Court Cases Soar : Bankruptcy: A System Under Stress

One summer Thursday last year Bankruptcy Judge R. Glen Ayers stepped up to his bench in a San Antonio courtroom to begin working through his calendar for the day. The docket was 105 pages long and covered more than 300 cases.

With hundreds of lawyers packed cheek-by-jowl into the immense room, Ayers worked furiously for two days to clear the docket in anticipation of the retirement of his one fellow judge and the arrival of a new, inexperienced partner.

Ayers’ effort had little lasting effect. Today, a year later, he and his new colleague share a docket of 13,000 cases.

“I push paper,” said the Harvard Law School graduate. “This is mass-production justice.”

With an oil-dependent economy in tatters, the Texas bankruptcy courts are among the most beleaguered in the nation. But they stand out only by degree. Throughout the country, bankruptcy courts have become overwhelmed with work as bankruptcy has shed its historical stigma and become an integral part of the life of tens of thousands of corporations and hundreds of thousands of consumers.

Corporations have declared bankruptcy to overturn their labor contracts, to facilitate their abandonment of environmentally dangerous property and to evade their responsibilities for paying pensions to retirees.

Individuals have asked the bankruptcy courts for help in fighting their evictions from public housing projects, to fight loan sharks and to hold off mortgage foreclosures.

Ruling in Traffic Accidents

Bankruptcy judges have even found themselves ruling on damage claims in traffic accidents and the appropriate scale of religious contributions.

Pure statistics tell much of the story: In 1986 there were 530,000 bankruptcy petitions filed by businesses and individuals in this country, up from 360,000 filings in 1981.

$51-Billion Shift

More money passes through America’s bankruptcy courts than through any other courts in the nation. The busiest such courts, those of the 9th Judicial Circuit, which includes Los Angeles, redistributed $51 billion from debtors to creditors last year.

“The bankruptcy system is being asked to consider more problems than (were) ever contemplated in the past,” said Karen Gross, a New York Law School associate professor. “We’re talking not about little problems but nationwide questions like the handling of mass torts (damage claims). The system has been overtaxed.”

Many of these cases raise important questions of national policy that might preferably be considered by Congress, including how to compensate the tens of thousands of persons who might be injured by a single industrial product such as asbestos. Instead, bankruptcy judges are effectively making national law.

Despite the torrent of cases--and their far-reaching ramifications--Congress has never managed to upgrade the linchpin of the system: the bankruptcy bench itself. Although the volume of cases has increased by 50% in the last 10 years, with most being bigger and more complex, the number of bankruptcy judges has remained steady at 232.

Congress last year approved the appointment of 52 additional judges, but most will not begin work until October. Because bankruptcy judges’ pay and benefits are inferior to those of other federal judges, the bench is overstaffed with young and inexperienced attorneys.

The U.S. bankruptcy system has become the object of expanding scrutiny and controversy in the wake of filings by several multinational companies that would not be considered bankrupt--that is, insolvent--by any traditional, layman’s definition of the term.

These include Texaco, the oil giant that filed in April for protection from creditors under Chapter 11 of the bankruptcy code, after it failed to reach a negotiated settlement of Pennzoil’s $11-billion court judgment against it, and Johns-Manville (now known as Manville), which sought Chapter 11 sanctuary in 1982 when a flood of lawsuits from asbestos-disease victims and the company’s own unwillingness to settle the cases threatened to destroy its financial health.

(Under Chapter 11, a company’s obligations to its creditors, including lenders, customers and personal injury plaintiffs, are suspended while it attempts to reorganize its debts and its business to better meet those claims.)

The cost of this form of fiscal justice unique in the world has never been higher. The expense of administering Manville’s bankruptcy estate since its 1982 Chapter 11 filing--money paid to the lawyers, accountants, investment bankers and others involved strictly with the huge company’s reorganization--last year passed $66 million.

Even in an average corporate bankruptcy the hiring of an investment banking adviser, now considered almost indispensable, can cost the bankruptcy estate more than $100,000 a month.

The roots of the bankruptcy explosion date to 1978, when Congress passed the most comprehensive reform of U.S. bankruptcy law in 80 years.

But long before, bankruptcy in the nation had been forged in a series of financial depressions and panics stretching back to the beginning of the 19th Century. These produced comprehensive new bankruptcy laws in 1800, 1813, 1841, 1867 and 1898, which articulated progressively more liberal principles.

Tried to Give ‘Fresh Start’

One was the notion of the “fresh start,” meaning that a debtor who made an honest attempt to surrender the property he owned at the time of bankruptcy could discharge all his debts and protect his future earnings from his old creditors. Another was the abhorrence of imprisonment or servitude for debt, although this “solution” for unpaid debts proved persistent. Between 1820 and 1830, the Boston jails held nearly 12,000 imprisoned debtors, far more than outright felons, and during that period the city’s entire population was never more than 63,000.

