Bankruptcy and Insolvency Legislation

Bankruptcy and Insolvency Legislation When the framers of the Constitution provided in Article I, section 8, that Congress be empowered to establish “uniform Laws on the subject of Bankruptcies throughout the United States,” they sought to promote a national economy based on interregional and international trade in agricultural products and manufactured goods. A national bankruptcy law was essential to that goal. Although some states, mainly in the North, had insolvency and bankruptcy systems of their own, the Constitution implied that Congress had exclusive jurisdiction in that field. Confirmation of that view can be found in section 10 of Article I, which prohibits state laws impairing the obligation of contracts, the essential feature of any bankruptcy law.

Early Bankruptcy Law

The first national bankruptcy law did not come until 1800. Unpopular with the Jeffersonians and restricted in its coverage, it was shortly repealed. The same fate befell the bankruptcy laws of 1841 and 1867, leaving the way open for the states to retain or to create their own insolvency and bankruptcy systems.

But could such laws be constitutional? It took the Court almost forty years to give the states definitive guidelines to follow. Three issues had to be resolved. Did the Constitution give Congress exclusive authority in the bankruptcy field? If not, could state laws discharge debts, thereby impairing the obligation of contracts? And could such discharges, if constitutional, apply to debts contracted in another state?

These questions did not reach the Court until 1819, suggesting that lenders and borrowers alike generally had no quarrel with state relief laws, seeing them as mutually beneficial and in the public interest. In Sturges v. Crowninshield, Chief Justice John Marshall spoke for the Court, striking down New York's insolvency law of 1811. Absent a national bankruptcy law, the states could create their own systems, but they could not discharge debt contracts. The next day the Court also struck down a Louisiana relief law in McMillan v. McNeill, a case involving a debt contracted in South Carolina. Taken together, these two rulings left state authority confused and uncertain. Did the Court intend to confer bankruptcy powers on the states but deny them the essential power of discharge? Or did it intend to restrict discharges to contracts entered into after the passage of the law (one of the issues in the Sturges case) and to contracts between parties within the state (the central issue in McMillan)?

The Court finally clarified state authority in Ogden v. Saunders (1827) by allowing the states to create their own bankruptcy systems in the absence of a national law. Discharges could be granted only to loans made after the passage of the statute, making the possibility of bankruptcy relief an implied feature of the debt contract. Interstate debts could not be discharged.

This clarification of state authority did not produce a flood of bankruptcy legislation. For example, Massachusetts did not begin discharging debts until 1838. Rhode Island, which had created a bankruptcy system by petition and private bill in 1756, abandoned that process following the Sturges decision in 1819 and did not reenter the bankruptcy field until 1896.

There are four principal explanations for the reluctance of the states to enact full relief laws. First, legislators worried that a bankruptcy law would discourage lending, encourage recklessness and fraud, and reduce business morality. Second, despite the Ogden decision, many continued to argue that state bankruptcy laws were unconstitutional and favored the enactment of a national law. Third, policy makers found it extremely difficult to frame a law acceptable to borrowers and lenders alike, one that would be easy to apply and that would not be open to fraud and chicanery. They also wanted a law that would return to the creditors as much as possible. Experience had shown that receivers and attorneys often gutted the insolvent's estate, leaving almost nothing for distribution to lenders. Fourth, some states evaded the constitutional issue by enacting stay and other relief laws during financial panics, as in 1819, 1837, and 1857, realizing that they would be thrown out by the courts, but knowing that debtors and creditors would in the meantime enjoy a breathing space in which to put their affairs in order.

The 1898 System

By the end of Reconstruction and with the experience of the disastrous bankruptcy law of 1867 behind them, leading politicians, lawyers, judges, and businessmen came to a consensus that a workable and permanent national relief system was urgently required. That did not happen until 1898, primarily because of the difficulties in drafting legislation acceptable to such a broad spectrum of interests. The law that finally emerged reflected a series of compromises on virtually every point of substance and procedure and was, as a consequence, seriously flawed. It survived into the 1970s primarily because no political agreement could be reached on fundamental reform. Essentially, the law gave both debtors and creditors the right to initiate bankruptcy proceedings; it denied bankruptcy relief to fraudulent insolvents; and it allowed the states to protect certain assets from attachment.

