The Fight Against An Alarming Trend: Section 706(b) Motions – Part 4
IV. The Constitutional Problem With A § 706(b) Motion
I thank Daniel Press, an attorney practicing in Virginia, Washington, DC, and Maryland, for giving me his notes, which served as an afflatus for some of today’s post.
A. Historical Background
1. The Chapter 13 Context
When Chapter 13 was enacted in 1978, it provided that only an individual could be a Chapter 13 debtor (11 U.S.C. § 109(e)), imposed limitations on the amount of debt a Chapter 13 debtor could have (11 U.S.C. § 109(e)), and — most important for today’s discussion — included postpetition earnings in the bankruptcy estate (11 U.S.C. § 1306(a)(2)) from which the debtor made Chapter 13 plan payments (11 U.S.C. § 1325(b)(1)(B)).
For a Chapter 13 Plan to succeed, the debtor must be a willing and active participant in the reorganization. Congress explicitly stated that an involuntary Chapter 13 would create a thirteenth amendment problem:
As under current law [Chapter XIII], chapter 13 is completely voluntary. This Committee firmly rejected the idea of mandatory or involuntary chapter XIII in the 90th Congress. The thirteenth amendment prohibits involuntary servitude. Though it has never been tested in the wage earner plan context, it has been suggested that a mandatory chapter 13, by forcing an individual to work for creditors, would violate this prohibition. On policy grounds, it would be unwise to allow creditors to force a debtor into a repayment plan. An unwilling debtor is less likely to retain his job or to cooperate in the repayment plan; and more often than not, the plan would be preordained to fail. (Footnotes omitted).
House Report at 120, and Sen. Report at 32, U.S. Code Cong. & Admin. News 1978 at 6080.
Matter of Noonan, 17 B.R. 793, 800 (Bankr. S.D. NY 1982).
Similar reasoning applied to an involuntary bankruptcy under section 303 of the Code:
Involuntary chapter 13 cases are not permitted either. To do so would constitute bad policy, because chapter 13 only works when there is a willing debtor that wants to repay his creditors. Short of involuntary servitude, it is difficult to keep a debtor working for his creditors when he does not want to pay them back.
2. The Chapter 11 Context
Prior to 2005, 11 U.S.C. § 1115 did not exist, so postpetition earnings were not included in an individual Chapter 11 debtor’s bankruptcy estate.
11 U.S.C. §§ 1123(a)(8) and 1129(a)(15) did not exist either, so the debtor did not have to dedicate postpetition earnings to a Chapter 11 plan. As a consequence, the thirteenth amendment limitations found in the Chapter 13 context did not exist in an individual Chapter 11 case.
Moreover, since 11 U.S.C. § 1141(d)(5) did not exist, an individual Chapter 11 debtor received a discharge immediately upon confirmation of the Chapter 11 plan, the automatic stay terminated pursuant to 11 U.S.C. § 362(c)(2), and the Court closed the case because it had concluded its involvement in it.
Of course, in practical terms it made no sense to involuntarily convert an individual Chapter 7 case to a Chapter 11 case because the Chapter 11 estate assets were the same assets that would be liquidated in the Chapter 7, since they did not include postpetition earnings.
Nevertheless, there was no constitutional impediment to forcing an individual debtor into Chapter 11 — through either an involuntary conversion under section 706(b), or an involuntary filing under section 303(a) — because the debtor’s postpetition earnings were not property of the estate, and the debtor did not have to devote them to paying creditors in a Chapter 11 plan.
In 1991, the United States Supreme Court adopted this position and held (emphasis added):
If an involuntary Chapter 11 debtor fails to cooperate, this likely will provide the requisite “cause” for the bankruptcy court to convert the Chapter 11 case to one under Chapter 7. See § 1112(b). In any event, the argument overlooks Congress’ primary concern about a debtor’s being forced into bankruptcy under Chapter 13: that such a debtor, whose future wages are not exempt from the bankruptcy estate, § 1322(a)(1), would be compelled to toil for the benefit of creditors in violation of the Thirteenth Amendment’s involuntary servitude prohibition. See H. R. Rep. No. 95-595, at 120. Because there is no comparable provision in Chapter 11 requiring a debtor to pay future wages to a creditor, Congress’ concern about imposing involuntary servitude on a Chapter 13 debtor is not relevant to a Chapter 11 reorganization.
