U. S. Bankruptcy Laws Took Very Long to Get Off the Ground

The Constitution empowered Congress to “pass uniform laws on the subject of bankruptcies,” which then took more than 100 years to do so.


  • The United State of America started its existence without a national bankruptcy law, and in fact without the ability to have one. The Continental Congress established the United States with its founding constitution consisting of the “Articles of Confederation and Perpetual Union,” drafted in 1776-1777. Not ratified by the 13 states until 1781, the Articles of Confederation did not provide for a nationwide bankruptcy system.
  • The American Revolutionary War ended in 1782, the U.S. Constitution was drafted in 1787 and was ratified by the states in 1789.  It did allow for, yet did not of itself create a national bankruptcy law. It merely empowered Congress to “pass uniform laws on the subject of bankruptcies”.
  • The Constitution may have thus empowered Congress, but Congress did not do a very good job at this for nearly half our nation’s history. Three different times during the 1800s, a federal bankruptcy law was passed in direct reaction to a financial “panic.” But these federal laws were each repealed after the financial crises were over.
  • During the long periods when there was no nationwide law in effect, the states developed a patchwork of bankruptcy and debtor-creditor laws. But these local laws became more and more cumbersome as commerce became ever more interstate.
  • Finally, Congress passed the Bankruptcy Act of 1898. This is the first one that was not quickly repealed, and lasted 80 years.  This law was inspired by commercial creditors, to help in the collection of debts. However, it included the following very important debtor-friendly provisions: most debts became dischargeable, and creditors no longer had to be paid a certain minimum percentage of their debts.
  • This Bankruptcy Act of 1898 was amended many times, significantly in 1938 in reaction to the Great Depression. Among other things that 1938 amendment added the “chapter XIII” wage earners’ plans, the predecessor to today’s Chapter 13s.
  • The 1978 Bankruptcy Reform Act, the result of a decade of study and debate, gave us the Bankruptcy Code. It has been amended every few years since then, most significantly in 2005 with BAPCPA, the so–called Bankruptcy Abuse Prevention and Consumer Protection Act. 
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The Truly Amazing History of Bankruptcy Law

Debtors’ prisons? There’s that and a lot more to the very colorful history of bankruptcy law.

 

American bankruptcy law naturally grew out of the law of England during our colonial history. Pre-Revolutionary War bankruptcy laws were extremely different from current law.

  • The first bankruptcy law in England was enacted more than 450 years ago during the reign of Henry VIII. Debtors were called “offenders” under this first law, in effect seen as perpetrators of a property crime against their creditors. The purpose of this law, and as expanded during the following hundred and fifty years, was not to give relief to debtors. Rather it was to provide to creditors a more effective way to collect against their debtors.
  • Given this purpose, it is not surprising that this first law did not give debtors a discharge—a legal write-off—of their debts. In a bankruptcy the assets of the “offender” were seized, sold, and the proceeds distributed to creditors. And then the creditors could still continue pursuing the “offender” for any remaining balance owed.
  • A bankruptcy proceeding could only be started by creditors, not by debtors.  Creditors accused a debtor of an “act of bankruptcy,” such as physically hiding from creditors, or hiding assets by transferring them to someone else.  The current extremely seldom used “involuntary bankruptcy” is a remnant of this.
  • Strangely, only merchants could file bankruptcy. Why? Credit was seen as immoral, with only merchants being allowed to use credit, for whom it was seen as a necessary evil. As the only ones who had access to credit, only merchants had the capacity to become bankrupt.
  • For the following century and a half through the late 1600s, Parliament made the law even stronger for creditors, allowing bankruptcy “commissioners” to break into the homes of “offenders” to seize their assets, put them into pillories (structures with holes for head and hands used for public shaming), and even cut off their ears.
  • Finally in the early 1700s the discharge of debts was permitted for cooperative debtors, but only if the creditors consented!
  • Yet the law still provided for the death penalty for fraudulent debtors (although it was very seldom used).
  • Cooperative debtors received an allowance from their own assets, the very early beginnings of the current Chapter 13 “adjustment of debts.”

So this was the English bankruptcy law that was largely in effect at the time that the U.S. Constitution was adopted. That gives some perspective on what the framers may have had in mind with the Bankruptcy Clause of the U. S. Constitution. That Clause gave Congress power to “pass uniform laws on the subject of bankruptcies.” Fortunately the language is so open-ended that it gave bankruptcy laws the opportunity to evolve during the last two hundred fifty years into one infinitely both more compassionate and beneficial for the economy.

