Available at SSRN: https://ssrn.com/abstract=7264844
Abstract
In 2017, Bestwall LLC filed for bankruptcy even though a generous funding agreement from its parent, Georgia-Pacific, meant it could pay “any conceivable liabilities now and in the foreseeable future.” Surprisingly, the Bankruptcy Code does not require voluntary debtors in chapter 11 to demonstrate or even allege insolvency. Does the Bankruptcy Power in the U.S. Constitution require debtors to be insolvent, and if so, what type of insolvent: cashflow, balance-sheet, or having unreasonably small assets?
An age of refinancing transactions and liability-management exercises has forced the issue. Restructuring attorneys across the country have used Texas’s divisional merger statute to create entities synthetically designed for bankruptcy, loaded up with debt and armed with funding commitments from their corporate parents. But when those funding commitments are uncapped or overly generous, debtors have arrived in bankruptcy court arguably solvent in every sense of the term.
Bestwall and other cases are deepening a circuit split over bankruptcy’s most important outer limit: insolvency. Unless Congress pulls back from the brink, the question whether the Bankruptcy Power carries an insolvency limit seems destined for the Supreme Court. If the Court takes up the question, it would be arguably the most important bankruptcy case since the Court approved of the business reorganization in 1935.
This Article tackles the Bestwall problem head-on, and it does so through an exhaustive investigation of insolvency provisions in American bankruptcy law, over roughly three hundred fifty years of history, from the earliest poor man’s oaths in the colonies to the 1978 Code revisions that set up the conundrum we see today.
This Article makes at least two novel contributions to the literature. First, unlike prior treatments that focus on whether the prevailing statute required insolvency or not, this Article provides a historical analysis of American bankruptcy law that focuses not only on express insolvency provisions but also on how they relate to bankruptcy procedure and remedies. Second, it proposes a framework for approaching the question of which sort of insolvency the Constitution requires, a framework that courts and attorneys need in a world of refinancings and liability management exercises.
The Bankruptcy Power requires that the debtor be either fraudulent, insolvent, or nonpaying, what this Article calls the “FIN” requirement. As for what kind of insolvency, the Article argues that cashflow insolvency is both the historic and economic touchstone of involuntary bankruptcy. Congress could not, I conclude, pass a statute under the Bankruptcy Power that allowed creditors to start involuntary proceedings against any debtor that was balance-sheet or USA insolvent. However, Congress may allow debtors that are balance-sheet or USA insolvent to file for bankruptcy on a voluntary basis, using much the same logic that allows contract parties to repudiate their obligations in anticipation of breach or that allows parties to seek a declaratory judgment in anticipation of being sued.
Summary
Professor Christopher Hampson’s The Bankruptcy Power and the Meaning of Insolvency starts with a very big corporate bankruptcy question but ends up raising equally important questions for consumer bankruptcy.
The immediate target is Bestwall, the Western District of North Carolina asbestos bankruptcy arising from Georgia-Pacific’s Texas Two-Step. Bestwall was saddled with asbestos liabilities but simultaneously given an uncapped funding agreement under which Georgia-Pacific would provide whatever money Bestwall needed. The bankruptcy court found that Bestwall appeared capable of paying “any conceivable liabilities now and in the foreseeable future,” yet declined to dismiss the case simply because Bestwall was solvent.
That produces Hampson’s central constitutional question: Can Congress authorize bankruptcy for a debtor that is not actually insolvent?
The Bankruptcy Code itself largely ducks that question. A voluntary debtor does not generally have to plead or prove insolvency when the petition is filed. And “insolvency” is hardly one thing anyway. Hampson identifies three historically important concepts:
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Cashflow or equitable insolvency: inability to pay debts as they become due;
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Balance-sheet insolvency: liabilities exceeding assets at a fair valuation; and
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Unreasonably Small Assets (“USA”) insolvency: insufficient capital or assets to continue operating, even though the debtor may still technically be paying bills and have assets exceeding liabilities.
Much of the Article is then a fascinating 350-year history of how American bankruptcy law has moved among those concepts.
Cashflow insolvency came first. The Bankruptcy Act of 1841 permitted voluntary bankruptcies but required individual debtors to swear that they were “unable to meet their debts and engagements.” That made inability to pay—not a calculation of assets versus liabilities—the initial gateway to voluntary bankruptcy.