Toibb v. Radloff, 501 U.S. 157, 165-66 (1991).
The law changed in 2005 with the passage of BAPCPA, which significantly altered the framework for individual Chapter 11 cases. In BAPCPA Congress attempted to graft onto Chapter 11 many provisions previously applicable only in Chapter 13 cases. As Judge Bruce Markell held:
[A]lthough not entirely free from doubt, it appears that Congress inserted the individual chapter 11 provisions to ensure no easy escape from means testing. The template for this effort was to adopt and adapt as much of chapter 13 as possible with respect to individual debtors in chapter 11. Again, these changes to chapter 11 were:
• redefining property of the estate in chapter 11 under Section 1115 along the lines of property of the estate under Section 1306;
• changing the mandatory contents of a plan pursuant to Section 1123(a)(8) to resemble Section 1322(a)(1);
• adding the disposable income test of Section 1325(b) to Section 1129(a)(15);
• delaying the discharge until the completion of all plan payments as in Section 1328(a);
• permitting a discharge for cause before all payments are completed pursuant to Section 1141(d)(5), similar to the hardship discharge of Section 1328(b); and
• the addition of Section 1127(e) to permit the modification of a plan even after substantial consummation for purposes similar to Section 1329(a).
In re Shat, 424 B.R. 854, 862 (Bankr. D. Nev. 2010).
In BAPCPA Congress appears to have copied virtually verbatim from Chapter 13 into Chapter 11 — with little thought of how the Chapter 13 provisions would integrate into the existing Chapter 11 framework, or how they would work in actual cases. In particular, neither section 706(b), nor section 303, was changed to reflect the new reality that postpetition wages were now part of the Chapter 11 estate that must be devoted to the Chapter 11 plan. Instead, the changes to Chapter 11 raised the specter of involuntary servitude. Some aspects of that involuntary servitude include the following:
• If a debtor’s case is involuntarily converted to Chapter 11, the debtor has no right to convert later. 11 U.S.C. § 1112(a)(3).
• There is no right to dismiss if creditors object to dismissal. 11 U.S.C. § 1112(b).
• The debtor must dedicate not only his disposable income to a plan (11 U.S.C. §§ 1123(a)(8) and 1129(a)(15)(B)), but he must also get creditors to vote for a plan. 11 U.S.C. § 1129(a)(10).
• If the unsecured creditors do not vote for the plan, the debtor could be forced to lose all of his property under the absolute priority rule in order to confirm a plan. 11 U.S.C. § 1129(b)(2)(B)(ii).
• A creditor could file a plan, explicitly forcing the debtor to work for his creditors. 11 U.S.C. § 1121(c).
• If the Debtor does not cooperate in dedicating wages to this enforced plan, the bankruptcy court could appoint a Chapter 11 Trustee under 11 U.S.C. § 1104, and force him to work for the Trustee.
• 11 U.S.C. § 1127(e) allows any holder of an allowed unsecured claim to seek modification of a confirmed plan to increase the amount of payments; and section 1127(f)(1) makes the requirements of 11 U.S.C. § 1129(a)(15) regarding postpetition income applicable to plan modifications under section 1127.
Once in an involuntarily converted Chapter 11, there is no sure exit. As described in In re Lobera, 454 B.R. 824, 854-55 (Bankr. D. N.M. 2011), supra, the debtor is literally trapped in Chapter 11.
In In re Molina y Vedia, 150 B.R. 393, 399 (Bankr. S.D. Tex. 1992), the Court analyzed whether an individual Chapter 11 debtor’s income was property of the estate. It compared Chapter 11 to Chapters 12 and 13 and noted that constitutional concerns were addressed by the debtor’s absolute right to covert: “Similar Congressional concern for the Thirteenth Amendment is evidenced by the fact that debtors under Chapter 12 and Chapter 13 have an absolute right to convert or dismiss their cases. See 11 U.S.C. § 1307 and 11 U.S.C. § 1208.” In sum, to be constitutional, either individual Chapter 11 debtors must have an absolute right to convert or dismiss, or involuntary conversions to Chapter 11 for individuals must be prohibited. However, that is not currently the case.
