Chapter 12 and Family Farm Bankruptcies


The creation of Chapter 12 - Adjustment of Debts of a Family Farmer with a Regular Annual Income - is a congressional response to the financial crisis facing many family farmers. Chapter 12 was closely modeled after existing Chapter 13. Experience with farmers in bankruptcy proceedings showed that most family farmers have too much income to qualify as debtors under Chapter 13 and were thus limited to relief under Chapter 11. Unfortunately, many found Chapter 11 to be too complicated, time consuming and expensive, and the obstacles to confirmation too great to really assist the typical farmer.

Chapter 12 is intended to assist those farmers who have a true potential to reorganize and allow them relief from their heavy debt burden, while at the same time ensuring that they pay creditors as much as possible under the current economic situation confronting agriculture.

The major features of Chapter 12 are as follows:

  1. The debtor is prohibited from using cash collateral unless a secured creditor consents or the court, after notice and hearing, authorizes such use.
  2. A separate test for determining adequate protection is provided for Chapter 12 cases. The farmer may pay reasonable market rent rather than lost opportunity cost.
  3. Preconfirmation sales of unneeded assets free of interest, although subject to approval of the court, may be made without the consent of the secured creditor.
  4. Subject to an exception for cause, confirmation hearings are to be concluded within forty-five (45) days after the filing of the plan.
  5. The plan may provide for postconfirmation financing secured by assets that have revested in the debtor.

ELIGIBILITY AND SCOPE OF PROTECTION

Only a family farmer with regular annual income may be a debtor under Chapter 12. 11 U.S.C. § 109(f). Individuals and individuals and spouses who are family farmers are those who:

  1. have aggregate debts not exceeding $1.5 million (it is significant to note that the $1.5 million debt limitation applies to contingent and unliquidated debts).
    • § 101(18) is silent regarding the appropriate date to determine the amount of debt for purpose of the $1.5 million dollar limitation, but it is reasonable to use the date of the filing of the petition. In re Labig, 74 B.R. 507 (S.D. Ohio 1987), In re Orr, 71 B.R. 639, 641 (Bkrtcy. E.D. N.C. 1987).
    • The 1.5 million dollar limitation is strictly enforced. See In re Stedman, 72 B.R. 49 (Bkrtcy. D. N.D. 1987) where the court found that debtors were ineligible for Chapter 12 relief since indebtedness was $1,544,103.43. (However, debtors could address this problem by dismissing their case, arranging to have some debt forgiven, and immediately refile.)
    • Family farmers who are spouses, and whose joint and several obligations total more than 1.5 million dollars, cannot file separate petitions in order to circumvent the debt limit of Chapter 12. In re Johnson, 73 B.R. 107 (Bkrtcy. S.D. Ohio). See also In re Cronkleton, 19 B.R. 792 (Bkrtcy. S.D. Ohio 1982).
  2. have at least eighty percent (80%) of their aggregate, non-contingent, liquidated debts as of the date of filing arising out of the farming operation they own or operate, with any debt for their principal residence being excluded unless that debt arises out of farming operations.
    • Courts will scrutinize the source of debtor's income. A determination must be made by considering the character of the business and whether its income is derived from its own farming or production efforts as opposed to the farming or production efforts of others. In re Dakota Lay'd Eggs, 57 B.R. 648 (Bkrtcy. D. N.D. 1986). See also In re Blanton Smith Corp., 7 B.R. 410 (Bkrtcy. M.D. Tenn. 1980); In re Miller, 122 B.R. 360 (Bkrtcy. N.D. Iowa 1990); In re Van Air Flying Service, Inc., 146 B.R. 816 (Bkrtcy. E.D. Ark. 1992).
  3. receive more than fifty percent (50%) of their individual or individual and spousal gross income from the farming operation, with the income being measured by the taxable year preceding the one in which the petition was filed. 11 U.S.C. § 101(18)(A).
    • See In re Shepherd, 75 B.R. 501 (Bkrtcy. N.D. Ohio 1987), where the court found that where a debtor filed his petition on December 31, 1986, the debtor's eligibility should be based upon the debtor's income in 1985, the year preceding the taxable year in which the case was filed.

In contrast, for business entities, more than eighty percent (80%) of the entities' assets must relate to the farming operations, more than fifty percent (50%) of the stock or equity must be owned by one family and relatives, and the family must conduct the farming operations. 11 U.S.C. § 101(18)(B). If the entity is a corporation, the stock of the corporation must not be publicly traded. 11 U.S.C. § 101(18)(B).

