Bankruptcy Law Public Policies

A public policy can be the principles upon which the law is based or the objectives that it hopes to achieve. By understanding the policy of law, it becomes easier to understand the law itself and why things are done as they are. In most cases, a public policy is not a stated goal, but is abstracted from the legislative history, court rulings, and from the law itself. Of course, public policy evolves over the years as public attitudes change, and as it becomes apparent what works and what doesn't.

Some public policies apply to all law, such as its efficient administration and fairness and its coherence with other law. However, the 2 main policies of bankruptcy law are to provide the debtor with a fresh start while treating all of the debtor's creditors equitably under the law.

Bankruptcy as a Creditors' Remedy

When bankruptcy law was first enacted in the time of Henry VIII, bankruptcy law was entirely a creditors' remedy and it applied only to traders—probably because they were the only people who incurred debt at that time. It allowed creditors to seize all of the debtor's assets and even imprison the debtor until family or friends paid the debtor's debt—much like paying a ransom for a kidnapped relative. Most bankruptcy proceedings until the middle of the 19th century were involuntary—the creditors filed the petition, not the debtor.

However, as credit started to spread and was used more frequently, it wasn't realistic to imprison debtors. Even seizing all of the debtor's assets seemed harsh, especially for those people who were honest, but victims of unfortunate circumstances. Hence, bankruptcy law started to evolve into a form of relief for the honest debtor, especially in the 20th century when the relief of a discharge of debt became available.

Bankruptcy as a Relief and a Fresh Start for the Debtor

The 1st major law providing relief to the debtor in the United States was the Bankruptcy Act of 1898. Previously, a debtor could only get a discharge of his debts if a minimum percentage of creditors agreed to the discharge, and if they were paid at least a minimum amount of their debt. (Chapter 11 still works much like this.) The Bankruptcy Act eliminated these conditions, giving the debtor a fresh start, a chance to begin anew, and, hopefully, pursue a better life by learning from one's past financial mistakes.

The other major accomplishment of the Bankruptcy Act was the equitable treatment of creditors by paying them a pro rata share of the debtor's assets. Previously, creditors who filed the bankruptcy petition first got most of the debtor's assets, much as creditors do today by filing for state remedies early. Under state law, each creditor had to file their own lawsuit or seek other remedies to collect their debt. This created a race for the courthouse as creditors sued early for a better chance of being paid.

Bankruptcy Estate and Equal Treatment of Creditors

Bankruptcy stops the race for the courthouse because the Bankruptcy Clause and the Supremacy Clause of the United States Constitution allow the federal bankruptcy court to assert jurisdiction over both the debtor's affairs and its creditors, forcing them all to act together to arrive at the best solution for all.

After filing the bankruptcy petition, the debtor's property is placed into the bankruptcy estate, which is under the control and supervision of the trustee and the bankruptcy court. Hence, the creditors can no longer seek anything of the debtor's property, since it is now part of the bankruptcy estate.

Creditors are notified of the bankruptcy and will have to file a claim to be paid on their claim. No other remedies are available to the creditor, since all other actions are barred by the automatic stay, which prevents any creditor from taking any action outside of the bankruptcy court. If the creditors are listed in the bankruptcy petition, but they refuse to file a claim, then they will not receive anything from the estate, nor will they be permitted to pursue their debt after the bankruptcy since their debt will be discharged—they will be forever barred from trying to collect on their debt.

If a creditor does have a legal remedy outside of the bankruptcy court, then it must apply for relief from stay from the court. By forcing all creditors to the same table, the bankruptcy court can treat each equally under the law—which, of course, doesn't mean that they all get the same percentage of their claim, but only that they will be given equal consideration under the law and their claims will be paid according to what is available in the bankruptcy estate and according to their rights under state and federal law—otherwise known as nonbankruptcy law. The race to the courthouse is eliminated because there is no benefit to being first as there would be under state remedies.

The trustee manages the bankruptcy estate for the benefit of creditors. To maximize the amount available for all creditors, the trustee has certain legal powers that can reverse the transference of assets by the debtor or preference payments made to preferred creditors. Since the debtor usually files the bankruptcy petition, the debtor often takes actions to pay preferred creditors, such as relatives, or to transfer assets to family or friends so that they will not be sold to pay creditors. The trustee can reverse most of these actions by requiring the transferees to either return the property to the estate or to pay its equivalent value. The trustee also has the power to avoid liens on the debtor's property that were not registered or perfected properly, or which were granted by the debtor as a preferential treatment to a creditor, or where the debtor was duped into granting such a lien.

The trustee also has the power to break onerous contracts to which the debtor is a party, thereby preserving funds to pay creditors. The trustee can also assume the contract, or assign it to a 3rd party if it is beneficial to the estate to do so.

Reorganization over Liquidation

There are 2 major methods used in bankruptcy to give the debtor a fresh start and to pay creditors as much of their claim as possible: liquidation and reorganization.

Liquidation involves taking the nonexempt, valuable assets of the debtor and using them, usually by selling the asset, to pay creditors. Most liquidations occur under Chapter 7, although debtors can also liquidate under Chapter 11. An individual debtor usually chooses to liquidate because the debtor has little or no nonexempt property that has enough value to be sold for a substantial sum and because it is much faster than reorganization under the other chapters of bankruptcy. In this case, unsecured creditors get little or nothing. (Secured creditors can foreclose on their collateral if they are not paid.) If business entities, such as corporations liquidate, then they cease to exist. Hence, liquidation only leads to a fresh start for the individual debtor.

Because creditors are often paid little or nothing in a liquidation and because jobs are not preserved in the liquidation of a business entity, there is a general policy to favor reorganization over liquidation. Reorganization, also known as rehabilitation, requires the debtor to pay creditors over an extended time from its future income according to a plan.

Some of the provisions in the law that favor reorganization over liquidation, includes the means test that prevents higher income debtors from liquidating under Chapter 7 and allowing debtors to keep all of their assets, including their home, under the reorganization chapters.

The main chapters for reorganization include Chapters 11, 12, and 13. Even though the law favors reorganization over liquidation, many more debtors file for Chapter 7 than all other chapters combined, because it is more beneficial to the low-income debtor, who is almost always the one to file the petition and to select the chapter to file under.