Chapter 12 Bankruptcy: Family Farm Restructuring

The following is from the Arkansas University School of Law

By Susan Schneider · May 15, 2015 · 2015 Ark. L. Notes 1686 
In categories: Administrative Law, Agricultural Law, Alternative Dispute Resolution, Bankruptcy, Business Law, Debtor/Creditor, Financial Institutions Law

This overview of Chapter 12 Bankruptcy is written to provide an introduction to the basic Chapter 12 process, highlighting some of the issues that distinguish it from other types of bankruptcy and explaining how it may be useful to family farmers and family fisherman who are experiencing financial distress. There are many complex issues that extend far beyond the scope of this short overview. For more information, attorneys should consult the Bankruptcy Code and Rules as well as the relevant case law from your jurisdiction.

I. Historical Perspectives

Chapter 12 was added to the Bankruptcy Code in 1986 during a deep financial crisis in the farm economy. It was designed to provide a special type of restructuring opportunity for “family farmers.”[1]

Chapter 13 bankruptcy was not seen as a viable option for family famers. The debt ceiling for eligibility was too low; the restrictions on reorganizing residential real estate debt did not allow for the restructuring a typical family farm mortgage debt; and, because payments had to all be scheduled during the relatively short plan term, a long-term workout was impossible.

Similarly, Chapter 11 was ill suited to a family farm operation. While Chapter 11 provides a good forum for large investor-owned corporations to work through complex financial difficulties, it is costly, cumbersome, and overwhelming for an unsophisticated small business. Moreover, the “absolute priority rule,” prohibits Chapter 11 debtors from retaining an equity interest in their farm over the objections of a dissenting class of unsecured creditors.[2] This makes Chapter 11 unworkable for most businesses with combined management and ownership, such as a family farm.

Chapter 12 was initially enacted as a temporary chapter of the Code, and it was extended numerous times, sometimes only after it had expired. Extension was not thought to be controversial, but it was a pawn in the lengthy negotiations on bankruptcy reform legislation. Chapter 12 was made permanent under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, effective July 1, 2005.[3] This Act also made several significant debtor-friendly changes to Chapter 12 that will be noted. The changes that took effect in 2005 are generally highlighted, as most of the published Chapter 12 case law is pre-2005, with cases decided under the pre-existing law.

There have never been as many Chapter 12 bankruptcy cases filed as were anticipated. There are several practical reasons for this –

1) Farmers experiencing financial distress are notorious for not seeking legal advice early enough, and by the time that they do, some may no longer have the potential for successful reorganization or the funds to pay for qualified representation.

2) Chapter 12 is a specialty within a specialty that represents an unfortunate gap in legal services. It can be viewed as either a subset of bankruptcy law or a subset of agricultural law. Bankruptcy attorneys may not see it as a large enough client pool; Agricultural law attorneys may not generally practice bankruptcy law. Moreover, its temporary status and periodic sunset periods discouraged many attorneys from developing it as a specialty. When it finally became permanent in 2005, the farm economy was doing very well and seemingly did not need a lot of Chapter 12 expertise. That is changing.

3) Perhaps the most important reason for the limited filings relates to the simplicity and certainty built into the Chapter 12 process. A pre-bankruptcy analysis can often persuasively sketch out the general terms of the ultimate Chapter 12 plan. This provides a perfect negotiation tool for the debtor and his/her creditors to reach agreement outside of bankruptcy. In reality, this may be the most important aspect of Chapter 12 – it provides a powerful tool for debtors to force creditors to the bargaining table.

