Extension of family farmer bankruptcy provisions : hearing before the Subcommittee on Economic and Commercial Law of the Committee on the Judiciary, House of Representatives, One Hundred Third Congress, first session on H.R. 416 ... March 10, 1993 online

there are features of borrower's rights and creditor's rights and all
sorts of other chapters that you deal with with any lending situa-
tion. All we're asking for is some changes in the structures of chap-
ter 12 to make it more equitable in general. And I think the other
comment I would make on the delays which Congressman Synar
has tried to deal with is the delay situation is not good for any
party.



22

I mean, that's not necessarily good for the borrowers because it
leaves them uncertain as to what's going on, the amendment
change is constantly changing. From the lender's standpoint you go
into years of litigation, attorney costs. A situation I had a lender
bring to my attention talked of 5 years and ultimately the loser on
that particular situation was the borrower because the final plan
was thrown out, which was bad enough for the borrower, but all
the costs accruing over that timeframe came back to that borrower
as a cost. So it was an absolutely poor situation for everyone in-
volved. I think the delay situation is one that I'm really pleased to
see being dealt with.

Mr. Fish. Thank you very much.

Mr. Brooks. You know that the current chapter 12 debt limit is
$1.5 million. Has the limitation operated in practice and how has
it operated? Do you think it should be raised or should it be low-
ered?

You're all going to have the same answers, I bet.

OK Mr. Underwood.

Mr. Underwood. Sir, I believe that the debt limitation needs to
be raised. And again, I state that because of the Coleman v. Block
years — and I've run into several cases where the only reason the
debtor could not qualify for chapter 12 was due to interest that had
accrued because neither party could do anything during that
nonnegotiation period, during those years where the FMHA was
enjoined from going forward.

So, I believe the debt limitation should be raised.

Mr. Brooks. What do you say, Mr. Plagge?

Mr. Plagge. My only comment on that is obviously in the ag sec-
tor, the operations are getting larger and larger, so the debt
changes can change dramatically. I guess I have no particular com-
ment on the overall debt level. And obviously, from a lender's
standpoint, I would just as soon it stay at the $1.5 million.

Mr. Brooks. Mr. Underwood, in your judgment, what would be
the consequences of not extending chapter 12?

Mr. Underwood. Well, Mr. Chairman, we would then be forced
to going and taking these agricultural borrowers into chapter 11 or
chapter 13, and neither one fits the agricultural scenario.

We would lose a negotiating tool. And for every chapter 12 I take
into bankruptcy, I keep one or two out. We're able to settle them
outside of bankruptcy. I don't rush them in.

We would lose that tool; the ability to negotiate the terms and
conditions and stay out of bankruptcy.

Mr. Brooks. Mr. Scott, the gentleman farmer in Virginia.

Mr. Scott. Mr. Plagge, could you go over the arithmetic at the
bottom of page 6 in your statement where you say that 90 to 100
percent of asset value of the farm is lost?

Mr. Plagge. Well, just to go at it from an example standpoint,
if you filed chapter — if you had a borrower that had, say a
$200,000 debt going into chapter 12, basically the arithmetic is
that the ending result is $100,000 or so. Ninety to 100 percent of
that remaining amount is lost due to cramdown features. That's
the figures that ERS came through in the average overall cost.

And from what I understand talking to them, that the main fac-
tor of that is the cramdown feature.



23

Mr. Scott. Wait a minute. It's 50 percent.

Mr. Plagge. Well, it depends on how you— I mean, if you're left
with 100 percent, you've lost 100 percent— or, if you're left with
$100,000, your loss was $100,000. I mean, you can look at it

Mr. Scott. Well, if I had a $200,000 debt and then I ended up
with $100,000, I lost 50 percent of the value.

Mr. Plagge. Well, they're looking at it from the other— I mean,
you can go either way on it. If you look at it from the 50-percent
value on that standpoint, you'd also change the arithmetic on the
chapter 11 figures as well.

They're looking at it as a total starting point; total ending point.
In the example I gave you, it's

Mr. Scott. The starting point is $200,000. Ending point is
$100,000. That's 100 percent loss?

Mr. Plagge. In terms of the remaining amount left. I mean,
you've lost exactly what you're left with. I talked to a gentleman
before this hearing started that's involved in that study. I assume
he could comment on how the arithmetic is done. I did not do the
arithmetic on that study.

Mr. Scott. OK. Usually, when people talk about a 100-percent
loss, they think they've got nothing left.

Mr. Plagge. Right.