The debtor’s inability to dismiss or convert, combined with the fact that his postpetition earnings are property of the estate and not his own, makes the Debtor an involuntary fiduciary, working not for himself, but for the estate (and thus for the creditors). See, e.g., In re Vincent, 4 B.R. 21 (Bankr. M.D. Tenn. 1979) (no authority to use property of the estate for family living expenses). In a word, he is in involuntary servitude.
B. The Thirteenth Amendment’s Protection Against Involuntary Servitude
Section 1 of the thirteenth amendment to the U.S. Constitution provides: “Neither slavery nor involuntary servitude, except as a punishment for crime whereof the party shall have been duly convicted, shall exist within the United States, or any place subject to their jurisdiction.” Thus, the amendment abolished both slavery and peonage. See also 42 U.S.C. § 1994, which provides:
The holding of any person to service or labor under the system known as peonage is abolished and forever prohibited in any Territory or State of the United States; and all acts, laws, resolutions, orders, regulations, or usages of any Territory or State, which have heretofore established, maintained, or enforced, or by virtue of which any attempt shall hereafter be made to establish, maintain, or enforce, directly or indirectly, the voluntary or involuntary service or labor of any persons as peons, in liquidation of any debt or obligation, or otherwise, are declared null and void.
The Supreme Court has long recognized that the thirteenth amendment prohibits peonage. See Pollock v. Williams, 322 U.S. 4 (1944); Baily v. Alabama, 219 U.S. 219 (1911); Clyatt v. United States, 197 U.S. 207 (1905). The Supreme Court described peonage as: “Peonage is a term descriptive of a condition which has existed in Spanish America, and especially in Mexico. The essence of the thing is compulsory service in payment of a debt. A peon is one who is compelled to work for his creditor until his debt is paid.” Baily, 219 U.S. at 242. The fact that a debt was voluntarily entered into does not exclude peonage from the thirteenth amendment’s prohibition. Pollock, 322 U.S. at 24 (a state may not “directly or indirectly command involuntary servitude, even if it was voluntarily contracted for.”).
The underlying purpose of the Bankruptcy Code is consistent with the purpose of the thirteenth amendment: To prevent the imposition of involuntary servitude on debtors who have not been convicted of a crime. Bankruptcy cannot be used as a tool by creditors to force debtors to choose between work and wage slavery. The thirteenth amendment contains no exemptions from its prohibitions for debtors in bankruptcy to be forced into involuntary servitude.
If you have not been convicted of a crime, the thirteenth amendment protects you from involuntary servitude.
Nine years after the enactment of BAPCPA, the court in Snyder, supra, expressed its concern over the constitutional problem with compelling an individual Chapter 7 debtor to convert to Chapter 11 (with emphasis added):
No one can force an individual to be a Chapter 13 debtor against her will, see §§ 706(c) and 1307(a), because doing so might violate the Thirteenth Amendment’s involuntary servitude prohibition. Lobera, 454 B.R. at 855. See generally Toibb v. Radloff, 501 U.S. 157, 165-66, 111 S. Ct. 2197, 115 L. Ed. 2d 145 (1991) (Congress’ primary concern about a debtor being forced into a Chapter 13 case was to avoid compelling debtors to toil for the benefit of creditors in violation of the Thirteenth Amendment). There are no similar statutory protections for potential individual Chapter 11 debtors, but the constitutional right against involuntary servitude remains. It seems likely that the potential constitutional problem would constitute grounds to convert or dismiss Debtor’s Chapter 11 case if Movant’s § 706(b) conversion motion were granted.
In re Snyder, 509 B.R. 945, 955 (Bankr. D. N.M. 2014).
It is in light of the 2005 bankruptcy amendments that added section 1115 (making postpetition earnings property of the Chapter 11 estate) and section 1129(a)(15) (requiring that disposable income be paid into the Chapter 11 plan), that the application of section 706(b) most clearly violates these long-established constitutional principles.
In sum, in my view the thirteenth amendment argument is dispositive, and renders the application of § 706(b) to an individual case unconstitutional, and therefore impermissible.
(Note: James Selth and I made a presentation at a local bar association. These are the notes we used. Although I wrote the notes, some of the content came from a brief Jim filed in one of his cases.)
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