BANKRUPTCY

BANKRUPTCY

A federally authorized procedure by which a debtor—an individual, corporation, or municipality—is relieved of total liability for its debts by making court-approved arrangements for their partial repayment.

Once considered a shameful last resort, bankruptcy in the United States is emerging as an acceptable method of resolving serious financial troubles. A record one million individuals filed for bankruptcy protection in the United States in the peak year of 1992, and between 1984 and 1994 the number of personal bankruptcy filings doubled. Corporate bankruptcies are commonplace, particularly when corporations are the target of lawsuits, and even local governments seek debt relief through bankruptcy laws.

The goal of modern bankruptcy is to allow the debtor to have a “fresh start,” and the creditor to be repaid. Through bankruptcy, debtors liquidate their assets or restructure their
finances to fund their debts. Bankruptcy law
provides that individual debtors may keep certain
exempt assets, such as a home, a car, and
common household goods, thus maintaining a
basic standard of living while working to repay
creditors. Debtors are then better able to emerge
as productive members of society, albeit with
significantly flawed credit records.
History of U.S. Bankruptcy Laws
U.S. bankruptcy laws have their roots in
English laws dating from the sixteenth century.
Early English laws punished debtors who sought
to avoid their financial responsibilities, usually
by imprisonment. Beginning in the eighteenth
century, changing attitudes inspired the development
of debt discharge. Courts began to
nullify debts as a reward for the debtor’s cooperation
in trying to reduce them. The public
increasingly viewed debtors with pity, as well as
with a realization that punishments such as
imprisonment often were useless to creditors.
Thus, a law that was first designed to punish the
debtor evolved into a law that protected the
debtor while encouraging the resolution of outstanding
monetary obligations.

England’s eighteenth-century insight did
not find its way into the first U.S. bankruptcy
statutes; instead, laws based largely on England’s
earlier punitive bankruptcy statutes governed
U.S. colonies. After the signing of the
Declaration of Independence, individual states
had their own laws addressing disputes
between debtors and creditors, and these laws
varied widely.
In 1789, the U.S. Constitution granted Congress
the power to establish uniformity with a
federal bankruptcy law, but more than a decade
passed before Congress finally adopted the
Bankruptcy Act of 1800. This act, like the early
bankruptcy laws in England, emphasized creditor
relief and did not allow debtors to file for
relief voluntarily. Great public dissatisfaction
prompted the act’s repeal three years after its
enactment.
Philosophical debates over whom bankruptcy
laws should protect (i.e., debtor or creditor)
had Congress struggling for the next forty
years to pass uniform federal bankruptcy legislation.
The passage of the Bankruptcy Act of 1841
offered debtors greater protections and for the
first time allowed them the option of voluntarily
seeking bankruptcy relief. This act lasted eighteen
months. A third bankruptcy act passed in
1867 and was repealed in 1878.