Mr. Scott. OK And that's not what you meant in your state-
ment?

Mr. Plagge. No.

Mr. Scott. OK I don't have any other questions.

Mr. Brooks. Mr. Plagge, just one thing, to follow up on Mr.
Scott's rather perceptive question. On page 6 of your statement,
you said that they lose the average total bankruptcy cost to the
creditor, the lender, which is 90 to 100 percent of the asset value
of the farm at the time of the bankruptcy. Did you obtain this
statement from the U.S. Department of Research in 1992?

Mr. Plagge. Yes.

Mr. Brooks. It cost them up to 90 percent?

Mr. Plagge. The study stated that in comparision to chapter 11,
which was 50 to 60 percent, chapter 12's were 90 to 100 percent.

[See appendix for material submitted for record by Mr. Plagge:
"Bankruptcy Costs Under Chapter 12," by Robert N. Collender.]

Mr. Brooks. The loss? Is the $100,000 loan the value of the farm
gross or $20,000? And it costs you 90 percent of that?

Mr. Plagge. In the cramdown features, in the fact that you've
lost the value of the original loan

Mr. Brooks. I understand. If they bring it down to $20,000 and
they bring the loan to $20,000, you say then you lose 90 percent
of the $20,000?

Mr. Plagge. I didn't do the arithmetic on the study, Mr. Chair-
man.

Mr. Brooks. Do you understand it?

Mr. Plagge. Well, I'm not sure after talking to you I do under-
stand it.

Mr. Brooks. All right. We thank you very much.

Mr. Scott. Mr. Chairman.

Mr. Brooks. Mr. Scott.



24

Mr. Scott. On that arithmetic I think they lost 400 percent of
their money.

Mr. Brooks. Yes. I want to thank our witnesses for their inform-
ative and useful testimony. The subcommittee will take into ac-
count concerns of both farmers and lenders raised by witnesses
today as we consider the need for the extension of chapter 12.

The subcommittee stands adiourned.

[Whereupon, at 11:50 a.m., the subcommittee adjourned.]



I



APPENDIX



UnK«d States
Department of
Agrtculture

Ecooomic
Research
Service

Agricutture
and Rural



Material SuBMnrED for the Hearing Record

Bankruptcy Costs
Under Chapter 12



DM^ro7 Robert N. Coilender



Bankniptqr Costs Under Chapter 12. By Robert N. CoUender. Agriculture and Rural

Economy Division, Economic Research Service, U.S. Department of Agriculture. Staff

Report No. AGES 9210.

Abstract



Chapter 12 bankruptcy, Adjustment of Debts of a Family Farmer With Regular Annual
Income, will expire on October 1, 1993, unless Congress intervenes. Chapter 12 imposes
certain economic costs, referred to as bankruptcy costs and considered deadweight losses
to the economy. The magnitude of these costs is an important element in the debate to
renew or extend Chapter 12. Based on White's model of indirect bankruptcy costs, total
bankruptcy costs under Chapter 12 may be between 90 and 100 percent of the value of
farm assets at the time of filing. This cost compares with estimates of 54 to 60 percent
for farms and other businesses filing for reorganization under Chapter 11 of the U.S.
Bankruptcy Code.



Keywords: Bankruptcy, Chapter 12, deadweight loss.



This report %vas reproduced for limited distribution to the research community
outside the U.S. Department of Agriculture and does not reflect an ofTicial
position of the Department



Washington, DC 20005-4788 September 1992

(25)



26



Contents

Page

Introduction 1

Farm Bankruptcy Alternatives 2

Previous Estimates of Direct Bankruptcy Costs 4

Estimates of Direct Costs for Farms Under Chapter 12 Bankruptcy 5

Indirect Bankruptcy Costs 6

A Model of Indirect Costs of Bankruptcy 8

Estimates of Indirect Bankruptcy Costs Under Chapter 12 11

Expected Bankruptcy Costs 15

Conclusions 16

References 17

Appendix-White's Model 19



27

Bankruptcy Costs Under Chapter 12

Robert N. Collender*

Introduction

The provisions of Chapter 12 of the U.S. bankruptcy code, as enumerated in the Family
Farmer Bankruptcy Act of 1986, are set to expire on October 1, 1993.' As debate on
renewal gets underway, the magnitude of the economic costs associated with Chapter 12
may be an important factor. These economic costs are referred to as bankruptcy costs
and are deadweight losses to the economy.

