debtors in pre-bankruptcy planning. Critics charge that the different outcomes are simply a result of different judges presiding at the initial bankruptcy court level, because the facts of the cases were so similar. Bankruptcy attorneys are frustrated by a lack of uniformity among court decisions that apply similar principles but reach different results, and also a lack of uniformity in exemption laws among states.

Indeed, forum shopping (searching for the most advantageous jurisdiction in which to file bankruptcy) is prevalent because of the wide diversity of state exemption laws. In re Coplan, 156 B.R. 88 (Bankr. M.D. Fla. 1993), illustrates the problem. The debtors, Lee Coplan and Rebecca Coplan, incurred substantial debt in their home state of Wisconsin before moving to Florida. After residing in Florida for one year and purchasing a house for $228,000, they sought bankruptcy relief and a homestead exemption under Florida law (West's F.S.A. Const. Art. 10, § 4(a)(1)), which allows an exemption for the full value of the homestead. The court found that the Coplans had engaged in a systematic conversion of assets by selling their home in Wisconsin and paying cash for their new home in Florida. This action was conducted, according to the court, solely for the purpose of placing the assets out of the reach of creditors. As a result, the bankruptcy court in Florida allowed a homestead exemption of only $40,000, the extent provided by Wisconsin law (W.S.A. § 815.20(1)). Yet other bankruptcy decisions have held that a conversion of nonexempt property to exempt property for the purpose of placing such property out of reach of creditors will not alone deprive the debtor of the exemption (see, e.g., In re Levine, 139 B.R. 551 [Bankr. M.D. Fla. 1992]).

Exemption is an integral part of bankruptcy law but a difficult area to navigate. Courts and legislatures must constantly determine whether exemptions constitute fair and just vehicles by which debtors can achieve a fresh start without getting a head start at the expense of creditors. Unfortunately for attorneys, debtors, creditors, and trustees, the laws regarding exemptions are inconsistent. Attempting to maximize the benefits granted by bankruptcy exemptions can be more of a gamble than a science.

FURTHER READINGS

Epstein, David G. 2002. Bankruptcy and Related Law in a Nutshell. St. Paul, Minn.: West Group.

Resnick, Alan N. 2002. Bankruptcy Law Manual. Eagan, Minn.: Thompson West.

CROSS-REFERENCES

Creditor.

When the debtor is an individual, once the liquidation and distribution are complete, the bankruptcy court may discharge any remaining debt. When the debtor is a corporation, upon liquidation and distribution, the corporation becomes defunct. Remaining corporate debts are not formally discharged, as they are with individuals. Instead, creditors face the impossibility of pursuing debts against a corporation that no longer exists, making formal discharge unnecessary.

Rehabilitation, or reorganization, of debt is an option that courts usually favor because it provides creditors with a better opportunity to recoup what is owed to them. Rehabilitative bankruptcies are governed most often by chapter 11 or chapter 13 of the Bankruptcy Code. Chapter 11 typically applies to individuals with excessive or complex debts, or to large commercial entities such as corporations. Chapter 13 typically applies to individual consumers with smaller debts.

Unlike liquidation, rehabilitation provides the debtor with an opportunity to retain nonexempt assets. In return, the debtor must agree to pay debts in strict accordance with a REORGANIZATION PLAN approved by the bankruptcy court. During this repayment period, creditors are unable to pursue debts beyond the provisions of the reorganization plan. This gives the debtor the chance to restructure affairs in the effort to meet financial obligations.

To be eligible for rehabilitative bankruptcy, the debtor must have sufficient income to make a reorganization plan feasible. If the debtor fails to comply with the reorganization plan, the bankruptcy court may order liquidation. A

debtor who successfully completes the reorganization plan is entitled to a discharge of remaining debts. In keeping with the general preference for bankruptcy rehabilitation rather than liquidation, the goal of this policy is to reward the conscientious debtor who works to help creditors by resolving his or her debts.

Farmers and municipalities may seek reorganization through the Bankruptcy Code's special chapters. Chapter 12 assists debt-ridden family farmers, who also may be entitled to relief under chapters 11 or 13. When a local government seeks bankruptcy protection, it must turn to the debt reorganization provisions of chapter 9.