But this evolution during our national history was extremely rocky, until surprisingly recently. That is the topic of the next blog. 

 

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A Sample Simple Save-Your-Business Chapter 13 Case

A business Chapter 13 case does not have to be complicated. Here’s how it can work.

 

It’s true that if you own a business that usually means you have a more complicated financial picture than someone punching a time clock or getting a regular salary. So usually if does take more time for an attorney to determine whether and how bankruptcy could help you and your business. But saving a business in the right circumstances can be relatively straightforward and extremely effective.

A good way to demonstrate this is by walking through a realistic Chapter 13 “adjustment of debts” case.

Jeremy’s Story

Jeremy, a single 32-year old, started a handyman business when he lost his job a little more than three years ago. He had ten years steady experience before that in construction and maintenance work. A hard worker and self-starter, he’d been itching to run his own business. He’d slowly accumulated the tools and equipment he needed, and had taken some courses at the local community college in small business management. He had decent credit at the time, owing nothing except his modest mortgage that he had never been late on plus about $2,800 spread out on a number of credit cards. Jeremy had always lived in the same area along with most of his extended family, so he had tons of contacts, and had a great reputation as a responsible guy who could fix anything. He had begun to accumulate some money to get him past the start-up of his business, but then his employer ran into financial problems and he was reluctantly laid off. So Jeremy decided to take the risk of starting his business in spite of having very little working capital. He had $8,500 of credit available on his credit cards if he got desperate.

His business started off slowly, partly because he didn’t have the cash to invest in advertising. But he was creative in setting up a website and using social media, and worked very hard building a customer base and a good business reputation. His income crept steadily upwards, but way too slowly. Over the course of the first year Jeremy maxed out his credit cards to keep current on his mortgage, feed himself, and keeps the lights on. But he simply didn’t have enough money to pay any estimated quarterly income taxes to the IRS, falling behind $3,500 to them that year.

Then during the second year of his business, Jeremy managed to keep current on the increased payments on his credit card debts but couldn’t pay them down any. Plus he fell behind another $6,000 in income taxes. Then recently, towards the end of his third year of business, after again failing to pay any estimated quarterly income taxes and falling another $4,500 behind, the IRS required him to start making $400 monthly payments on his $14,000 debt, plus to pay his estimated quarterly payments going forward. As a result he started not being able to keep current on his credit card payments, leading to ratcheted-up interest rates, pushing him over the credit limits and into the vicious cycle of large extra fees piling up. And now he’s missed two payments on his mortgage, putting him $3,000 in arrears.

In spite of all these distractions Jeremy’s business now has reasonably steady income, which continues to increase, slowly but quite consistently. His accumulated debt problems ARE taking a toll on his ability to focus on growing his business. In spite of this he still very much likes his work and being his own boss, and realistically believes he can keep increasing his income, especially as the economy improves. He very much wants to keep his business going.

But his creditors have him in an impossible situation. If he misses a payment, the IRS could levy on his business equipment or even garnish his business customers—requiring them to pay the IRS instead of him and trashing his very hard-won reputation. A couple credit cards creditors are sending their accounts to collection agencies. He not too far behind on his mortgage but still doesn’t see how he could catch up on even just two missed mortgage payments considering his other financial pressures.

The Chapter 13 Solution

If Jeremy met with an experienced business bankruptcy attorney, this is likely what the attorney would tell him that a Chapter 13 case would accomplish:

  • Cancel the $400 monthly payments to the IRS, giving him 5 years to pay that debt, with no additional ongoing interest or penalties during that whole time. This would significantly reduce the amount that he would need to pay each month and overall.
  • Stop all collection efforts by the credit card creditors and any collection agencies. They would only receive any money after Jeremy caught up on the house arrearage and paid off the income taxes, and then only to the extent that Jeremy’s budget would allow.
  • Immediately protect all his business and personal assets—tools and equipment, his business truck and/or personal vehicle, receivables owed by customers for prior work, and his business and personal bank and/or credit union accounts.
  • Enable Jeremy to concentrate on his business by greatly relieving his month-by-month financial burden, as well as save him a lot of money in the long run.
  • At the end of his 3-to-5 year Chapter 13 case, Jeremy will be current on his mortgage, he would owe nothing to the IRS, and he would have paid as much as he could afford on the credit cards, with any remaining amount discharged (legally written off).