DEBTOR'S AND TRUSTEE'S POWERS

Chapter 12 provides that a standing trustee will be appointed in each case, but in the ordinary course, actual operation of the farm will remain with the debtor. 11 U.S.C. § 1202, § 1203. Additionally, the debtor, as debtor in possession, has all rights, responsibilities, and powers as would a debtor in possession under Chapter 11. 11 U.S.C. § 1203.

Chapter 12 does not provide for the appointment of creditors' committees.

Among other duties and powers, the Chapter 12 trustee may appear and be heard at any valuation hearing, confirmation or modification hearing, or any hearing involving the sale of property of the estate. 11 U.S.C. § 1202(B)(3). Except as otherwise provided in the plan, the trustee makes all payments under the plan. 11 U.S.C. § 1226(c).

The debtor may convert his case to a case under Chapter 7 at any time. 11 U.S.C. Section 1208(a).

On request of a party in interest, and after notice and a hearing, the court may dismiss a case for cause; including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor, either before or after the commencement of the case. 11 U.S.C. § 1208(c).

The grounds for dismissal under Section 1208(c) are very similar to the dismissal factors under 11 U.S.C. § 1112(b). Thus, case law under Section 1112(b) should be persuasive authority. See In re Becker, 38 B.R. 913 (Bkrtcy. D. Minn. 1984) (Dismissal awarded where cash flow statements showed negative cash flow, where value of the machinery was declining through use, and value of corn was declining through spoilage); In re Anderson, 52 B.R. 159 (Bkrtcy. N. D.N. 1985) (Dismissal awarded where farm debtor had proposed two plans in two years and both were rejected).

In In re Lubbers, 73 B.R. 440 (Bkrtcy. D. Kan. 1987) the court dismissed the Chapter 12 bankruptcy case because the debtors did not timely file schedules or make a request for an extension. Furthermore, the debtors in this instance did not file a plan within ninety (90) days of the filing of the Chapter 12 proceeding and did not request an extension of the time to file a plan. The court also determined that the plan contained no basis on which creditors could evaluate its feasibility.

CASH COLLATERAL, AUTOMATIC STAY AND INCURRING SECURED DEBT

Chapter 1 (General Provisions), Chapter 3 (Case Administration), and Chapter 5 (Creditors, the Debtor and the Estate) of the Bankruptcy Code apply in a case under Chapter 12. 11 U.S.C. § 103(a).

Section 363(c)(2) permits the use of cash collateral under two circumstances. First, the lender may consent to such use. Second, the court may authorize the debtor to use the cash collateral, but only after "notice and a hearing," and only if adequate protection is provided.

A petition filed under Chapter 12 operates as a stay, applicable to all entities, of:

  1. the commencement or continuation of any action or proceeding against the debtor that was or could have been commenced before the commencement of the case;
  2. the enforcement, against the debtor or against the property of the estate, of a judgment obtained before the commencement of the case;
  3. any act to obtain possession of the property of the estate or to exercise control over property of the estate;
  4. any act to create, perfect or enforce any lien against property of the estate;
  5. any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case;
  6. the setoff of any debt owing to the debtor that arose before the commencement of the case. 11 U.S.C. § 362(a).

ADEQUATE PROTECTION

Chapter 12 introduced a new concept of allowing family farmers to provide adequate protection in the form of paying reasonable market rent. 11 U.S.C. § 1205. This section makes 11 U.S.C. § 361 inapplicable in Chapter 12 cases. This has the effect of eliminating the "indubitable equivalent" requirement contained in 11 U.S.C. § 361(3) and makes it clear that what needs to be protected is the value of the property, not the value of the creditor's interest in the property. See In re Rennich, 70 B.R. 69 (Bkrtcy. D. S.D. 1987).

Section 1205 provides that adequate protection may be provided by:

  1. cash or periodic cash payments;
  2. additional or replacement liens;
  3. payment for the use of farmland of the reasonable rent customary in the community in which the property is located; or
  4. granting such other relief as will adequately protect the value of the property securing a claim or interest.

SALES FREE OF INTERESTS

11 U.S.C. § 1206 permits the sale of farmland or farm equipment free and clear of interests after notice and hearing, except that the proceeds of such a sale are subject to such interests. Sales may be made without the consent of secured creditors. This section allows Chapter 12 debtors to scale down the size of their farming operations by selling off unnecessary assets. The creditor's interest, which includes a lien, attaches to the proceeds of the sale.

CHAPTER 12 PLAN

No disclosure statement. The disclosure statement required in Chapter 11 bankruptcies (11 U.S.C. § 1125) is not required in Chapter 12 bankruptcies. (But see extensive disclosure requirements in local Chapter 12 rules.)