Balance-sheet insolvency arrived later and, importantly, partly to protect debtors. Farmers and others could have substantial assets yet temporarily lack cash to pay debts as they matured. Congress did not want creditors forcing otherwise viable debtors into bankruptcy merely because of a temporary shortage of liquidity.
The rise of railroad and corporate reorganizations complicated matters further. Eventually, Congress and the courts moved insolvency tests from one context to another, while the 1978 Bankruptcy Code largely removed any insolvency requirement at the front door of a voluntary case. Section 301 essentially says that an eligible debtor starts a voluntary case by filing a petition. Insolvency is not separately required.
But Congress did not entirely abandon concerns about debtors who supposedly could pay. Instead of closing the front door, Congress increasingly restricted the relief available after the debtor entered bankruptcy.
Hampson identifies three especially important consumer examples: student loans, the means test, and limitations on unlimited exemptions.
The FIN Test
Hampson’s proposed constitutional boundary is what he calls the FIN requirement: bankruptcy must concern a debtor who is Fraudulent, Insolvent, or Nonpaying.
Those alternatives are disjunctive. A debtor need not necessarily satisfy every conventional definition of insolvency. Bankruptcy historically dealt not merely with debtors whose liabilities exceeded assets but also with debtors who stopped paying or engaged in conduct harmful to creditors.
For involuntary bankruptcy, however, Hampson argues that cashflow insolvency is the constitutional touchstone. A creditor should not be able to force a debtor into bankruptcy merely because an appraisal suggests liabilities exceed assets if the debtor is continuing to pay every obligation when due.
That distinction has considerable practical appeal. Cashflow insolvency creates the classic bankruptcy problems: the race to the courthouse, preferential payments, increasingly desperate borrowing, liquidation of productive assets, and creditors dismembering the debtor before there is anything left to reorganize. Hampson argues that those concerns are much weaker where a debtor is merely balance-sheet insolvent but continues making payments.
Voluntary bankruptcy is different. Hampson would permit debtors to file before actually defaulting if they are balance-sheet insolvent or have unreasonably small assets. His analogy is anticipatory repudiation or declaratory judgment practice: the law should not require a debtor to deliberately stop paying creditors before allowing the debtor to address a financial collapse that is already reasonably apparent.
That distinction between involuntary and voluntary bankruptcy is particularly important for consumers.
Commentary: Consumer Debtors Are Often “Solvent” Only on Paper
The Bestwall facts make the solvency problem look like one peculiar to gigantic corporations manufacturing bankruptcy eligibility through Texas Two-Steps.
It isn't.
Consumer bankruptcy lawyers routinely represent debtors whose financial distress does not fit neatly into a balance-sheet definition of insolvency.
Start with exemptions.
Hampson expressly recognizes the problem created by state exemption laws, especially uncapped homestead exemptions. Since federal bankruptcy law generally respects state exemptions, someone in Florida or Texas can have a home worth substantially more than all of their debts and still properly file bankruptcy. Congress has restricted some exemption planning through residency requirements, the federal homestead cap for recent movers, restrictions involving fraudulent conversions of property, and other limitations, but it has never abolished the basic principle that exempt property remains protected.
And unlimited homesteads are only the most obvious example.
A consumer can be “solvent” in a balance-sheet sense because a house purchased twenty years ago has appreciated dramatically while having absolutely no realistic means of paying $80,000 of credit-card and medical debt.
The same problem exists even in states without unlimited homestead exemptions. Housing prices have increased far more quickly than many state exemption amounts. A homeowner can therefore be house-rich and cash-poor, with substantial equity on paper but no ability to borrow against that equity—or no ability to afford the resulting mortgage payment even if a lender were willing to make the loan.
That homeowner is not experiencing imaginary financial distress merely because Zillow says the house is worth $500,000.
Retirement Accounts Complicate “Solvency” Even More
Retirement accounts make a simple asset-minus-liabilities test even less useful for consumer debtors.
A debtor approaching retirement may have hundreds of thousands of dollars in a 401(k). That account can be relevant in some insolvency calculations even though a qualified retirement plan is ordinarily excluded from the bankruptcy estate and is generally beyond the reach of ordinary judgment creditors.
Calling such a person “solvent” because she could hypothetically destroy her retirement security to pay today's credit-card debt misses much of what bankruptcy exemption law has always been designed to accomplish.
The historical connection is important.