Bankruptcy costs are a measure of the efficiency effects that bankruptcy laws have on
economic activity. The magnitude of these costs is important because they represent
deadweight losses to the economy that, ideally, should be minimized. Deadweight losses
are avoidable reductions in economic well-being that arise from restraints on economic
activity such as monopoly production, excise taxation, and unnecessarily high costs of
doing business, including bankruptcy costs.

These costs include both direct and indirect costs. Direct bankruptcy costs specifically
include the legal and administrative costs of liquidation or reorganization under
bankruptcy protection. Indirect bankruptcy costs result from economic distortions
associated with bankruptcy or the threat of bankruptcy. Resource allocation is distorted
because both creditors and managers change business decisions in anticipation of
bankruptcy. Creditors attempt to reduce their losses in the event of a filing, and
managers attempt to raise the expected return to equity by increasing the firm's risk
because their downside exposure is limited. Such distortions may include the loss of sales
due to weakened assurance of delivery, the inability to make otherwise profitable
investments, and, in the case of a firm that should be liquidated, the value lost from not
reallocating resources-including human resources - to their most profitable use. The
magnitude of indirect bankruptcy costs is the difference in the value of the most
profitable use of the firm's resources and the value of the firm given distortions
associated with bankruptcy.



'Robert N. Collender is a financial economist with the Agriculture and Rural Economy Division,
Economic Research Service, U.S. Department of Agriculture. This paper has greatly benefited from the
helpful comments of many reviewers including Ralph Chite, Phil Harris, Robin Jeweller, Steven Turner,
and Nick Walraven. Any remaining errors or omissions are. of course, the responsibility of the author.

'Congress is considering legislation (S. 1985 and H. 2867) that would extend the expiration date to
October 1, 1995.

1



28



The purpose of this report, then, is twofold. First, I document the magnitude of direct
costs for farmers under Chapter 12 bankruptcy and estimate the magnitude of indirect
bankruptcy costs arising from reorganizing farms that should be liquidated. Second,
some of the marginal effects on economic efficiency of Chapter 12 compared with
Chapter 11, the most widely used alternative prior to passage of Chapter 12, are
estimated.

Farm Bankruptcy Alternatives

Farmers may file for bankruptcy under four alternative chapters of the U.S. Bankruptcy
Code. These include Chapter 7 (liquidation), and Chapters 11, 12, and 13, which allow
the debtor to reorganize a business under court protection. Table 1 summarizes some of
the important differences among the provisions of the latter three chapters. These
differences include eligibility, the definition of adequate protection, the application of the
absolute priority rule (see below), whether creditors may file a reorganization or
liquidation plan, the duration of a plan, the creation of a separate taxable estate, and the
duration of the automatic stay against lender foreclosure.

Of the differences between Chapter 12 and other bankruptcy alternatives, two particular
provisions have the greatest consequences for efficiency in that they increase the
incentive to reorganize rather than liquidate or continue farming without the intervention
of the legal system. The first change is the relaxation of the absolute priority rule, similar
to Chapter 13 bankruptcy. The second change is the relaxation of the definition of
adequate protection of secured creditors' interests.

The absolute priority rule refers to provisions in the Bankruptcy Code that determine the
order in which each claimant class is paid and the amount each claimant class receives.
Under Chapter 11, the pre-existing bankruptcy provision allowing reorganization, any
class of creditors can vote to block a reorganization plan if that class does not receive the
full value of its claims and any lower priority class receives any payment or retains any
property. Under Chapter 12, creditors do not vote on the plan and can block its
confirmation only if an individual creditor will not receive at least as much as it would
under Chapter 7 liquidation. This change allows the debtor to retain possession of farm
assets, while secured claims are written down to the current market value of the security.
The undersecured portion of each claim is then treated equally with all other unsecured
claims.

Adequate protection relates to the retention and use of collateral by a debtor during the
course of the bankruptcy case. The provisions of adequate protection are generally
applicable to Chapter 12. The one variation in Chapter 12 is that adequate protection
can be provided for real estate collateral through payments equal to market rent.
Because rental payments for agricultural assets are considerably lower than interest costs



29



Table 1 - Sunary of diffcrancM anong Chapter* 11, 12, and 13, U.S. bankrt^tcy cod*



Differences Chapter 11



Chapter 12



Chapter 13



Eligibility



No specific rule*.



Fama and ranches with total
debt less than S1.S million,
at least 80 percent of debt
fron faraing, and at least 50
percent of gross incone fron
faming.



Individuals with regular
income and ixwecured debts
of (ess than S100,000 and
secured debts of less than
X3SQ,000.



