Bankruptcy Law Sources

The laws governing bankruptcy have diverse sources, including the United States Constitution, federal and state statutes, and case law.

United States Constitution

The power to enact bankruptcy laws resides with Congress. Specifically, Article I, Section 8, Clause 4, often referred to as the Bankruptcy Clause, of the United States Constitution states: "To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States." A concern of the framers of the Constitution was that interstate commerce would be burdened without a national bankruptcy law that gave creditors from different states a common remedy by which debts could be collected; otherwise the framers gave little thought to the subject, as evidenced by its short reference in the Constitution. Hence, the framers envisioned bankruptcy as a remedy for creditors that would apply across state lines. It was never envisioned as a method of providing a fresh start for the debtor or to protect the jobs of a bankrupt business. As expressed by James Madison in Federalist Paper No. 42:

"The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed into different States, that the expediency of it seems not likely to be drawn into question."

Since bankruptcy was conceived to be only a creditors' remedy to collect debts, bankruptcy was originally commenced by creditors in what is currently referred to as involuntary bankruptcy, and the debtor received no discharge of its debts. The Bankruptcy Act of 1841 changed bankruptcy significantly for individual debtors by allowing them to commence a bankruptcy case on their own initiative and to receive a discharge after the distribution of his assets to creditors.

Uniformity

Much of the bankruptcy law depends on nonbankruptcy law, which includes federal statutes outside of the Bankruptcy Code, but also includes state law, which has a large influence on the particulars of a case. Nonbankruptcy law governs the relationship between creditors and debtors, and what their remedies are outside of bankruptcy. Furthermore, the federal government has given the states some say in how bankruptcy is conducted for their residents. For instance, states were allowed to use their own exemption list in lieu of the federal exemption list, and to decide whether their residents would have a choice in exemptions between the state and federal list.

This deference to states and the incorporation of nonbankruptcy law in the federal law has made the results of bankruptcy decidedly non-uniform for debtors with similar debts in similar amounts. (This non-uniformity has also greatly increased the complexity of bankruptcy over what is needed to accomplish its goals.)

The uniformity requirement by the Constitution was addressed by the Supreme Court in Hanover National Bank v. Moyses 186 U.S. 181 (1902) by asserting that only geographical uniformity was necessary. In other words, the bankruptcy law was uniform in the way it incorporated nonbankruptcy law and in its deference to the States, not in the end result for the debtor.

Other Amendments of the Constitution that Pertain to Bankruptcy

There are several other amendments that also affect bankruptcy law and procedure.

Fifth Amendment

The 5th Amendment prohibits the taking of private property without just compensation or due process of law. A provision of the Bankruptcy Reform Act of 1978, 11 U.S.C. § 522(f)(2) permits individual debtors in bankruptcy proceedings to avoid nonpossessory, nonpurchase-money liens on certain property, including household furnishings and appliances, which some have argued is a government taking of private property. The Supreme Court resolved this conflict by ruling that liens that were perfected before the enactment of the Bankruptcy Reform Act cannot be avoided.459 U.S. 70 (1982). This is the legal basis for preserving a secured creditor's right to the value of its collateral.

Seventh Amendment

The 7th Amendment guarantees the right of a defendant to a jury trial. Since juries only rule on questions of fact, not law, juries are not used extensively in bankruptcy, since most of the facts in a bankruptcy case are not disputed. However, the Supreme Court decided in Katchen v. Landy 382 U.S. 323(1966) that any creditor that submits a claim to the bankruptcy estate forfeits its right to a jury trial. When a creditor submits a claim, it also submits itself to the jurisdiction of the bankruptcy court, which has the power to decide questionable issues arising in the bankruptcy case. Hence, the creditor accepts adjudication by the bankruptcy court by filing a claim; therefore, res judicata and collateral estoppel prevent any further litigation on the matter, which serves the general policy of expediency for bankruptcy procedures.

Eleventh Amendment

The 11th Amendment grants States sovereign immunity; hence, they can't be sued unless the State allows it. Since States are oftentimes creditors of debtors, what prevents a State from ignoring the jurisdiction of the bankruptcy court and its automatic stay and collecting its debt from the debtor regardless of the debtor's bankruptcy or keeping a preference payment? While various arguments have been presented over the years, the Supreme Court, in Central Virginia Community College v. Katz 546 U.S. 356 (2006), ruled that the States had essentially agreed not to assert their sovereign immunity over bankruptcy proceedings by ratifying the U.S. Constitution with its Bankruptcy Clause. After all, how can "uniform laws" be established "throughout the United States" if the States, willy-nilly, can simply ignore the bankruptcy courts by claiming sovereign immunity? Since they agreed to the Bankruptcy Clause, they also agreed, in essence, to be subjected to the "uniform laws" of bankruptcy.

The other argument for resolving the 11th Amendment issue is that bankruptcy jurisdiction is an in rem jurisdiction over the bankruptcy estate whereas the States' sovereign immunity is only against an assertion of personal jurisdiction against non-consenting States.

Thirteenth Amendment

The 13th Amendment prohibits slavery and involuntary servitude. Indeed, if it were not for bankruptcy, many people would become lifetime servants of banks, especially those issuing credit cards. After all, how would most people pay off huge debts at interest rates of 30% or higher that the banks charge on defaults? It's outrageous enough that we had to bail them out of debt and to pay for those huge bonuses that bankers and other employees of financial service companies got for bankrupting their companies during the 2007 - 2009 Credit Crisis.