Once the United States outlawed debtors’ prison, the American bankruptcy laws were unique in the world for their absence of a punitive element and their orientation toward rehabilitating debtors. But the first such laws were fashioned on the English model. Aimed entirely at merchants and embracing the presumption that those who failed to pay their debts were engaged in fraud, they allowed creditors to force a debtor into a bankruptcy in which only his clothes and bedding for his family were exempt from seizure.

Voluntary Filings Allowed

But in 1841 the American law allowed merchants and non-merchants to declare bankruptcy voluntarily, and to discharge, or extinguish, debts regardless of whether creditors consented (assuming no dishonesty was involved). With the 13th Amendment, enacted during the Civil War, all slavery and peonage, including debtors’, was abolished.

Nevertheless, bankruptcy remained a stigma in America, discouraging frivolous or borderline filings.

That meant that companies or individuals still declared bankruptcy only as a last resort. Corporate reorganizations in which a new, stronger company emerged--common today--were rare. As late as the 1970s bankruptcy lawyers were regarded by their colleagues as scarcely a step above ambulance chasers, another factor that tended to discourage innovation in the field.

By then, however, eight decades had passed without a comprehensive revision of the law, which had become encrusted with outdated rules. Many corporate bankruptcies developed as disasters for unsecured creditors--chiefly suppliers and lenders who in effect were lending money without collateral to the debtor--for the law recognized a strict priority that placed the interests of bondholders and shareholders above these unsecured debts.

Beginnings of New System

Thus the effort began in the late 1960s to establish a new system that would allow the interests of all creditors to be more fairly represented. As the first bankruptcy law in U.S. history not inspired by a recession or panic, the 1978 reform act minimized bankruptcy’s traditional role as a last-chance financial defense for companies and individuals facing fiscal crisis and as an arena for creditors to apportion the remaining assets of a moribund enterprise.

Instead, by removing the power of any creditor to force a business or individual into liquidation, it recast bankruptcy more as a device through which debtors could negotiate with all creditors. Theoretically, this improved a debtor’s prospects of financial survival.

“From that time,” says Arthur Olick, a leading New York bankruptcy lawyer, “distressed companies could consider Chapter 11 not as a last resort but as one of many viable alternatives for alleviating stress.”

As corporations began to see bankruptcy as a more appealing tool, the bankruptcy bar grew in prestige and number. More lawyers, of course, meant more cases, as attorneys at respected law firms became less chary of recommending bankruptcy to their corporate clients. In a very few years, bankruptcy had become part of the life of American businesses and consumers.

“I’d be willing to bet that the reason bankruptcy became more respectable is that more respectable people began using it,” says George Treister, one of the top bankruptcy attorneys in Los Angeles.

Impact of Recession

Two other factors contributed to the tidal wave of new filings that followed implementation of the new law in October, 1979. One was the nearly simultaneous arrival of a deep nationwide recession; even once the recession eased after 1982, near depression-scale slumps continued to afflict the oil patch of Texas and Louisiana as well as the Midwest Farm Belt.

Another was the legal community’s discovery that the new bankruptcy law was marvelously flexible. “Lawyers welcomed the opportunity to find a court that was less hung up on rules of discovery and procedure than the others,” says Dean Gandy, a former Dallas bankruptcy judge now in private practice.

The post-1978 bankruptcy courts were not entirely devoid of procedural intricacies; the law installed several with which bankruptcy lawyers quickly learned to maneuver to their clients’ advantage. Chief among these is the “automatic stay,” the mechanism through which all pending legal actions against a bankrupt entity are suspended until the bankruptcy judge can take a crack at them.

Because the reform act established that bankruptcy judges had the authority to decide any legal issue that had even a peripheral impact on the condition of the debtor corporation or individual, the automatic stay became an indispensable tool for shifting bothersome lawsuits and government regulatory actions into bankruptcy court, where debtor corporations and individuals can often count on a more sympathetic hearing than in a federal or state courtroom.

Cloudburst in California

California and other active real estate markets have seen a cloudburst of Chapter 11 filings from developers using the automatic stay to stave off foreclosure by their lenders, a step that was hardly anticipated by the drafters of the new Chapter 11.

One variety of abuse of the automatic stay by landowners keeping creditors at arm’s length is so common in some parts of the country that it has its own name: the “new debtor syndrome.”

In these cases, a developer or landowner creates several shell corporations with no assets to shelter a parcel of land subject to an impending foreclosure. Such transfers are generally regarded as bad faith maneuvers by bankruptcy judges, who dismiss the bankruptcy filing and allow the foreclosure to go forward. When that happens, the landowner simply transfers the property into yet another shell, places that one into bankruptcy and buys a little more time until yet another judge expresses exasperation and dismisses the case.