II. Eligibility for Chapter 12

There are specific eligibility criteria for Chapter 12 relief. Initially, only a “family farmer” who had “regular annual income” was eligible for Chapter 12. The 2005 Bankruptcy Reform Act extended eligibility to “family fisherman” as well. [4]

For a farmer or a farm business to be eligible for Chapter 12 relief, they must meet the definition of “family farmer” that is explicitly set forth in the Code.[5] This definition includes the requirement that the debtor be “engaged in a farming operation” as well as other specific eligibility requirements. Note that family farmer and farmer are defined differently.[6]

The “family farmer” definition incorporates requirements regarding the maximum amount of debt, the percentage of debt that comes from the farming operation, and the percentage of income that comes from the farming operation. For farm businesses, family ownership and control is also required.[7] The Bankruptcy Reform Act extended eligibility, broadening these categories somewhat.

An individual or a married couple that engage in a farming operation must now meet the following specific eligibility requirements as set forth in § 101(18)(A):

• The farmer’s total amount of debt cannot be greater than $4,031,575 as of the day the case is filed. This limit increases with the Consumer Price Index every three years.[8] The original limitation was $1,500,000, and it was not indexed.
• At least fifty percent (50%) of the aggregate, non-contingent, liquidated debt must come from the farming operation.[9] Prior to 2005, eighty percent (80%) was required.
• The farmer must meet a “gross income from farming” test. More than fifty percent (50%) of the gross income for the taxable year before the bankruptcy is filed must come from the farming operation. The Bankruptcy Reform Act provided an alternative. Farmers can also meet the gross income test if more than fifty percent (50%) of their gross income in each of the second and third taxable years before the bankruptcy filing came from the farming operation.

A corporation or partnership that engages in a farming operation can also be eligible for Chapter 12 relief if it meets the following specific eligibility requirements set forth in § 101(18)(B):

• More than 50 percent of the outstanding stock or equity in the partnership or corporation must be held by one family, or by one family and the relatives of the members of that family.
• This family or their relatives must conduct the farming operation.
• More than 80 percent of the value of the assets of the corporation or partnership must be related to the farming operation.
• The debts of the corporation or partnership must not be greater than $4,031,575, with this amount increased each 3 years with the Consumer Price Index. This reflects a change, as noted with regard to the individual limitation.
• Not less than fifty percent (50%) of the corporation or partnership aggregate, non-contingent, liquidated debt must arise out of the farming operation that is owned or operated by the corporation or partnership.[10]Previously, eighty percent (80%) was required.

• If a corporation issues stock, its stock must not be not publicly traded.

Note that most aspects of the definition of “family farmer” will depend on defining some aspect of farming: farm income, farm debt, engaged in farming. There has been a considerable amount of case law on these issues, sometimes with inconsistent results between jurisdictions.[11]

The 2005 Bankruptcy Act expanded Chapter 12 to allow a “family fisherman” to be eligible for relief. A family fisherman is defined as someone “engaged in a commercial fishing operation.”[12] A commercial fishing operation is defined as “the catching or harvesting of fish, shrimp, lobsters, urchins, seaweed, shellfish, or other aquatic species or products of such species; or . . . aquaculture activities consisting of raising for market” any of these species or products.[13]

For an individual or a married couple, the definition of “family fisherman” requires that their total debt not be more than $1,868,200 and that not less than 80 percent of the aggregate, non-contingent, liquidated debt arise out of their commercial fishing operation. In addition, they must have received more than 50 percent of their gross income from their commercial fishing operation for the taxable year preceding the year in which the bankruptcy case was filed.[14]

For a corporation or partnership, more than 50 percent of the outstanding stock or equity must be held by the family and the family must conduct the commercial fishing operation. More than 80 percent of the value of the assets must be related to the commercial fishing operation. Total debts must not exceed $1,868,200 and not less than 80 percent of the aggregate, non-contingent, liquidated debt must arise out of the commercial fishing operation. If the corporation issues stock, the stock must not be publicly traded.[15]

Regardless of whether the debtor is an individual, corporation or partnership, a family farmer or a family fisherman, the debtor must have “regular annual income.” This means that there must be income that is “sufficiently stable and regular” to allow the debtor to make payments under a plan.[16] Non-farm income can be used to satisfy this requirement. There is a significant amount of case law on family farm eligibility, although there is significant variation between jurisdictions.