The Bankruptcy Act of 1898 endured for
eighty years, thanks in part to numerous
amendments, and became the basis for current
bankruptcy laws. The 1898 act established bankruptcy
courts and provided for bankruptcy
trustees. Congress replaced this act with the
Bankruptcy Reform Act of 1978 (11 U.S.C.A. §
101 et seq.), which, along with major amendments
passed in 1984, 1986, and 1994, is known
as the Bankruptcy Code.
Federal versus State Bankruptcy Laws
In general, state laws govern financial obligations
such as those involving debts created by
contracts—rental leases, telephone service, and
medical bills, for example. But once a debtor or
creditor seeks bankruptcy relief, federal law
applies, overriding state law. This is because the
U.S. Constitution grants Congress the power to
“establish . . . uniform Laws on the subject of
Bankruptcies throughout the United States”
(U.S. Const. art. I, § 8). Federal bankruptcy
power maintains uniformity among the states,
encouraging interstate commerce and promoting
the country’s economic stability. States
retain jurisdiction over certain debtor-creditor
issues that do not conflict with, or are not
addressed by, federal bankruptcy law.
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.
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.
Federal Bankruptcy Jurisdiction
and Procedure
Regardless of the type of bankruptcy and
the parties involved, basic key jurisdictional
and procedural issues affect every bankruptcy
case. Procedural uniformity makes bankruptcies
more consistent, predictable, efficient, and
fair.
Judges and Trustees Pursuant to federal
statute, U.S. COURTS OF APPEALS appoint bankruptcy
judges to preside over bankruptcy cases
(28 U.S.C.A. § 152 [1995]). Bankruptcy judges
make up a unit of the federal district courts
called bankruptcy court.Actual jurisdiction over
bankruptcy matters lies with the district court
judges, who then refer the matters to the bankruptcy
court unit and to the bankruptcy judges.
A trustee is appointed to conduct an impartial
administration of the bankrupt’s nonexempt
assets, known as the bankruptcy estate. The
trustee represents the bankruptcy estate, which
upon the filing of bankruptcy becomes a legal
entity separate from the debtor. The trustee may
sue or be sued on behalf of the estate. Other
trustee powers vary depending on the type of
bankruptcy, and can include challenging transfers
of estate assets, selling or liquidating assets,
objecting to the claims of creditors, and objecting to the discharge of debts. All bankruptcy
cases except chapter 11 cases require trustees,
who are most commonly private citizens elected
by creditors or appointed by the U.S. trustee.
The office of the U.S. trustee, permanently
established in 1986, is responsible for overseeing
the administration of bankruptcy cases. The
U.S. Attorney General appoints a U.S. trustee to
each bankruptcy region. It is the job of the U.S.
trustee in some cases to appoint trustees, and in
all cases to ensure that trustees administer bankruptcy
estates competently and honestly. U.S.
trustees also monitor and report debtor abuse
and FRAUD, and oversee certain debtor activity
such as the filing of fees and reports.
Procedures Today, debtors file the vast
majority of bankruptcy cases. A bankruptcy filing
by a debtor is known as voluntary bankruptcy.
The mere filing of a voluntary petition
for bankruptcy operates as a judicial order for
relief, and allows the debtor immediate protection
from creditors without the necessity of a
hearing or other formal adjudication.
Chapters 7 and 11 of the Bankruptcy Code
allow creditors the option of filing for relief
against the debtor, also known as involuntary
bankruptcy. The law requires that before a
debtor can be subjected to involuntary bankruptcy,
there must be a minimum number of
creditors or a minimum amount of debt. Further
protecting the debtor is the right to file a
response, or answer, to the allegations in the
creditors’ petition for involuntary bankruptcy.
Unlike voluntary bankruptcies, which allow
relief immediately upon the filing of the petition,
involuntary bankruptcies do not provide
creditors with relief until the debtor has had an
opportunity to respond and the court has determined
that relief is appropriate.
When the debtor timely responds to an
involuntary bankruptcy filing, the court will
grant relief to the creditors and formally place
the debtor in bankruptcy only under certain circumstances,
such as when the debtor generally is
failing to pay debts on time. When, after litigation,
the court dismisses an involuntary bankruptcy
filing, it may order the creditors to pay
the debtor’s attorney fees, COMPENSATORY DAMAGES
for loss of property or loss of business, or
PUNITIVE DAMAGES. This reduces the likelihood
that creditors will file involuntary bankruptcy
petitions frivolously or abusively.
One of the most important rights that a
debtor in bankruptcy receives is called the automatic
stay. The automatic stay essentially freezes
all debt-collection activity, forcing creditors and
other interested parties to wait for the bankruptcy
court to resolve the case equitably and
evenhandedly. The relief is automatic, taking
effect as soon as a party files a bankruptcy petition.
In a voluntary chapter 7 case, the automatic
stay gives the trustee time to collect, and
then distribute to creditors, property in the
bankruptcy estate. In voluntary chapter 11 and
chapter 13 cases, the automatic stay gives the
debtor time to establish a plan of financial reorganization.
In involuntary bankruptcy cases, the
automatic stay gives the debtor time to respond
to the petition. The automatic stay terminates
once the bankruptcy court dismisses, discharges,
or otherwise terminates the bankruptcy case,
but a party in interest (a party with a valid claim
against the bankruptcy estate) may petition the
court for relief from the automatic stay by showing
good cause.
The Bankruptcy Code allows bankruptcy
judges to dismiss bankruptcy cases when certain
conditions exist. The debtor, the creditor, or
another interested party may ask the court to
dismiss the case. Petitioners—debtors in a voluntary
case, or creditors in an involuntary
case—may seek to withdraw their petitions. In
some types of bankruptcy cases, a petitioner’s
right to dismissal is absolute; other types of