Filing deadlines. The Chapter 12 debtor is given ninety (90) days after the order for relief to file a plan. The court may extend the ninety (90) day period if an extension is substantially justified. 11 U.S.C. § 1221. See In re Bentson, 74 B.R. 56 (Bkrtcy. D. Minn. 1987) where the court sets forth factors that should be considered in determining whether an extension of time to file a new plan should be granted. If time limits cannot be met, the case will be dismissed and cannot be refiled. However, See In re Raylyn AG. Inc., 42 B.R. 523 (Bkrtcy. S.D. Iowa 1987) where the court did not dismiss a case when the plan was filed ninety-one (91) days after the filing of the petition. The court determined that the debtor's delay did not adversely affect creditors.

Confirmation hearing. The Chapter 12 confirmation hearing is to be held after expedited notice and, except for cause, shall be concluded not later than forty-five (45) days after the filing of the plan. 11 U.S.C. § 1224. See In re Ryan, 69 B.R. 598 (Bkrtcy. M.D. Fla. 1987) where the court held that the debtor's request for extension of time to work out problems with certain creditors was an insufficient reason to establish "cause" for an extension of the forty-five (45) day requirement.

Plan duration. Plan terms are ordinarily limited to three (3) years although the court, for cause, may approve a term not longer than five (5) years. 11 U.S.C. § 1222(c). Two types of plan provisions are excepted from these time limits:

  1. those providing for the cure of default of any unsecured claim or any secured claim having a final payment due after the plan's final payment;
  2. those providing for payment of allowed secured claims consistent with 11 U.S.C. § 1225(a)(5) that calls for confirmation of plans if, with respect to each allowed secured claim --
    1. the holder of such claim has accepted the plan;
    2. the plan provides that the holder retain the lien securing its claim and the value of property to be distributed on account of the claim is not less than the allowed amount of the claim; or
    3. the debtor surrenders the property securing the claim to the holder. 11 U.S.C. § 1225(a)(5)&(9).

Plan contents.

Income to trustee. The plan will provide for the submission of all or such portion of future earnings and income of the debtor to the supervision and control of the trustee as is necessary for the execution of the plan. 11 U.S.C. § 1222(a)(1). Nevertheless, the debtor shall remain in possession of all property of the estate. 11 U.S.C. § 1207(b). Payments and funds received by the trustee shall be distributed according to the plan. If the plan is not confirmed, the trustee shall return such payments to the debtor. 11 U.S.C. § 1226(a).

An issue will arise as to whether a debtor may provide for payment of some creditors "outside the plan." For a discussion of the contrasting positions of this issue see In re Overholt, 125 B.R. 202 (Bkrtcy. S.D. Ohio 1990). Under Chapter 13, payments "outside the plan" are allowed only where there is exceptional circumstances. See In re Mouser, 99 B.R. 803 (Bkrtcy. S.D. Ohio 1989). Moreover, the general rule is that payments outside the plan are subject to the trustee's fee. See Matter of Foster, 670 F.2d 478 (5th Cir. 1982); See also In re Logemann, 88 B.R. 938 (Bkrtcy. S.D. Iowa 1988).

In the recent case of In re Beard, 45 F.3d 113 (6th Cir. 1995), the court ruled that a Chapter 12 debtor may bypass the trustee and make direct payments on the secured portion of an undersecured debt to the creditor.

For a discussion of the Chapter 12 trustee's duties as a "disbursing agent", see In re Citrowske, 72 B.R. 613 (Bkrtcy. D. Minn. 1987). See also In re Meyer, 73 B.R. 457 (Bkrtcy. E.D. Mo. 1987), where the court denied the debtor's argument that the trustee's fee was too burdensome, saying that the debtor must reasonably anticipate a trustee's fee of ten percent (10%) of all amounts received by the trustee since the duties imposed upon the Chapter 12 trustee are at least as time consuming as those imposed on a Chapter 13 trustee.

Administrative payments. The plan shall provide for full payment, in deferred cash payments, of all claims entitled to priority under § 507 of the Code. 11 U.S.C. § 1222(a)(2).

Classified claims. If the plan classifies claims and interests, it shall provide the same treatment for each claim or interest within a particular class unless the holder of a particular claim or interest agrees to less favorable treatment. 11 U.S.C. § 1222(a)(3). The plan may designate a class or classes of unsecured claims, but may not discriminate unfairly against any class so designated. However, such plan may treat claims for a consumer debt differently from other unsecured claims. 11 U.S.C. § 1222(b)(1).