Adequate Cash payiaents to offset
protection depreciation, replacement
liens, such other relief as
will result in the creditor
realizing the indiAitable
equivalent of the interest in
the property or no payments
at all if marlcet values are
not declining.'



SaoK as Chapter 11 except for
real estate. For real estate,
adequate protection may be
provided by payment of fair
market rent.



Same as Chapter 11.



Atsolute Any class of creditors can
priority block reorganization plan if
rule it does not receive full

payment and if a lower
priority claimant receives
anything.



Not applicable.



Not applicable.



Who may Debtors, exclusively for 120
file plan days. Thereafter, creditors
â– ay file a plan for
liquidation.



Debtors.



Debtors.



Creation of Separate taxable estate

separate for local. State, and Federal

taxable income tax purposes created

estate upon confirmation of plan.



Separate taxable estate
for local and State (not
Federal) tax purposes created
i^on confirmation of plan.



Same as Chapter 11.



Time limits:
Plan f i ling



120 days after petition is
filed.



Confirmation 60 days after filing plan.
Autcmatic stay Until confirmation of plan.
Plan length Unlimited.



90 days after petition is
filed.

«S days after filing plan.

Length of plan.

3 years (up to S with court
approval).



15 day* after petition is
filed.

No specific limit.

Length of plan.

3 years (up to 5 with
court approval).

In 1988, the U.S. Supreme Court ruled that adequate protection did not mwidate opportinity cost payments
under Chapter 11. The Court concluded that undersecured creditors are only entitled to protection against a
decrease in the value of their collateral, not to compensation for delay in exercising their fireclosure
rights (see United Savings Association of Texas v. Timbers of Inwood Forest Associates).



30



on their value, provisions in Chapter 12 represent a significant advantage to the debtor
relative to previous provisions.

These provisions of Chapter 12 reflect the concerns expressed in the 1986 Congressional
Conference Committee report (U.S. Congress):

Under current law, family farmers in need of financial rehabilitation may
proceed under either Chapter 11 or Chapter 13 of the Bankruptcy Code. Most
family farmers have too much debt to qualify as debtors under Chapter 13 and
are thus limited to relief under Chapter 11. Unfortunately, family farmers have
found Chapter 11 needlessly complicated, unduly time-consuming, inordinately
expensive and, in too many cases, unworkable.

Accordingly, this subtitle creates a new chapter of the Code-Chapter 12-to be
used only by family farmers. It is designed to give family farmers facing
bankruptcy a fighting chance to reorganize their debts and keep their land. It
offers family farmers the important protection from creditors that bankruptcy
provides while, at the same time, preventing abuse of the system and ensuring
that farm lenders receive a fair repayment.

This new chapter is closely modeled after existing Chapter 13. At the same
time, however, the new chapter alters those provisions that are inappropriate
for family farmers - the requirement that the plan be filed within 15 days of the
petitions; the requirement that plan payments start within 30 days of the plan
confirmation; and the low debt limits found in Chapter 13.

Under this new chapter it will be easier for family farmers to confirm a plan of
reorganization.



Previous Estimates of Direct
Banlu'uptcy Costs

Although I am not aware of any attempts to document the magnitude of bankruptcy
costs for production agriculture, several attempts have been made to do so for other
sectors of the economy. White (1983) and Altman (1984) estimated the direct costs of
financial distress for large, publicly traded firms to be small, not over 3 percent of the
market value of the firm. In a study of direct financial distress costs of 20 railroad
bankruptcies during 1930-35, Warner (1977) found that net financial distress costs were,
on average, 1 percent of the market value of the firm 7 years before bankruptcy, with the
costA'alue ratio increasing as bankruptcy approached. For example, net costs rose to 2.5
percent of the market value of the firm 3 years before bankruptcy. However, Warner
pointed out that expected costs of bankruptcy are relevant and estimated these to be well
under 1 percent of market value.

Earlier studies of bankruptcy costs focused on small firms and individuals and are
probably more relevant to the case of agriculture. Baxter (1967) cited statistics that
indicate the direct costs of personal bankruptcy range from roughly 20 percent for estates



31



over $50,000 (in 1965 dollars) to 26 percent for smaller estates. Stanley and Girth (1971)
estimated direct costs for bankruptcy proceedings (both personal and business) to be
between 25 and 30 percent, depending on the type of proceedings involved. These
statistics may exaggerate the magnitude of direct bankruptcy costs because they measure
bankruptcy costs relative to the realized value of a bankrupt estate rather than the
market value of a continuing business. At the time of liquidation, the business may have
already sold many assets and lost much value.