Title 11 of the United States Code — the Bankruptcy Code

Title 11 of the United States Code contains the substantive law of bankruptcy, and, hence, is referred to as the Bankruptcy Code, which was created by the Bankruptcy Reform Act of 1978, with major amendments in 1984, 1986, 1994, and 2005. The Code consists of 9 chapters, all odd except for Chapter 12, which started as a temporary provision for family farmers and has been made permanent in the 2005 amendments known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Chapter 15, which deals with cross-border bankruptcies that were commenced in other countries, was added by BAPCPA. Referenced sections are easy to find because they all start with the chapter number. For instance, §362 Automatic Stay is in Chapter 3 and §707 contains the law for the dismissal of a Chapter 7 case.

TITLE 11—BANKRUPTCY

Chapters 1, 3, and 5 deal with general principles and case administration that apply to all bankruptcies, while Chapters 7, 9, 11, 12, 13, and 15 deal with more specific types of bankruptcies.

Chapters 9, 11, 12, and 13 are the so-called rehabilitative bankruptcies, which allow the debtor to reorganize its finances by allowing it to reject burdensome contracts and to pay, out of their future income, unsecured creditors a percentage of their debt. Chapter 7 is a liquidation, where the trustee sells the debtor's nonexempt assets that have significant value and distributes the proceeds to his unsecured creditors. Chapter 11 also allows liquidation that has some benefits over a Chapter 7 liquidation.

Chapter 7 and Chapter 11 also have subchapters that apply to specific debtors.

Other Federal Statutes Relating to Bankruptcy

There are several other sections of the Federal Code that apply to bankruptcies, the most prominent are the following:

Title 28 - Judiciary and Judicial Procedure Title 18 - Crimes and Criminal Procedure

Title 26 - Internal Revenue Code

Federal Rules of Bankruptcy Procedure, Official Bankruptcy Forms, and the Advisory Committee on Bankruptcy Rules

While Title 11 provides most of the substantive law of bankruptcy, the Federal Rules of Bankruptcy Procedure and the Official Forms used in a bankruptcy proceeding provides the procedural law of bankruptcy, where it is stipulated in how procedures are to be done. These are the procedures that must be done by the debtor and the forms that must be used so that a bankruptcy petitioner can obtain a discharge.

Although Congress has given the Supreme Court the power to enact procedures to be used in bankruptcy, the actual work is done by the Advisory Committee on Bankruptcy Rules, composed of federal judges, lawyers, and law professors appointed by the Chief Justice, who meet twice a year to discuss how the rules are working and to propose beneficial changes.

Any amendments proposed by the Advisory Committee are then submitted to the Standing Committee, which, if the amendment is approved, publishes the proposed amendment so that the public can comment. The Advisory Committee then reviews the comments. If the amendment is approved, then it must be submitted to the Standing Committee, the Judicial Conference, thence to the Supreme Court. The Supreme Court then submits the rule changes to Congress on May 1, which has 3 months to reject it. If the rule changes are not rejected, then they go into effect on December 1.

If any bankruptcy rules contradict the substantive law, then the substantive law controls.

The Title 11 Appendix, Federal Rules of Bankruptcy Procedure and Official Bankruptcy Forms, consists of the following sections:

Local Court Rules

The bankruptcy court or the district court may also issue some procedures that are particular to that jurisdiction. However, any local court rules would have to be compliant with the Bankruptcy Code, the Bankruptcy Rules, and the Official Forms. However, a debtor can choose to use the federal rules without prejudice. Although Rules 8018 and 9029 allow a judge to regulate its practice as long as it conforms to federal law, the judge cannot impose any sanctions for noncompliance unless the debtor is provided specific notice of the requirement.

State Law

Although the federal bankruptcy law pre-empts state remedies for creditors and the U.S. Constitution gives the federal government the power to enact bankruptcy laws, the property interests of both creditor and debtor, as well as the exemptions that the debtor is entitled to, are determined by state law. So although federal law describes the bankruptcy estate in broad terms, state law determines its actual composition.

State law determines whether a creditor actually has a claim against the debtor. Hence, a creditor's claim against the bankruptcy estate will not be allowed if the creditor does not have a valid claim under state law. Likewise, security interests and liens and their perfection must conform to state law to be valid. Indeed, the trustee can often strip liens from property that have not been properly registered or perfected according to state law. The trustee can also set aside fraudulent conveyances using state law, even though the Bankruptcy Code has its own provision for fraudulent conveyances in §548.

Although the trustee can assume or reject executory contracts of the debtor, state law determines whether the contract is valid, the rights and duties of the parties, and what constitutes a breach. Hence, if the trustee assumes the contract, then performance requirements under the contract will be determined by state law. However, federal law nullifies any ipso facto clauses, which are contract terms that take effect on the bankruptcy of a contractant.

The trustee also has the power to assign a contract, if it is beneficial to the estate, to relieve the bankruptcy estate of any further liability even if state law does not allow assignment or relief from liability for the assignor.

State law also determines what is fraud, or fiduciary defalcation, or willful and malicious injury, which is pertinent to bankruptcy because Section 523(a) of the Bankruptcy Code lists some debts that cannot be discharged when these factors were involved in the incurrence of the debt. If a state court convicts the debtor of any of these crimes, the bankruptcy court will recognize the findings of the state court and will prevent the debtor from re-litigating the issue in bankruptcy court.

Finally, if there is a conflict between state law and the federal bankruptcy law, then the Supremacy Clause of the United States Constitution resolves the conflict in favor of the federal law.