III. The Chapter 12 Process

Although the Chapter 12 debtor will usually continue to operate the farm as the “debtor-in-possession,” a trustee is appointed in each Chapter 12 case.[17] In addition to monitoring the bankruptcy and conducting the first meeting of creditors, his or her duties include participation in most of the hearings that will be held throughout the bankruptcy.[18]

In addition, the trustee is directed to “ensure that the debtor commences making timely payments as required by a confirmed plan.”[19] “Except as otherwise provided,” plan payments are made to the trustee for disbursement to creditors.[20] The trustee is compensated by the debtor using a percentage formula based on plan payments.[21]

The definition of “property of the estate” in Chapter 12 is different than that in Chapter 7. Section 1207 provides that property of the estate includes not only that property that the debtor had at the time of filing, but also all property acquired up until the time that the case is closed, dismissed, or converted to another chapter. It also includes “earnings from services performed by the debtor.” [22]

Within 90 days of filing the bankruptcy, the Chapter 12 debtor is required to submit a reorganization plan to the bankruptcy court.[23]Unlike in Chapter 11 reorganization, the debtor need not obtain creditors’ approval of the plan, and creditors will not have an opportunity to vote on or to otherwise reject the plan. Any “party in interest,” the trustee or the United States Trustee, however, may object to a plan proposed by the debtor.[24] A hearing will be held in which the debtor will seek court approval of the plan and defend the plan against objections.[25] Section 1225 specifically provides that the court “shall confirm a plan” if the requirements are met.[26]

Confirmation requirements are set forth with specificity in sections 1222 and 1225, and an attorney structuring a Chapter 12 reorganization plan should attend closely to these provisions. The most significant requirements are summarized as follows:

1) The plan must have been proposed in good faith, that is, the debtor must be sincere in his or her intention to reorganize the farming operation according to the plan. Chapter 12 is not to be used solely to delay the creditors from enforcing their legal rights.[27]

2) The plan must provide for each of the secured claims, with three alternative ways to modify each such claim.

• First, the secured creditor can agree to its treatment under the plan. This involves negotiation with the creditor.[28]
• Second, the plan can provide that the secured creditor receive the “present value” of its secured claim while retaining its lien on its collateral. The value of the creditor’s secured claim will most often be the debt reduced to the value of the collateral. This second alternative is the one that is used most often by Chapter 12 debtors. In general terms, it means that the creditor will be paid an amount equal to the fair market value of the collateral.[29] This amount can be paid over time, often for as long a period as would be appropriate for a new loan of that type. The creditor will be entitled receive interest payments at market rate.[30]
• The third alternative is that the plan can provide that the secured property is surrendered to the creditor in satisfaction of the secured claim. This means that the debtor can give back secured property and receive credit at a value determined by the court.[31]

3) The plan must provide that unsecured creditors be paid at least as much as they would receive if the debtor liquidated the farming operation in a Chapter 7 bankruptcy. This is often referred to as the liquidation test. In order for the debtor’s plan to be confirmed, that plan must provide the unsecured creditors with an amount that is not less than the value of the unsecured assets, less the exempt property, as of the effective date of the plan.[32]

4) In addition, if either the trustee or an unsecured creditor objects to the plan, either the plan must provide that the unsecured creditor will receive the full value of his or her claim, or the plan must provide that all of the debtor’s projected disposable income will be applied to make payments.[33] This requirement is referred to as the disposable income requirement. Disposable income is defined as income that is “not reasonably necessary for the maintenance or support of the debtor” and dependents and for the “continuation preservation, and operation” of the farm.[34] An area of controversy has been determining what is necessary for continuation of the farming operation.

