Restructuring

Contributed by Sara Coelho
Last Thursday, we wrote about Louisville Joint Sock Land Bank v. Radford, a case where the Supreme Court voided the Frazier Lemke act, a depression-era bankruptcy law that allowed certain agricultural debtors to restructure their secured debt through deferred payments on statutorily prescribed terms.  The Court found that the law so impinged security interests that it was a taking of private property, in violation of the Fifth Amendment.  The decision was rendered in difficult times, however, and the Court’s holding was tested immediately.  Three months after the Court’s ruling in Radford, Congress passed a modified version of the law, and lower courts split on its constitutionality.  Almost two years after the ruling, in Wright v. Vinton Branch of the Mountain Trust Bank of Roanoke, the Court considered a challenge brought by a mortgagee to the revised law in which the mortgagee asserted that the new law deprived the mortgagee of its property without due process.  This time, however, the Court upheld the statute.  What changed?  And what does this say about the ability of Congress to pass bankruptcy laws that affect the rights of security interest holders?
In assessing the constitutionality of the revised Frasier Lemke act, the Court considered whether the law remedied the taking of the “five substantive rights in specific property” on which it had focused most in Radford, including:

The Court framed Radford as holding only that the first Frazier Lemke’s cumulative effect on these rights effected a deprivation of property, allowing room for Congress to permissibly affect some or all of these rights through its enactment of the later statute.  Indeed, the Court found that the framers of the new Frazier Lemke act “sought to preserve to the mortgagee all of these rights so far as essential to the enjoyment of his security” and assessed how changes to the law remedied the impermissible infringements on the five enumerated rights. 
The Court found that three of the enumerated rights were “adequately preserved” by the revised act.  First, the statute expressly provided that the mortgagee’s lien would be preserved (the first right).  It was unclear why the Court ever thought that the earlier Frazier Lemke law allowed a lien to be compromised before payment, but one explanation is that the Court may have thought that release of the lien at the end of a procedure where the secured creditor might receive less than the full value of its debt was improper.  This theory is a promising one, as, in Wright, the Court discussed, with approval, some legislative history where Congress considered and rejected limiting the lien value to an appraisal value.  Similarly, the new statute expressly provided for the right to realize on the security through judicial public sale (the second right) by requiring such a sale if requested by the mortgagee.  Finally, the Court found that, while the act didn’t expressly give the mortgagee a right to bid at public sale (the fourth right), legislative history indicated that Congress believed secured creditors would have this right under the revised statute. 
There was contention over whether a three-year stay imposed by the revised act improperly impaired the secured creditor’s right to determine when a judicial public sale would be held, subject only to discretion of the court (the third right).  The Court found, however, that the stay was not “absolute” and that the court could terminate it earlier and order a sale of the mortgaged property.  Moreover, the debtor would be required to make rental payments to the secured creditor, and, if necessary to protect creditors from loss by the estate or to conserve security, might also be ordered by the court to make principal payments during the period of the stay.  The court could lift the stay at any time and order the property sold if these obligations were violated or if “at any time” the debtor was “unable to refinance himself within three years,” which the Court interpreted to mean that the stay would lift if there was no reasonable hope of rehabilitation by the end of the three year stay.  Finally, a bankruptcy court could shorten the three-year stay if it found that the national emergency that motivated the act had passed in the court’s locality. 
Under this analysis of the stay, providing an insolvency court with discretionary powers to condition or limit a stay, providing for protection of the secured creditor’s interest during the tenure of the stay and limiting the application of the stay where rehabilitation is unrealistic was sufficient to vindicate the secured creditor’s right to control the timing of a judicial sale, and these are all features of the contemporary bankruptcy system.  Just as the Court did not specify which combination of rights of secured creditors must be maintained under bankruptcy law to avoid a Constitutional defect, the Court did not opine on how robust any of these protections for secured creditors must be.