bankruptcy cases require a hearing and judicial
approval before the case is dismissed. Particularly
with voluntary bankruptcies, creditors, the
court, or the U.S. trustee has the power to terminate
bankruptcy cases when the debtor engages
in dilatory or uncooperative behavior, or when
the debtor substantially abuses the rights
granted under bankruptcy laws.
Recent Developments in Federal
Bankruptcy Law
Brought about by a surge in bankruptcy filings
and public concern over inequities in the
system, the Bankruptcy Reform Act of 1994 is
one illustration of Congress’s continuing effort
to protect the rights of debtors and creditors.
Consistent with Congress’s goal of promoting
reorganization over liquidation, the legislation
made it easier for individual debtors to qualify
for chapter 13 reorganization. Previously, individuals
with more than $450,000 in debt were
not eligible to file under chapter 13, and instead
were forced to reorganize under the more complex
and expensive chapter 11 or to liquidate
under chapter 7. The 1994 amendments allow debtors with up to $1 million in outstanding
financial obligations to reorganize under chapter
13.
The new law helps creditors by prohibiting
the discharge of credit card debts used to pay
federal taxes, or those exceeding $1,000 incurred
within sixty days before the bankruptcy filing. In
this way, the law deters debtors from shopping
sprees and other abuses just before filing for
bankruptcy. Creditors also benefit from new
provisions that set forth additional grounds for
obtaining relief from the automatic stay, and
require speedier adjudication of requests for
relief from the stay.
It looked as though the bankruptcy system
would see more reform with the introduction of
the Bankruptcy Reform Act of 1998. The act
was a response to a report issued by the
National Bankruptcy Review Commission,
which recommended that the existing code be
fine-tuned in order to provide incentives to
debtors to file chapter 13 reorganization and to
increase debt repayment. The report was issued
in response to concern that debtors were taking
advantage of the bankruptcy system, evidenced
by the fact that a record number of consumers
filed for bankruptcy during a time of economic
prosperity.
But the Bankruptcy Reform Act of 1998 was
never enacted, and it turned out to be only the
beginning volley in one of the most tortuous
paths any legislation has seen. The House of
Representatives has passed a bankruptcy reform
bill no fewer than seven times since 1998, with
the Senate close behind, and yet bankruptcy
reform has yet to be passed into law as of the
time of this writing, despite the fact that President
GEORGE W. BUSH and the majorities in the
current House and Senate all currently favor
some sort of bankruptcy reform.
All of the bankruptcy reform legislation
introduced since 1997 shares the same main
thrust. Individual debtors would be discouraged
from filing under chapter 7, which allows them
to liquidate their debts, and would be encouraged
to file under chapter 13 instead. The filing
under chapter 7 will be presumed abusive if the
debtor is deemed able to pay a portion of his
debts under a formula set forth in the Reform
Act. Debtors who have an ability to repay a portion
of their debts out of future income will be
forced to reorganize under chapter 13.
The main criticism of all the bankruptcy
reform acts that have been passed since 1997 is
that they favor creditors at the expense of
debtors who truly might not be able to pay, but
who technically fail the means test that is used to
determine whether they can make some form of
repayment. But this criticism has not been the
only reason why bankruptcy reform has not
passed. For example, the Bankruptcy Reform
Act of 2001 failed because a provision was
included to prevent anti-abortion protesters
from avoiding criminal fines by claiming bankruptcy.
Anti-abortion legislators who otherwise
would have supported the bill joined forces with
opponents of the bill to defeat it. Another bankruptcy
reform act passed in the House of Representatives
by a vote of 315–113 in March 2003.
While Congress was considering bankruptcy
reform, the U.S. Supreme Court handed down
two decisions that further defined the limits of
bankruptcy law. In Cohen v. De La Cruz 523 U.S.
213, 118 S. Ct. 1212, 140 L. Ed. 2d 341, a unanimous
court held that where a debtor committed
actual fraud and was assessed punitive damages,
the debt would be not dischargeable because the
Bankruptcy Code’s prohibition against the discharge
of fraudulently incurred debts is not
restricted to the value of the money, property, or
services received by the debtor. In Young v. U.S.,
535 U.S. 43, 122 S. Ct. 1036, 152 L. Ed. 2d 79.
The court held that three-year lookback period
allowing IRS to collect taxes against a debtor was
tolled during pendency of a debtor’s earlier
chapter 13 proceeding.
Apart from developments in the law, bankruptcy
was much in the news during the opening
years of the twenty-first century as an
economic downturn forced many of American’s
most prominent companies into chapter 11
bankruptcy. In 2001, the energy-trading firm
Enron filed for the biggest corporate bankruptcy
in history, with $64 billion in assets. Less than a
year later, TELECOMMUNICATIONS firm World-
Com topped that record when it listed $104 billion
in assets in its bankruptcy filing. Other
prominent American companies filing for bankruptcy
included retailer K-Mart, financial services
firm Conseco, and United Airlines parent
company UAL.
FURTHER READINGS
Anderson, Nick. 2003. “House Passes Bankruptcy Reform
Bill For the 7th Time.”Los Angeles Times (March 20).
Hubler, James T. 2002. “The End Justifies the Means: The
Legal, Social, and Economic Justifications for Means
Testing Under the Bankruptcy Reform Act of 2001.”
American University Law Review (October).
Jewell, Mark. 2002. “Conseco Bankruptcy Ranks Third in
U.S.” Associated Press (December 19).
Reid, Linda. 2001.“Bankruptcy Reform Legislation”Arkansas
Lawyer (fall).
CROSS-REFERENCES
Petition in Bankruptcy.

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 selfsufficient
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 postbankruptcy
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 prebankruptcy
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.