Although this requirement has always referenced “projected disposable income,” early Chapter 12 decisions, particularly in the 8th Circuit, interpreted it to mean “actual disposable income.” Under this interpretation, at the end of the plan term, the debtor was required to go back and provide a complete accounting, paying any amount of income that exceeded expenses before the discharge could be granted.[35]

The Bankruptcy Reform Act amended the law to reject this interpretation. Debtors should affirmatively establish “projected disposable income” as part of the plan confirmation process. Obligations under the plan can now only be increased under specific plan modification provisions in §1229.[36]

5) The plan must provide for the payment of the trustee for his or her services.[37] This payment may be up to 10% of the total of all of the other payments under the plan.[38] Some courts, however, have allowed debtors to make some payments directly to their creditors and to avoid the trustee’s fee on those payments; other courts have rejected this approach.[39]

6) The debtor must be able to show the court that the plan is feasible, that is, that he or she can afford to make all of the payments that are required under the plan.[40] This is likely to require carefully prepared cash flow projections for the full term of the plan and may require the debtor to testify at the confirmation hearing. Non-farm income can be used to make plan payments and can be used to show feasibility.

In practical terms, in many cases, Chapter 12 allows the debtor to alter the secured debt by reducing the amount owed to the fair market value of the property, reducing the interest rate to the current market rate interest and/or extending the payment period on the debt. Subject to the liquidation and disposable income tests, the debtor may be allowed to pay only a small portion of the unsecured debt.

If the debtor is unable to propose a plan that the court will confirm, the case may be dismissed. The debtor has an absolute right to request the dismissal of the case, although some courts have restricted this right if fraud is shown, allowing the case to instead be converted to Chapter 7.[41]

The bankruptcy court’s initial involvement in a Chapter 12 case may last several months, up until the court confirms the plan. The terms of the plan and the involvement of the trustee will last from three to five years.[42] At the end of the plan term, provided that the debtor has complied with all aspects of the plan, the unsecured debt will be discharged and the trustee will be dismissed.[43] The debtor will make any remaining scheduled payments to the secured creditors directly.[44]

Post confirmation, the debtor, the trustee, or an allowed unsecured claimholder can petition the court to modify the terms of the plan. Plan modification may be appropriate when circumstances beyond the debtor’s control cause a problem with plan compliance. Conversely, the trustee or an unsecured creditor may seek to modify the plan to recover additional amounts from the debtor if circumstances change significantly. The bankruptcy reform law places limits on plan modification that is brought to increase the debtor’s responsibility and attempts to protect the viability of the post-plan farming operation.[45]

IV. Conclusion

Many of the issues that arise in other bankruptcies will also be part of a Chapter 12 case – exemption planning, lien avoidance, objections to discharge, determining pre-petition/post-petition debt, preferences, property of the estate, use of cash collateral, to name but a few. However, Chapter 12 bankruptcy grants unique powers to the debtor to restructure and reduce secured debt and to reduce and perhaps eliminate unsecured debt. And, it is set up as a relatively straightforward and efficient process. It provides a powerful tool for family farmers and family fisherman to use when confronting financial distress. As they confront the challenges of a global market and production risks associated with climate change, attorneys should be prepared to assist.

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Notes

[1] Bankruptcy Judges, United States Trustees and Family Farmer Bankruptcy Act of 1986, Pub. L. No. 99-554, tit. II, § 255, 100 Stat. 3105-3113 (1986) (codified at 11 U.S.C. §§ 1201 – 1231).

[2] See, Norwest Bank v. Ahlers, 485 U.S. 197, 108 S. Ct. 963, 99 L. Ed. 2d 169 (1988) (rejecting a creative, pre-Chapter 12 attempt to adapt Chapter 11 to a family farm setting).

[3] The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23 (codified in scattered sections of 11 U.S.C.) (hereinafter, 2005 Bankruptcy Reform Act).

[4]   11 U.S.C. § 109(f).

[5]   11 U.S.C. § 101(18).

[6]   11 U.S.C. §§ 101(18), (20).