That was the technique of one Byron L. Kinney, a Compton landowner who for three years flipped a plot of commercial property into and out of the control of five periodically bankrupt members of his family, like a volleyball team keeping a ball in the air, to avert foreclosure by Imperial Bank of Los Angeles. The ball was finally whistled dead by Bankruptcy Judge Geraldine Mund, who remarked: “This case principally involves one attorney, one family, one piece of real property, one transfer, but 10 case filings.” (She also fined the attorney $2,500.)

Cases Move, Despite Rules

As it happened, the Kinneys had managed to keep filing despite the rules prohibiting such abuse because of the enormous caseload and confusion of the Los Angeles court; the family’s 10 cases had come before six different judges, none of whom was aware of the other cases.

Meanwhile, bankruptcy’s new flexibility has brought it into conflict with other laws, as corporate attorneys choose to litigate difficult issues in bankruptcy court rather than the more procedure-bound federal district courts.

The consequences of such reshuffling of America’s legal priorities are more than theoretical. Last year, for example, Oklahoma’s health and water-resources regulators learned that a refinery site with a 70-year legacy of dumped arsenic, petroleum, lead, cadmium and other toxic minerals was about to be abandoned by its bankrupt owner’s court-appointed trustee. The refinery sat atop an aquifer and by the banks of a stream that provided drinking water to a nearby town.

By any reading of the applicable state and federal environmental protection laws, the site’s owner, Oklahoma Refining Co., was liable for more than $3 million in cleanup costs and responsibility for monitoring the property for 30 years. But the only available money in the bankrupt estate was held as collateral by the company’s largest secured creditors, Continental Illinois Bank and a second local bank, both of which objected to contributing their security for the purpose.

Judge Backs Company

Bankruptcy Judge Richard L. Bohanon found that the bankruptcy law took precedence--and that it supported the position of the banks and the company. “To require strict compliance with state environmental laws,” he wrote in approving the abandonment of the site, “could create a bankruptcy case in perpetuity and fetter the estate to a situation without resolve.”

“The judge concluded that not even the Supreme Court required a bankruptcy proceeding to be so drastically affected as to require a bankrupt estate to administer a property for 30 years,” says Jerry Barnett, an official of the state Water Resources Board, which fought the abandonment. Since Bohanon’s ruling last July, Barnett says, no cleanup has been accomplished at the scene: “Our ongoing enforcement is somewhat at a standstill now.”

Because such conflicts tend to be resolved in the debtor’s favor, creditors have moved more aggressively to protect themselves in Washington. The reformed code, originally designed to force all creditors to negotiate their claims from positions of equal standing, now has become one of the leading targets of special-interest groups seeking to give their constituents preferential treatment.

“Special-interest legislation creeps into the bankruptcy code every year,” says Kenneth L. Klee, who as associate counsel to the House Judiciary Committee in 1978 helped draft the reform act.

Among the creditor categories that now have priority status--meaning their claims must be settled before all others--are grain merchants, commodity and security brokers and several government agencies. The Department of Transportation has the right to seize ships on which there are outstanding government mortgages, even though private lenders may have better claims. U.S. fishermen have priority over foreigners.

After a campaign by Mothers Against Drunk Drivers, Congress voted to prohibit court judgments in drunk-driving cases from being extinguished in consumer bankruptcies--but not routine personal injury judgments, which in many instances can be more important to a victim.

None of these preferences is necessarily objectionable in principle, but bankruptcy professionals say their accumulation could eventually make bankruptcy so complex that its efficiency will disappear and its usefulness will evaporate.

But as Congress has moved to serve these creditors’ narrow interests, it still has failed to take an important step toward making the entire bankruptcy system more efficient: upgrading the stature and pay of judges. Lawyers for debtors and creditors say that, with some notable exceptions, the bankruptcy bench is too inexperienced and overworked to face the onslaught of new cases. Even many judges agree.

Seen as ‘Training Ground’

“As judges get older, they can’t stand the workload and retire,” says Ralph H. Kelly of Chattanooga, Tenn., the immediate past president of the National Conference of Bankruptcy Judges. “Instead, you get some bright young person who serves for two or three years, gets to be called ‘Judge’ and leaves to join a law firm to make $100,000 to $200,000 a year. So it’s a training ground. But by the time they get trained to be a judge they’re gone.”

The principal obstacle to finding qualified judges is the post’s salary. In drafting the 1978 reform, Congress intended to give bankruptcy judges all the stature and benefits of federal district judges, including life tenure and a salary that today would be $120,000. But just before a vote on the bill, Chief Justice Warren E. Burger, a particularly staunch defender of the federal judiciary’s status, objected to elevating people who were then known as bankruptcy “referees” to the equivalent of district judges.

As a result, bankruptcy judges today earn $72,500 and serve 14-year terms. The comparatively low salary and inadequate job protection contributed to a 73% turnover in bankruptcy judges over the last five years, according to figures provided by the administrative office of the U.S. courts. “Most lawyers who appear before you make more than the judge,” Kelly says.