Hampson traces exemption concepts all the way back to ancient procedures in which debtors surrendered assets but retained a minimum amount of personal property. Bankruptcy has therefore never simply meant gathering every conceivable resource a debtor possesses and handing it to creditors.
That remains true today.
The point of exemption law is that society has decided some assets are not the appropriate measure of a debtor's ability to pay creditors.
Once that principle is accepted, balance-sheet solvency becomes an especially shaky constitutional gateway for consumer bankruptcy.
Chapter 13 Makes the Problem Even Clearer
Chapter 13 further complicates any simplistic idea that a person who is “solvent” does not need bankruptcy.
Many Chapter 13 debtors pay little or nothing to general unsecured creditors.
But others file precisely because they do have assets worth protecting.
A debtor with substantial nonexempt home equity may be required by the § 1325(a)(4) liquidation test to pay unsecured creditors considerably more than another debtor with identical income and debts. That does not mean the homeowner has no financial distress. It means Chapter 13 permits the debtor to preserve property while paying creditors at least what Chapter 7 liquidation would have produced.
And plenty of Chapter 13 debtors are “solvent” when viewed through one lens and hopelessly insolvent through another.
A debtor might have:
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$250,000 of equity in a house;
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$400,000 in a protected 401(k);
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$80,000 of unsecured debt;
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a mortgage that is $25,000 delinquent; and
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barely enough monthly income to meet present living expenses.
On a crude balance sheet, that debtor looks wealthy.
At the kitchen table, she may be weeks away from foreclosure.
That is exactly why cashflow insolvency is such an important concept for consumer bankruptcy.
Congress Already Regulates the “Can-Pay” Debtor—Just Not Through Insolvency
One particularly useful part of Hampson’s history is his demonstration that Congress has repeatedly worried about people receiving bankruptcy relief when lawmakers believed they could afford to pay their debts.
But Congress generally has not responded by requiring those consumers to prove insolvency at the courthouse door.
It instead limits what relief they can receive.
The student-loan provisions are an obvious example. Hampson uses the hypothetical recent professional graduate who has enormous educational debt but enough current income to service it. Such a debtor might be balance-sheet insolvent but cashflow solvent. Congress initially required five years of repayment before student loans were freely dischargeable, expanded that to seven years, then eliminated the time limit in 1998 and left “undue hardship” as the principal route to discharge.
Whether those restrictions ever made good policy is another matter. Hampson notes that evidence of widespread abuse by newly minted doctors and lawyers was thin.
But the structural point matters: Congress addressed its concern by limiting dischargeability rather than declaring those borrowers constitutionally ineligible for bankruptcy.
BAPCPA did much the same thing.
Congress feared that higher-income consumers were using Chapter 7 when they could repay some debt through Chapter 13. The resulting means test is complicated, clumsy, and often bears only a loose relationship to a debtor’s actual ability to pay. But Congress again did not impose a universal insolvency test. It restricted access to a particular form of relief and attempted to channel certain debtors toward repayment plans.
That history strongly supports one of the Article’s broader insights: the question “Can this debtor file bankruptcy?” is different from “What relief should this debtor receive once there?”
Consumer bankruptcy policy has increasingly answered the second question rather than the first.
“Solvent” Does Not Mean Financially Healthy
That distinction becomes especially important as household balance sheets change.
Home values have dramatically increased. Retirement balances grow as workers age. Neither necessarily produces spendable income.
The result is a growing population of consumers who may be technically solvent under one definition while plainly experiencing financial distress.
An older homeowner with a paid-off or nearly paid-off house may have considerable net worth but insufficient Social Security and retirement income to service credit cards.
A middle-aged worker may have a substantial 401(k) but face garnishment of wages needed for current housing and food.
A Chapter 13 debtor may have substantial home equity but need the automatic stay and a five-year cure to avoid foreclosure.
Those cases are not abuses of bankruptcy. They are among the reasons bankruptcy exists.
Indeed, Hampson’s history suggests that American bankruptcy law has repeatedly changed its definition of insolvency because different definitions answer different questions.
Balance-sheet insolvency can be useful for fraudulent-transfer law and determining whether creditors are sharing a limited pool.
Cashflow insolvency better identifies the debtor whose immediate inability to pay is producing the collective-action problems bankruptcy solves.
“Unreasonably small assets” can identify financial failure before the actual missed payment.