[7]   11 U.S.C. § 101(18).

[8]   11 U.SC. § 104(b)(2).

[9]   This applies to “aggregate, non-contingent, liquidated debts . . . on the day the case is filed.” There is a possible exclusion for the debt associated with a principal residence, unless the debt arises out of the farming operation. This can be a critical issue. See, First National Bank Of Durango v. Woods (In re Woods), 743 F.3d 689 (10th Cir. 2014) (holding that the debt on the residence did not arise out of the farming operation, resulting in the debtors’ ineligibility).

[10]   There is also an exclusion for a residence, raising similar issues as the individual requirements. See 11 U.S.C. § 101(18)(B)(ii).

[11]   For an extensive listing of many of the cases decided under Chapter 12, issue-by-issue, consult the chapter on farm bankruptcy contained in the Consumer Bankruptcy Guide published by the National Consumer Law Center, https://library.nclc.org/bookstore.

[12]   11 U.S.C. § 101(19A).

[13]   11 U.S.C. § 101(7A). Note that some aquaculture activities such as catfish farms were considered “family farms” under the general eligibility standards prior to the Bankruptcy Reform Act.

[14]   11 U.S.C. § 101(19A)(A).

[15]   11 U.S.C. § 101(19A)(B).

[16]   11 U.S.C. §§ 101(19), (19B).

[17]   See 11 U.S.C. §§ 1203, 1204, 1207.

[18]   11 U.S.C. § 1202.

[19]   Id.

[20]   11 U.S.C. § 1226(c).

[21]   28 U.S.C. §586(e).

[22]   11 U.S.C. § 1207.

[23]   11 U.S.C. § 1221. It is sometimes possible to get an extension of time, provided that the request is made during the 90-day period.

[24]   11 U.S.C. § 1224.

[25]   11 U.S.C. §§ 1224, 1225.

[26]   11 U.S.C. § 1225(a).

[27]   11 U.S.C. § 1225(a)(3).

[28]   11 U.S.C. § 1225(a)(5)(A).

[29]   The value of the secured claim will generally be determined under 11 U.S.C. § 506(a)(1). Note that setoff claims may enhance the value of the creditor’s secured claim. Id., see also, 11 U.S.C. § 553.

[30]   11 U.S.C. § 1225(a)(5)(B). Note that the U.S. Supreme Court has provided guidance on market rate of interest. Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951, 158 L.Ed.2d 787 (2004).

[31]   11 U.S.C. § 1225(a)(5)(C).

[32]   11 U.S.C. § 1225(a)(4).

[33]   11 U.S.C. § 1225(b)(1).

[34]   11 U.S.C. § 1225(b)(2).

[35]   See, e.g., Rowley v. Yarnall, 22 F.3d 190 (8th Cir. 1994).

[36] 11 U.S.C. §§ 1225(b), 1229. For a discussion of this issue and the change in the law, see Susan A. Schneider,

Bankruptcy Reform and Family Farmers: Correcting the Disposable Income Problem, 38 Tex. Tech. L. Rev. 309 (2006) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=928255.

[37] 11 U.S.C. § 1226.

[38] 11 U.S.C. § 586(e).

[39]   See Wagner v. Armstrong (In re Wagner), 36 F.3d 723 (8th Cir. 1994); But see, Fulkrod v. Savage (In re Fulkrod) 973 F.2d 801 (9th Cir. 1992).

[40] 11 U.S.C. § 1225(a)(6).

[41] 11 U.S.C. § 1208. See, e.g. Graven v. Fink, 936 F.2d 378 (8th Cir. 1991) (allowing the conversion of the case to Chapter 7 despite the debtor’s motion to dismiss, based on a finding of fraud).

[42] 11 U.S.C. § 1222 (c).

[43]   11 U.S.C. § 1228.

[44]   11 U.S.C. §§ 1222(a)(9), 1228.

[45]   11 U.S.C. § 1229.