The Burger Court in 1982 overturned much of the bankruptcy judges’ new authority, precisely because they did not have the life tenure that Burger himself found so objectionable. Congress was forced to respond with some technical tinkering.

Sees Confusion Persisting

“In terms of real power, bankruptcy courts still cannot decide many cases without ambiguity and confusion,” says Dean Gandy, the former judge.

That and the poor salary and benefits make recruitment difficult. The leading candidate for the sole new judgeship in Kelly’s jurisdiction withdrew his name last year just after President Reagan gutted a proposal to give the bench another raise.

“Our most likely No. 1 candidate now,” Kelly says, “is a 35-year-old lawyer with no experience as a private practitioner. He was a law clerk. He’s going to be a bit handicapped.”

As the bench has remained mired in its crisis of prestige, the bankruptcy bar has experienced a surge in importance and size that its oldest practitioners never expected to see.

Once ‘Rag Trade Province’

“Twenty years ago this was the dregs of the law business,” says Arthur Olick, the head of a firm of bankruptcy specialists in New York. “Chapter 11 used to be the exclusive province of the rag trade--the textile business.”

“The lodestar is the fees, which have grown huge with huge filings,” says Jack Gross, a New York lawyer who joined the prestigious firm of Stroock & Stroock & Lavan as its chief bankruptcy practitioner in 1980 after having practiced law for 47 years with his own firm. Did he ever expect to see firms so prominent operating a bankruptcy section? “When I started practicing,” he says, “we called such firms ‘white-shoe’ firms. They would never have had anything to do with bankruptcy.”

THE RULES OF BANKRUPTCY The key provisions of the bankruptcy law are as follows. According to legislative tradition, the main provisions are odd-numbered to allow room for later additions;chapters 1, 3, and 5 embrace general rules applying to all bankruptcies. BUSINESS CHAPTER 7 is designed to accomplish a liquidation of a failing business; its remaining assets are generally apportioned on a pro-rata basis to creditors, although some creditors, including the Internal Revenue Service, get priority. CHAPTER 11 allows a business to suspend its obligations to creditors while it attempts to restructure those debts and reorganize its operation. The goal is to emerge from bankruptcy as a financially healthier enterprise. Under the law, debts incurred prior to the filing are subject to modification with some exceptions. This provision is a revision of the pre-1978 Chapter X and Chapter XI, which were less flexible and gave certain creditors more power to control a business’s reorganization. INDIVIDUAL CHAPTER 7 allows a debtor to discharge, or extinguish, most debts once he or she establishes that they cannot be paid out of any predictable stream of income. Some debts cannot be discharged, including student loans, some taxes, those that result from the debtor’s fraud, alimony and child support, and drunk-driving judgments. The debtor must give up all assets with certain exceptions governed by state or federal law, including some home equity and personal items with nominal value. Debtors cannot file Chapter 7 bankruptcies more than once every six years. CHAPTER 12 Was added to the bankruptcy code as the latest in a series of special farm aid provisions enacted over the years to help farmers survive periodic economic slumps. It allows farmers with heavy real-estate debts to avoid foreclosure by pledging portions of their future crop proceeds while temporarily paying lenders the equivalent of a fair-market rent which is typically lower than mortgage payments. The provision is set to automatically expire in 1993.

CHAPTER 13 allows a consumer debtor to devise a plan to repay creditors over a period of three to five years out of his or her post-bankruptcy income. It supersedes a similar provision of pre-1978 law known as the Chapter XIII “wage-earner” plan. Under the rules, a debtor can propose a plan to pay only a portion of his or her debts, but the payments must represent all the debtor’s disposable income (Whatever is not needed for shelter, food, and other necessities). It is only available to debtors with less than $100,000 in unsecured debts (such as credit cards) and less than $350,000 in secured debts (such as mortgages and car loans). Anyone with greater debts generally must declare bankruptcy under Chapter 11, similar to a business bankruptcy.

OTHER CHAPTER 9 allows municipalities, public agencies, and other government entities to reorganize their debts, much like businesses in Chapter 11.

BANKRUPTCY FILINGS

Year ended June 30 Ch 11 Ch 7 Ch 13 Total (Business) (nonbusiness) (nonbusiness) 1986 477,856 21,175 285,536 112,772 1985 364,536 18,866 204,003 91,328 1984 344,275 17,213 194,870 84,535 1983 374,734 18,306 207,561 94,455 1982 367,866 12,385 217,081 92,689 1981 360,329 7,230 230,404 81,913 1980 360,957 4,488 314,856** 1979 226,476 29,500* 196,976**

* Represents total of all business filings ** Represents total of all nonbusiness filings Source: Administratvie Office of the U.S. Courts.