Restructuring

Contributed by Sara Coelho
During the Great Depression, much like in our own times, policy makers struggled with the problem of how to relieve businesses and individuals from the ongoing burden of excessive debt without trampling the interests of creditors.  One depression-era bankruptcy law, the Frazier-Lemke Act of 1934, attempted to address this problem by adding provisions to the Bankruptcy Act that enabled certain agricultural debtors to repurchase their mortgaged agricultural properties at appraised values through deferred payments on statutorily prescribed terms.  The law applied only to existing debts, and its purpose was to slim down the indebtedness of borrowers while preserving their ownership and use of certain mortgaged properties.  It didn’t last long.  In 1935, in Louisville Joint Sock Land Bank v. Radford, the Supreme Court struck the law down as a taking of private property without just compensation, in violation of the Fifth Amendment of the Constitution.  Two years later, however, in Wright v. Vinton Branch of the Mountain Trust Bank of Roanoke, the Court upheld a modified version of the bill, not long after Franklin Delano Roosevelt spearheaded legislation to expand the size of a Supreme Court that was striking down New Deal reforms.  Both opinions give insight into what rights are viewed as fundamental to holders of security interests in our system and the Constitutional limits of Congressional authority to affect these rights through bankruptcy law.  This entry considers Radford, and an entry next Thursday will consider Wright.
The Frazier-Lemke Act provided two new mechanisms for restructuring secured debt: a consensual purchase of the mortgaged property by the debtor-borrower at an appraised value, and a non-consensual, deferred purchase after five years, also at an appraised value.  The consensual path involved an immediate purchase, where the debtor would acquire title and possession, but would make deferred payments according to a statutorily prescribed schedule of payments over six years, together with interest at a rate of 1% per annum.  Justice Brandeis, delivering the Court’s opinion, calculated, however, that the present value of all the payments prescribed by statute was just 76.6% of the appraisal value.  Brandeis also objected to the lender being deprived of the “ordinary fruits of an immediate sale on deferred payments” because there would be no down payment and to the lack of protections against waste of the mortgaged property during the deferral period.
If the lender didn’t consent, the alternative path allowed for the debtor to require that the bankruptcy court stay all proceedings for a period of five years, while leaving the debtor in possession of the mortgaged property, subject to payment by the debtor of reasonable annual rent.  At any time during or at the end of the five year period, the debtor could purchase the property at its appraisal value.  Brandeis complained that, subject to limited instances where there was waste or failure to pay rent, the debtor’s purchase option was not subject to termination by the bankruptcy court, leaving the mortgagee at risk of diminished property values and missed opportunities for sale.
Brandeis considered carefully the nature of security interests as property rights, including their historical roots, previously accepted practices for restructuring them through compositions and sales free and clear of liens and the particular rights under Kentucky state law granted to holders of security interests exercising remedies against their collateral.  He found that the forced sales provided for in the Frazier-Lemke Act altered the substantive property rights of security interest holders, emphasizing the following effects in particular:

 
As a result of its infringements on these property rights of security interest holders, Brandeis found the Frazier-Lemke Act void as a taking of private property (i.e., of certain of the mortgagee’s rights to its security) without just compensation, in violation of the Fifth Amendment.  He held, “[i]f the public interest requires and permits, the taking of property of individual mortgagees in order to relieve the necessities of individual mortgagors, resort must be had to proceedings by eminent domain, so that, through taxation, the burden of the relief afforded in the public interest may be borne by the public.”
The holding is a significant limitation on the federal government’s ability to impose systemic reforms in the bankruptcy system as they relate to property interests, but it also left considerable room for Congress to legislate prospectively.  Brandeis specified that the Court had “no occasion to decide . . . whether the bankruptcy clause confers upon Congress generally the power to abridge the mortgagee’s rights in specific property” and said that the “power over property pledged as security after the date of the Act may be greater than the property pledged before . . . .”  It was because the Act was retroactive that the Fifth Amendment was implicated.
In fact, in discussing the scope of Congress’s power under the bankruptcy clause, Brandeis refused to circumscribe that power through historical practice, even though he relied heavily on historical practice to establish the substantive nature of a security interest and even though the mortgagee in the case argued that, if Congress were allowed to effect a “fundamental change” in the “relative rights of mortgagor and mortgagee” to collateral, Congress could legislate extensively in areas where regulation is reserved by the Constitution to the states.  Yet Brandeis declined to limit the bankruptcy power to its historical manifestations, saying “the scope of the bankruptcy power conferred upon Congress is not necessarily limited to that which has been exercised.”  Therefore, while the Court was unwilling to define the limits of prospective laws to re-order security interests, its holding restricts the government’s power to legislate in a manner that affects existing and fundamental private property rights.
Congress did not accept this decision as the last word, however.  It adapted the Frazier Lemke Act to accommodate some of Brandeis’s complaints, and a subsequent challenge to the new act made its way back to Brandeis’s desk, where the act was upheld in 1937.  What could Congress possibly do to overcome such a drastic holding (aside from making a credible threat to pack the Court)?  Wright contains the explanation given by the Court, and we’ll consider it next week.