There is no obvious reason to force all three concepts into one universal consumer eligibility rule.
A Caution About the FIN Test for Consumers
I therefore largely agree with Hampson’s distinction between voluntary and involuntary bankruptcy, but consumer cases demonstrate why the outer constitutional limit should remain a very distant one.
Hampson would exclude a debtor who is cashflow solvent, balance-sheet solvent, adequately capitalized, paying creditors, and neither fraudulent nor otherwise within the FIN categories. He describes the question partly as one of bankruptcy “ripeness”: financial distress must be sufficiently real and immediate to justify bankruptcy jurisdiction.
That seems a far better approach than demanding balance-sheet insolvency.
But courts should be extremely cautious before turning FIN into another judicially created consumer-bankruptcy morality test.
We already have plenty of those.
“Good faith,” “abuse,” the means test, projected disposable income, the liquidation test, exemption limitations, discharge exceptions, and numerous specific Code provisions all police what consumers may accomplish in bankruptcy.
A free-floating constitutional insolvency doctrine could easily become another vehicle for deciding that a debtor who has accumulated too much home equity, saved too much for retirement, earns too much money, or has not yet missed enough payments is somehow undeserving of bankruptcy.
That would turn Hampson’s historical inquiry on its head.
One of the most interesting lessons of the Article is that insolvency rules repeatedly developed not merely to protect creditors from debtors, but also to protect debtors from creditors.
Balance-sheet insolvency entered the federal bankruptcy story partly because farmers and others might temporarily be unable to pay debts despite owning more than they owed. Congress did not want those debtors destroyed by involuntary proceedings merely because they had a liquidity problem.
That history should matter just as much in modern consumer cases.
History Matters Here
Apart from the constitutional argument, this Article is an excellent addition to the growing literature on the history of American bankruptcy.
Hampson discusses the foundational histories—Charles Warren’s Bankruptcy in United States History, David Skeel’s Debt’s Dominion, Bruce Mann’s Republic of Debtors, Edward Balleisen’s Navigating Failure, and more recent scholarship from Stephen Lubben, Rafael Pardo, Louis Hyman, Emily Zackin and Chloe Thurston, among others.
What Hampson adds is a somewhat different organizing principle.
Rather than asking simply what bankruptcy law permitted at a particular point in American history, he follows what insolvency meant, who had to prove it, when they had to prove it, and what remedy followed from that finding.
That turns out to illuminate a great deal of bankruptcy history.
Cashflow insolvency, balance-sheet insolvency, and unreasonably small assets did not merely replace one another as better accounting terminology developed. They arose in different procedural settings to solve different problems.
That history gives considerably more depth to the modern debate over Bestwall, LTL, Texas Two-Steps, and mass-tort bankruptcies.
But it also gives consumer lawyers a useful reminder:
Bankruptcy has never been only for people whose liabilities happen to exceed the appraised value of everything they own.
The Consumer Bankruptcy Takeaway
The most useful implication of Hampson’s Article for consumer lawyers may therefore be this:
Financial distress and balance-sheet insolvency are not synonyms.
A debtor can own a valuable house and still be unable to pay creditors.
A debtor can have a large retirement account that creditors cannot reach and still need bankruptcy.
A debtor can have enough income to make some payments but still need Chapter 13 to stop foreclosure, restructure secured debt, cure arrears, or resolve overwhelming unsecured obligations.
And a debtor should not necessarily have to wait until the sheriff arrives, the garnishment begins, the car is repossessed, or the foreclosure sale is scheduled before bankruptcy becomes constitutionally permissible.
Hampson’s proposed distinction between involuntary and voluntary bankruptcy recognizes that reality. Creditors should not be able to drag a paying debtor into bankruptcy simply because somebody's valuation model says liabilities exceed assets. But neither should an individual debtor be required to deliberately default before seeking a collective solution to financial distress that is already apparent.
The corporate cases may ultimately force the Supreme Court to determine whether the Constitution itself imposes an insolvency boundary on the Bankruptcy Power.
If it does, the Justices should remember that the rule they announce will not remain confined to Texas Two-Steps, asbestos liabilities, or billion-dollar corporations.
It will eventually reach the homeowner whose house appreciated faster than the exemption statute, the worker who responsibly accumulated retirement savings, the family trying to cure a mortgage in Chapter 13, and the debtor whose balance sheet says “solvent” while the checking account says otherwise.
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