Modification of treatment. The plan may modify the rights of holders of secured claims, or holders of unsecured claims, or leave unaffected the rights of holders of any class of claims. 11 U.S.C. § 1222(b)(2).

Curing of waiving default. The plan may provide for the curing or waiving of any default (11 U.S.C. § 1222(b)(3)); however, what constitutes a "reasonable" time to cure a default is a question of fact that must be decided on a case by case basis. See In re Hickson, 52 B.R. 11 (Bkrtcy. D. Fla. 1985), construing similar language under Chapter 13. The plan may provide for the curing of any default within a reasonable time and maintenance of payments while the case is pending on any unsecured claim or secured claim in which the last payment is due after the date on which the final payment under their plan is due. 11 U.S.C. § 1222(b)(5). The plan may also provide for the assumption, rejection, or assignment of any executory contract or unexpired lease of the debtor. 11 U.S.C. § 1222(b)(6).

Objection to plan confirmation. A party in interest, the trustee, or the United States Trustee may object to confirmation. 11 U.S.C. § 1224. Most of the litigation up to the present time involving objections to Chapter 12 plans have concerned creditors' objections to interest rates that debtors have proposed to apply to secured claims. The courts have noted that there are several methods by which discount rates can be calculated. They include:

  1. the contract rate;
  2. the legal rate;
  3. the rate determined under 26 U.S.C. § 6621 of the Internal Revenue Code;
  4. the Treasury Bill rate; and
  5. the Treasury Bill rate with adjustment made for risk.

In the case of In the Matter of Doud, 74 B.R. 865 (Bkrtcy. S.D. Iowa 1987), the court found that the contract rate was to be the appropriate discount rate to be applied to the fact situation in that case. See also In re Lenz, 74 B.R. 413 (Bkrtcy. C.D. Ill. 1987) where the court also applied the contract rate to a claim of the Federal Land Bank. See In re Hardzog, 77 B.R. 840, 74 B.R. 701 (Bkrtcy. W.D. Okla. 1987), rev'd sub nom. Hardzog v. Federal Land Bank of Wichita (In re Hardzog), 901 F.2d 858, 22 C.B.C. 2d 1253 (10th Cir. 1990) where the court applied the cost of funds approach as the appropriate discount rate. See In re Foertsch, 167 B.R. 555 (Bkrtcy. D.N.D. 1994) where the Court said that "in determining the discount rate, the court must consider the prevailing market rate for a loan of a term equal to the payout period, with due consideration for the quality of the security and the risk of subsequent default." See also In re Koch, 131 B.R. 128 (Bkrtcy. N.D. Iowa 1991) where the Court refused to bind the secured creditor to a repayment term longer than the market normally provided for such debts. In In re Janssen Charolais Ranch, Inc., 73 B.R. 125 (Bkrtcy. D. Mont. 1987) the court denied confirmation of the debtor's plan pursuant to the objection of secured creditors saying that the debtor could not pull an interest rate "out of his hat" which had no resemblance to present market interest rates. See also In re Edwardson, 74 B.R. 831 (Bkrtcy. D. N.D. 1987) where the court found that an interest rate of eight percent (8%) was totally inadequate.

Requirements for plan confirmation.

Unsecured debt. Except as provided above, the plan may not provide for payments over a period that is longer than three (3) years unless the court, for cause, approves a longer period, but in any event no longer than five (5) years. 11 U.S.C. § 1222(c). The plan will be confirmed only if the value of the property to be distributed under the plan, on account of each allowed secured claim, is not less than the amount that would be paid on such claim if the debtor were liquidated under Chapter 7. 11 U.S.C. § 1225(a)(4). If a holder of an unsecured claim objects to the confirmation of the plan, the court cannot approve the plan unless the plan provides that all the debtor's projected disposable income to be received in the three (3) year period will be applied to make payments under the plan. 11 U.S.C. § 1225(b)(1). For a discussion of the confirmation requirements designed to protect unsecured creditors see Matter of Fortney, (7th Cir. 1994)

The unsecured creditor, both general and priority, is not entitled to post-petition interest on its pre-petition claim. See In re Wakehill Farms (Bkrtcy. N.D. Ohio 1990) where the court held that the Internal Revenue Service was not entitled to interest on their pre-petition priority claim.

Secured debt. The plan will only be confirmed if:

  1. the holder of such secured claim has accepted the plan;
  2. the plan provides the holder of such claim will retain its lien securing the claim and the value as of the effective date of the plan, of property to be distributed under the plan on such account is not less than the allowed amount of such claim; or
  3. the debtor surrenders the property securing such claim to the secured holder. 11 U.S.C. § 1225(a)(5).