Orange County Bankruptcy and Chapter 9 Seldom used, chapter 9 attained notoriety in late 1994 following the bankruptcy of Orange County, California, the largest municipal bankruptcy in history. A county of 2.6 million people with one of the highest per capita incomes in the United States, Orange County held an investment fund that was composed largely of derivatives that were based on speculation on the direction of interest rates. The problem was made worse because the county had borrowed the money it was investing. When interest rates began to climb in 1994, Orange County's leveraged investments drained the investment fund's value, prompting lenders to require additional collateral. The only way to raise the collateral was to sell the investments at the worst possible time. The result was a $1.7 billion loss. After consulting with finance experts and reviewing alternatives, county officials filed for chapter 9 protection on December 6, 1994.

Residents of the affluent county faced immediate repercussions. Close to 10 percent of the fifteen thousand Orange County employees lost their jobs. School budgets were slashed, infrastructure improvements were put on hold, and experts predicted that property values in Orange County would decline. Legal fees involved in a bankruptcy of this complexity are extensive, and officials did not expect Orange County to emerge from bankruptcy for several years.

Critics of current bankruptcy law argue that irresponsible debtors too frequently receive protection at the expense of noncreditors, such as the residents of Orange County. Victims who allege corporate NEGLIGENCE and sue for injuries from dangerous products also become unwilling creditors when a corporation files for bankruptcy. But negligent or not, corporations battling multiple lawsuits often rely on the traditional rationale supporting bankruptcy: that it offers an opportunity to pay debts that otherwise might go unpaid.

Dow Corning Corporation and Chapter 11 Dow Corning Corporation was a major manufacturer of silicone breast implants used in reconstructive and plastic surgeries. In 1991, after receiving thousands of complaints of health problems from women with silicone implants, the U.S. FOOD AND DRUG ADMINISTRATION banned the devices from widespread use. Women who had obtained the silicone implants in breast reconstruction or breast enlargement surgeries complained that the implants leaked, causing a variety of adverse conditions such as crippling pain, memory loss, lupus, and connective tissue disease. Dow Corning soon became a defendant in a worldwide PRODUCT LIABILITY CLASS ACTION suit as well as at least nineteen thousand individual lawsuits.

Citing an inability to contribute $2 billion to a $4.2 billion settlement fund and pay for the defense of thousands of individual lawsuits, Dow Corning filed for chapter 11 bankruptcy protection in May 1995. The bankruptcy move halted new lawsuits and enabled the company to consolidate existing claims while preserving business operations. As a result of the filing, Dow Corning stalled its obligation to contribute to the settlement fund.

The Dow Corning strategy was similar to that employed in the mid–1980s by A.H. Robins Company, distributor of the Dalkon Shield intrauterine device for BIRTH CONTROL. Like Dow Corning, A.H. Robins faced financial ruin owing to thousands of product liability lawsuits filed at the same time. Also like Dow Corning, A.H. Robins sought relief under chapter 11 of the Bankruptcy Code, which allowed the company time to formulate a plan to pay the many outstanding claims. A reorganization plan approved by the courts involved the merger of A.H. Robins with American Home Products Corporation, which agreed to establish a $2.5 billion trust fund to pay outstanding product liability claims (In re A.H. Robins Co., 880 F.2d 694 [4th Cir. 1989]).

On May 22, 1995, Dow Corning filed a request to stay all litigation against its parent companies, Dow Chemical Company and Corning Incorporated, so that company lawyers could concentrate on the bankruptcy reorganization. That move further threatened the chance of recovery for the plaintiffs seeking compensation for injury.

Family Farmers and Chapter 12 In 1986, responding to an economic farm crisis in the United States, Congress designed chapter 12 to apply to family farmers whose aggregate debts did not exceed $1.5 million. Congress passed the law to help farmers attain a financial fresh start through reorganization rather than liquidation. Before chapter 12's existence, family farmers found it difficult to meet the prerequisites of bankruptcy reorganization under chapters 11 or 13, often because they were unable to demonstrate sufficient income to make a reorganization plan feasible. Chapter 12 eased some requirements for qualifying farmers.

Congress created chapter 12 as an experiment, and scheduled its automatic repeal for 1993. Determining that additional time was necessary to evaluate the effectiveness of the law, Congress in 1993 voted to extend it until 1998. It was either extended or allowed to expire—then restored—eight times between November 1998 and January 1, 2004, when it expired again.

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