Chapter 11 of the U.S. Bankruptcy Code allows financially distressed businesses to reorganize and emerge from bankruptcy free of their pre-bankruptcy debts and obligations. In general, a business can achieve this kind of “fresh start” by confirming a plan of reorganization or pursuing a going-concern sale that typically facilitates a change in ownership, a reduction in leverage, and the elimination of most claims against the company’s assets. Through these kinds of transactions, a business can emerge from bankruptcy with a stronger balance sheet and often a new ownership structure. It also can streamline operations by, for example, assuming valuable contracts and rejecting burdensome ones under the relevant provisions of the Bankruptcy Code. Although creditors’ claims may lose value through the bankruptcy process, all similarly situated creditors are treated fairly and in a nondiscriminatory manner.
Distressed companies and their creditors should not have to worry about variances in state law insolvency schemes that might facilitate similar going-concern sales, but treat creditors differently or allow a process without the same kind of court or creditor oversight. Yet, states are increasingly adopting debtor-creditor laws that mimic key provisions of the Bankruptcy Code and permit the kind of fresh start for business debtors historically available only under federal bankruptcy law. These state laws may also provide rights or distributions to creditors that differ from, and conflict with, the provisions and purposes of the Bankruptcy Code. These new, sweeping state law insolvency schemes raise serious constitutional questions under both the Bankruptcy Clause and the Contract Clause. Policymakers and courts need to rethink and rebalance the allocation of powers between Congress and the states with respect to bankruptcy laws. More specifically, they need to define more clearly the parameters of federal preemption and preserve Congress’s exclusive authority over laws affecting the rights of creditors and other stakeholders in the context of a fresh start for business debtors.