 

As a result the business that he loves and in which he has invested so much hope and effort would be thriving and providing him a decent livelihood. 

 

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Some General Guidance about Business Bankruptcy

If your business needs bankruptcy relief, you have to start with basic questions about how your business was set up and its debt amount.

 

The Sole Proprietorship Business

The most straightforward business bankruptcies tend to be those in which the business is a sole proprietorship. Your business is operated through you, not through a separate formal business entity. In other words, you and the business are legally a single entity because you have NOT set up that business as a separate legal entity–a corporation or limited liability company (LLC), or a partnership. You operate it under your own name, or through an assumed business name but not a corporation, LLC, or partnership.

Other Forms of Business

But what if your business is not a simple sole proprietorship, but instead is in one of these separate legal entities, and you are contemplating bankruptcy relief (for either the business, you personally, or both)?

If so, if you have not already done so, you should quickly find and sit down with a competent business bankruptcy attorney.  There are advantages and disadvantages to every form of doing business. But one practical disadvantage of running your business as a corporation/LLC/partnership is that this can make things more complicated in the bankruptcy world. This CAN give you more flexibility—you can file a bankruptcy for yourself without directly filing for the business, and the other way around. But with more flexibility and more options come more complications.

The General Guidance

Beyond these initial points, here are some basic rules for background purposes. They will help you be a bit more prepared when you come to meet with me or another attorney.

1. A corporation, or LLC, or partnership cannot file a Chapter 13 “adjustment of debts.”

Only an “individual” can. This means that you and your sole proprietorship can together file a Chapter 13 case. And if your business is a corporation, LLC, or partnership, you (and your spouse) can file a personal Chapter 13 case to deal with your own liabilities, but that will almost never be adequate for dealing with the business’ own liabilities if you are trying to keep operating that business.

2. Chapter 13s are sometimes mislabeled “wage-earner plans,” but any source of “regular income” is allowed.” The requirement is simply “income sufficiently stable and regular to… make payments under a plan under Chapter 13.” So if your business income—combined with any other income—is even somewhat stable, you would likely qualify under this “regular income” requirement.

3.  But you and your sole proprietorship CAN’T file a Chapter 13 case if your total unsecured debt is $383,175 or more, or if your total secured debt is $1, 149,525 or more. (Note: these were adjusted for inflation as of April 1, 2013 and are valid for the following 3 years.) While these may seem like relatively high maximums, be aware that they include BOTH personal and business debts (since you are personally liable for all the debts of a sole proprietorship). Also the unsecured debt amounts can include less obvious ones such as the portions of your mortgages and other secured debts in excess of the value of the collateral. So a $750,000 debt secured by real estate now worth $550,000 adds $200,000 to the unsecured debt total. Also some debts—especially business ones—can be much higher than you’d expected, such as damages from the terminated lease of business premises, or resulting from business litigation. This can also be pertinent if your business is not a sole proprietorship, because you are likely personally liable for most or all of your corporation’s or LLC’s debts through personal guarantees and otherwise. Either way, add up your potential debts carefully before assuming that you can file a Chapter 13 case.

4. If your debt totals are above one of the above debt limits, you can still file a Chapter 7 “straight bankruptcy” case, but that is very seldom an effective way to keep a business operating. Chapter 7 tends to be a better option for cleaning up after a closed business, whatever its legal form.

5. If your debt totals are above one of the Chapter 13 debt limits and you are trying to save the business, one option is a Chapter 11 “business reorganization.” Also, a business corporation, LLC, or partnership can file a Chapter 11 case to keep the business afloat. The disadvantage of Chapter 11 is that it is a hugely more complicated repayment procedure than Chapter 13, and therefore many times more expensive. This, and the many times higher filing fee, plus significant ongoing court and U.S. Trustee fees, unfortunately makes Chapter 11 a practical solution in only limited small business situations. Bankruptcy courts have tried to address this shortcoming with streamlined “fast-track” Chapter 11s, but they are still often prohibitively expensive.