The mortgagee argued that the substantial delays the new statute imposed on its ability to exercise its rights supported a finding that the statute, even as revised, was unconstitutional and that the limitations imposed by the second Frazier Lemke act went beyond a permissible modification of a remedy.  The Court re-framed the inquiry into one of whether “the legislation modifies the secured creditor’s rights, remedial or substantive, to such an extent as to deny due process of law guaranteed by the Fifth Amendment.”  The Court gave no explanation for why it abandoned inquiry into whether property rights were taken by the statute, as in Radford, and instead asked whether those rights are taken without due process of law, a separate Fifth Amendment requirement.  After pointing to previously accepted impairments of secured creditor rights as a result of marshaling, selling property free of liens (with liens to attach to the sale proceeds) and enjoining sales of collateral where the sale would hinder a reorganization, the Court held that Congress may enjoin similar actions by a mortgagee “which would defeat the purpose of [a portion of the Frazier Lemke act] to effect rehabilitation of the farmer mortgagor.” 
The Court dispatched with the fifth (and final) right, the right control the property, subject to judicial discretion and to have the rents and profits collected by a receiver for the satisfaction of the debt.  Regarding a secured creditor’s right to control the property, the Court found the justification for that argument – a belief that possession by the debtor is less favorable to creditors than possession by a receiver or trustee – to be false.  The debtor, the Court stated, is familiar with the property and incentivized to “exert himself to the uttermost” to preserve ownership and is therefore more likely to serve the interests of all parties than a “disinterested receiver or trustee.  Perhaps these concerns were particularly salient with respect to farm properties during the Great Depression.  There might have been only a limited number of receivers to go around at the time, and, to the extent they were less effective at running farms than farmers, there could be disruptions to food production.
Regarding the second part of the final Radford right – the right to have rents and profits collected by the receiver for the satisfaction of debt – the mortgagee argued that a year was too long for the mortgagee to wait the first rental payment.  The Court made a point of not ruling on whether a year was too long, interpreted some clumsy language in the statute to require the first payment to occur within six months, and held that a statute prescribing this amount of time could not be “deemed arbitrary or unreasonable.”  The Court did not provide any further guidance on how it viewed necessary compensation for secured creditors during periods of default when the creditors would be stayed from exercising remedies against property.  It is also unclear whether the Court was more lenient as a result of the ability of the lower court to impose periodic principal payments as well.
Finally, the mortgagee also challenged the constitutionality of a part of the statute that required rental payments to be applied first to payment of taxes and keeping the property in repair, arguing that these payments benefitted only the debtor, who might exercise the “option to purchase” (or in modern thinking, retain) the property.  The Court dismissed the argument because the payments were consistent with common practice in foreclosure proceedings where property was held by a receiver and because the debtor would be presumed to take the property only after paying for its full value, given the secured creditor’s options under the statute to request reappraisal or a public sale where it could bid.
What can we take from this analysis about the Constitutional limits of Congress’s authority to affect property rights through bankruptcy law?  First, the Court abandoned the takings analysis in assessing the statute, instead framing the question as whether the statute violated due process of law, without commenting on why, and without telling us that Wright over-rules Radford.  In fact, the Court subsequently has cited Radford in a contemporary takings case, indicating that Radford still has some application.  While it appears that the Court hasn’t been willing to abandon Radford, the Court may be hesitant to apply it to defeat Congress’s exercise of its Constitutional power to promulgate bankruptcy law, particularly where Congress has built protections for the interests of secured creditors into the law.   The Court didn’t say this in Wright, but it’s also possible that the Court didn’t pursue the takings analysis because the revised statute was not aimed solely at existing debts.
Second, the Court’s insistence that the statute be evaluated as a whole and its numerous statements about how particular creditor rights were protected leaves open the possibility for Congress to modify secured creditor rights through insolvency law and to create many different bankruptcy regimes.  Use of traditional mechanisms, such as adequate protection, court supervision and procedures that ensure fair property valuations can sufficiently protect the property rights of secured creditors, but precisely what is required remains subject to further definition.