There were three principal difficulties with the 1898 system. Although the Supreme Court issued rules for the guidance of the courts, jurisdiction lay in the district courts, which, in effect, delegated authority to separate bankruptcy courts. These inadequately staffed courts suffered from enormous caseloads and officers unqualified to deal with so complex a field of law (see Lower Federal Courts). Second, district judges, by the nature of their functions, were generalists and had neither the time nor the skills to provide close supervision. Third, the referees in bankruptcy, later called judges, were unsalaried, being paid instead by fees for service, which raised questions about their impartiality. Also troublesome was the combination, in such judges, of both administrative and judicial functions. Finally, appeals from their rulings lay with the very district judges who had appointed them. The system worked, but to the complete satisfaction of few.

Bankruptcy Reform

Congress corrected some of these defects by statute and a sympathetic Supreme Court by repeated changes in the rules of procedure, but it became increasingly clear that the whole system needed overhauling. What may have suited business needs in 1898 was totally outmoded by the 1960s. The public also became alarmed at the magnitude of some corporate failures, such as the Penn Central collapse in 1970, and at the prospect of widespread municipal bankruptcies, as New York City's financial crisis of the 1970s demonstrated. An extended period of public debate culminated in the Bankruptcy Reform Act of 1978, which established the Bankruptcy Court as a separate judicial entity charged with the administration of the new law.

The underlying thrust of the new system reveals how far public policy has shifted from the punitive principles of the eighteenth century to the rehabilitative ones of the late twentieth. There are many instances in which insolvent individuals are in such desperate plight that they need to be discharged from all their past debts, and insolvent corporations so bereft of assets that they need to be closed down. Nonetheless, the main business of the bankruptcy courts is providing individuals with a breathing space in which to get their affairs in order and failing corporations with reorganization so that they can work their way back to solvency

Several additional observations can be made. First, the new bankruptcy code has been used by some corporations, most notably Texas Air Corporation, to rescind labor contracts. Second, the uniformity requirement in the bankruptcy clause of the Constitution has caused some difficulty. In Railway Labor Executives Association v. Gibbons (1982), the Court ruled that statutes protecting the rights of employees could not deal with the problems of a single railroad. Uniformity might not be required in the case of geographically isolated railroads because of the problems presented, but the Rock Island liquidation had to be incorporated in uniform legislation dealing with comparable major railroad bankruptcies if it were to meet the constitutional test.

Third, as highly technical as bankruptcy law may have become in the twentieth century, judges have nevertheless been forced by the breadth and complexity of the issues presented to become generalists. They deal, for example, with questions as diverse as Fifth Amendment rights, international law, the rules of evidence, and innovative financial instruments.

Fourth, for this reason much of the debate over the bankruptcy bill focused on the quality of judicial appointments. Should judges have lifetime tenure “during good behavior” or should they be appointed by and serve at the pleasure of district or appeals court judges? Congress voted for a compromise between these extremes—presidential appointments for fourteen‐year terms. The Supreme Court struck down that provision in Northern Pipeline v. Marathon Pipe Line (1982), declaring that the judge's tenure violated the provisions of Article III, section 1, of the Constitution.

Congress responded with difficulty, finding agreement impossible until 1984. Amendments then made bankruptcy judges once more adjuncts to the district courts, serving without limited tenure. Congress also restricted the use of bankruptcy proceedings to modify labor contracts and imposed some limitations on the rights of individuals to bankruptcy relief.

Finally, the Court has accepted the proposition, in Granfinanciera, S.A. v. Nordberg (1989), that parties accused of fraud in bankruptcy proceedings are entitled, in accordance with the Seventh Amendment, to a jury trial, but it has not decided whether bankruptcy courts can hold such trials.

See also Capitalism; Contracts Clause.

Bibliography

Peter J. Coleman , Debtors and Creditors in America: Insolvency, Imprisonment for Debt, and Bankruptcy, 1707–1900 (1974).
Martin A. Frey, Warren L. McConnico, and and Phyllis Hurley Frey , An Introduction to Bankruptcy Law (1990).
Charles Warren , Bankruptcy in United States History (1935).

Peter J. Coleman