6. If you do end up filing a personal Chapter 7 case when owing substantial business debt, you may have the advantage of being exempt from qualifying under the “means test” (a test based on your income and allowed expenses) if your business debts are more than half of your total debts.

To repeat, if you are trying to save your financially struggling business, it is crucial to get competent business bankruptcy advice, and to do so just as soon as possible. You have no doubt been working extremely hard trying to keep your business alive. You very likely now need a solid game plan for using the bankruptcy and other laws to your advantage.

 

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Filing a Chapter 7 Case to Save Your Business

A Chapter 13 case is often the preferred way to keep a sole proprietorship business alive. But can a regular Chapter 7 one ever do the same?

 

In my last blog I said that “if you own an ongoing business… which you intend to keep operating, Chapter 7 may be a risky option.” Why? Because Chapter 7 is a “liquidating bankruptcy,” so the bankruptcy trustee could make you surrender any valuable components of your business, thereby jeopardizing the viability of the business. But this deserves further exploration.

Your Assets in a Chapter 7 Bankruptcy

When a Chapter 7 bankruptcy is filed, everything the debtor owns is considered to be part of the bankruptcy “estate.” A bankruptcy trustee oversees this estate. One of his or her primary tasks is to determine whether this estate has any assets worth collecting and distributing to creditors. Often there are no estate assets to collect and distribute because the debtor can protect, or “exempt,” certain categories and amounts of assets. The exempt assets continue to belong to the debtor and can’t be taken by the trustee for distribution to the creditors. The purpose of these “exemptions” is to let people filing bankruptcy keep a minimum amount of assets with which to begin their fresh financial start afterwards. In the vast majority of consumer Chapter 7 cases, the debtor can exempt everything in the estate, leaving nothing for the trustee to collect.  This is called a “no-asset” estate.

Business Assets in a Chapter 7 Case

If you own a sole proprietorship, are all the assets of that business exempt and protected? In other words, is the entire value of the business covered by exemptions, whether approaching the business as a “going concern” or broken up into its distinct assets.

Many very small businesses cannot be sold as an ongoing business because they are operated by and completely reliant for their survival on the services of its one or two owners.  In most such situations the business only has value when broken into its distinct assets.  So the Chapter 7 trustee must consider whether the debtor has exempted all of these business assets to put them out of the trustee’s reach.

The assets of a very small business may include tools and equipment, receivables (money owed by customers for goods or services previously provided), supplies, inventory, and cash on hand or in an account. Sometimes the business may also have some value in a brand name or trademark, a below-market lease, or perhaps in some other unusual asset.  

Whether a business’ assets are exempt depends on the nature and value of those assets, and on the particular exemptions that the law provides for them. For example, a very small business may truly own nothing more than a modest amount of office equipment and supplies, and/or receivables. In these situations the applicable state or federal “tool of trade” or “wildcard” exemptions may protect all the business assets. You need to work conscientiously with your attorney to make certain that all the assets are covered.

So it is possible for a business-owning debtor to have a no-asset Chapter 7 case, potentially allowing the business to pass through the case unscathed.

The Potential Liability Risks of the Business

However, there is an additional issue: will the trustee allow the business to continue to operate during the (usually) three-four months that a no-asset case is open or instead try to force the business to be shut down because of its potential liability risks for the trustee?

How could the Chapter 7 trustee be able to shut down the business? Recall that everything that a debtor owns, including his or her business, becomes part of the bankruptcy estate.  As the technical owner—even if only temporarily—of the business, the trustee becomes potentially liable for damages caused by the business while the Chapter 7 case is open. For example, if a debtor who is a roofing subcontractor drops a load of shingles on someone during the Chapter 7 case, the estate, and thus the trustee, may be liable for the injuries.

The main factors that come into play are whether the business has sufficient liability insurance, and the extent to which the business is of the type prone to generating liabilities. There’s a lot of room for the trustees’ discretion in such matters, so knowing the particular trustee’s inclinations can be very important. That’s one of many reasons why a debtor needs to be represented by an experienced and conscientious attorney who knows all of the trustees on the local Chapter 7 trustee panel and how they deal with this issue.

Conclusion

In many situations it IS risky to file a Chapter 7 case when you want to continue operating a business. You need to be confident that the business assets are exempt from the bankruptcy estate, and that in your situation the trustee will not require the closing of the business to avoid any potential business liability. 

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