"In order for a secured creditor to receive a value that is at least equal to the allowed amount of its claim as of the effective date of a plan, the payments provided under a plan of reorganization must be discounted by an appropriate rate of interest, thus providing the creditor with the present value of its claim." In re Foertsch, 167 B.R. 555 (Bkrtcy. D.N.D. 1994).

The plan may provide for payment of allowed secured claims over a period exceeding the three (3) to five (5) year period. 11 U.S.C. § 1222(b)(9).

Feasibility. The debtor must show that the plan has been proposed in good faith and that he will be able to make all payments under the plan and to comply with the plan. 11 U.S.C. § 1225(a)(3) & (6). "The feasiblity test contemplates the probability of actual performance of teh provisions of the plan, and whether the things to be done under the plan can be done as a practical matter under the facts." In re M & S Associates, Ltd., 138 B.R. 845, 849 (Bkrtcy. W.D. Tex. 1992).

POST-CONFIRMATION CREDIT

Except as otherwise provided in the plan, the confirmation of the plan vests all of the property of the estate in the debtor. 11 U.S.C. § 1227(b). A Chapter 12 debtor may receive authorization from the court to obtain credit pursuant to 11 U.S.C. § 364(d)(1).

ABSOLUTE PRIORITY

Significantly absent in Chapter 12 is any reference to the so-called "absolute priority rule" that provides primary protection to unsecured creditors in Chapter 11 cases. The rule requires that, unless a class of claims accepts the plan, no plan can be approved unless that class is paid in full, or no lesser class retains any interest under the plan. 11 U.S.C. § 1229(b). The practical effect of the absolute priority rule is that the debtor cannot retain ownership of the farm unless his unsecured creditors agree, he invests substantial new value, or he pays the unsecured claims in full. The underlying premise of Chapter 12, however, is that it is desirable to retain family ownership of the farming operation and that this objective justifies the abolition of the absolute priority rule. Chapter 12 omits the absolute priority rule entirely and creates an effective right to retain farm ownership. This right represents one of the major benefits of the new Chapter 12 for the debtor, while also removing one of the tools available to creditors to combat plan confirmation.

DISPOSABLE INCOME

If a trustee or a holder of an unsecured claim objects to the plan, the court cannot approve the plan unless the plan provides that all of the debtor's projected disposable income to be received during the plan will be applied to make payments under the plan. 11 U.S.C. Section 1225(b)(1). It is significant to understand that an objection by the mentioned parties must be made for the court to consider this requirement.

"Disposable Income" means income which is received by the debtor and which is not reasonably necessary to be expended:

  1. for the maintenance or support of the debtor or a dependent of the debtor; or
  2. for the payment of expenditures necessary for the continuation, preservation, and operation of the debtor's business. 11 U.S.C. § 1225(b)(2)

Chapter 12 debtors must turn over disposable income during the course of their farm operations under a plan. The debtors should also provide an accounting for the final disposable income determination at the end of the plan, prior to discharge, to ensure that they have not accumulated an unreasonably large reserve of funds at the time of discharge. In re Broken Bow Ranch, 33 F.3d 1005, 1008-1009 (8th Cir. 1994). Courts have held that the debtor bears the burden of proving what expenses are reasonably necessary for their farming operations and living expenses. In re Kuhlman, 118 B.R. 731 (Bkrtcy. D. S.D. 1990); In re Gage, 159 B.R. 272 (Bkrtcy. D.S.D. 1993). See In re Coffman, 90 B.R. 878 (Bkrtcy. W.D. Tenn. 1988) for a discussion of what factors need to be examined to determine the extent to which the debtors use of net income in each plan year is reasonable. "Overall, this must be an inquiry, both by the trustee and the court, into what is commercially reasonable under all facts and circumstances." Id. at 886.

MISCELLANEOUS

Discharge. The court shall grant the debtor discharge of all debts provided for under the plan as soon as practical after the completion by the debtor of all payments under the plan, other than payments to holders of allowed claims. 11 U.S.C. § 1228(a).

Hardship discharge. The court may grant a hardship discharge to a debtor that has not completed payments under the plan if the debtor's failure to complete such payments was due to circumstances for which the debtor cannot be held accountable. 11 U.S.C. § 1228(b).

Co-debtor stay. A creditor may not commence any action against a co-debtor who is liable on a consumer loan with the Chapter 12 debtor unless:

  • such co-debtor became liable in the ordinary course of business; or
  • the case is closed, dismissed or converted to a case under Chapter 7 of this Title.