Estimates of Direct Costs for Farms
Under Chapter 12 Bankruptcy

Chapter 12 was designed to be less complicated and less costly for farm debtors than
Chapter 11. Table 2 compares various costs of Chapters 11, 12, and 13.



Table 2 - Costs of various types of bankruptcy



Costs



Chapter 11



Chapter 12



Chapter 13



Ft I ing fee



S500.



X200.



J90.



Trustee's

fee '2



15 percent on first SI, 000;
6 percent on amounts greater
than $1,000, but not more than
13,000; 3 percent on excess.



10 percent of anxxjnts not to
exceed t450,000; 3 percent on
excess.



10 percent.



Professional Employed by trustee. Payment
persons determined by the court based
upon reasonable terms and
conditions. (Persons etnployed
may include attorneys,
appraisers, accountants, farm
management experts.)



Same as Chapter 11.



Same as Chapter 11 .



Debtor's
attorney



Payment approved by the court
after careful scrutiny.



Same as Chapter 1 1 .



Same as Chapter 11 .



Trustee's fees are calculated upon all payments made under a plan, except to the debtor, but including
holders of secured claims. There is mjch variation among courts as to which payments are used as the t>asis
for fee calculations. Payments to trustees for salary and expenses are limited by the bankruptcy code,
with excess collections paid either to the U.S. Trustee System fund or the Treasury of the United States
depending on whether the judicial district is part of the U.S. Trustee System.



In Chapter 11 and 12 cases,
without fee.



the debtor in possession may handle most of the duties of s trustee but



32



Table 3 presents statistics on the direct costs of bankruptcy for farmers who filed under
Chapter 12 in the eastern district of North Carolina between November 26, 1986, and
November 17, 1987. These direct costs include attorneys' fees and costs, filing fees, and
trustees' fees. Filing and trustees' fees are set by law as shown in table 2; attorneys' fees
and costs are tabulated from docket sheets. Average trustees' fees of $1,905 per case
were calculated as 10 percent of expected administrative expenses, priority claims, and
payments to unsecured creditors. Payments to secured creditors were excluded from the
calculation, because they can be made outside the plan without incurring trustees' fees.
If these payments were included in the calculation of trustees' fees, then these costs
would be much larger. However, if many debtors receive court permission to make plan
payments directly or fail to actually make plan payments at all, then trustees' fees would
be lower.

My estimate of total direct costs under Chapter 12 bankruptcy comes to 2.9 percent of
the average asset value. This estimate is considerably below previous estimates of direct
bankruptcy costs for small businesses reported by Baxter, and Stanley and Girth. There
are several explanations for this finding. First, bankruptcy laws have changed
considerably since the earlier studies were published. At least one impetus for these
changes was to reduce the costs of bankruptcy. Second, the size of the estates involved
here (average size is $235,000) is larger than in previous studies even after adjusting for
inflation. Because many direct costs of bankruptcy are fairly independent of estate size,
these costs decline in relation to estate value as estate value increases. The percentage
magnitude of this estimate of direct bankruptcy costs is in line with previous estimates of
direct bankruptcy costs for larger corporations (Warner, 1977, and Miller, 1977).

Note that roughly equal direct bankruptcy costs as a percent of assets is consistent with
reducing the cost for bankruptcy for smaller businesses. Since many bankruptcy costs are
fixed regardless of asset size, the expectation is for direct bankruptcy costs to fall as a
percent of assets as asset size increases.



Indirect Bankruptcy Costs

Indirect bankruptcy costs are particularly difficuh to quantify. Altman attempts to
measure anticipated profits up to 3 years prior to bankruptcy and attributes any shortfalls
to indirect bankruptcy costs. Haugen and Senbet (1988) strongly criticized Altman's work
for failing to identify the direction of causality between falling profits and bankruptcy.
White used a simple, two-period model to derive upper bounds on costs associated with
firms that reorganize or continue in business when efficiency would dictate that they be
liquidated. Note that each of these attempts quantifies only a subset of ex ante
bankruptcy costs.

Because one focus of this report is to determine the marginal effects of Chapter 12
bankruptcy on bankruptcy costs, my approach closely follows White's. The provisions of
Chapter 12 bankruptcy give farmowners different incentives than do the other chapters
of bankruptcy. In panicular. Chapter 12 offers indirect rewards to reorganizing above