Thursday, January 20, 2011

Bankruptcy, BAPCPA and the Social Contract

Once upon a time, I had a client tell me that he loathed bankruptcy because bankruptcy was socialism and he only believed in market solutions. While his use of terminology was imprecise, it is beyond dispute that bankruptcy represents government changing the terms of privately negotiated contracts. If you substitute government action for socialism and substitute private contract for the market, his point is well taken but wrong.

Government Intervention in Private Decision Making: It Cuts Both Ways

While bankruptcy constitutes government interference with private contracts, private contracts would be of limited enforceability without the assistance of government. We are so accustomed to the idea that contracts may be enforced through government action, whether it be through suit on a promissory note or laws governing secured credit, that it is easy to forget that enforceability of contracts depends on the collective agreement that contracts should be enforced against the will of the non-complying party.

It is possible to imagine a contract regime which operated entirely without the intervention of government. In that instance, credit would only be extended based on trust or force. If a debtor did not pay, the creditor's recourse would be limited to not extending any more credit in the future, social pressure such as shunning or in the extreme case, violence. Alternatively, credit could be extended based on the creditor taking possession of collateral and not giving it back until the debt was paid.

While you can imagine a contract system that functioned without the help of government it would be inefficient. As a result, we have laws allowing enforcement of contracts and recognizing secured transactions because they facilitate the extension of credit, encourage economic growth and avoid violence as a means of contract enforcement. In other words, laws enforcing contracts improve the general welfare.

The Social Contract (No, It's Not the Movie About Facebook)

Collective action to enforce contracts is an example of the social contract. The framers of the Constitution were inspired by the social contract theories of Hobbes, Locke and Rousseau. According to Hobbes, life would be "nasty, brutish and short" absent political authority. Under social contract theory, people band together and surrender some of their autonomy in return for security, protection of property rights and the general welfare.

Because enforcement of contracts is a creature of the social contract, government will not blindly enforce all contracts. You cannot go to court and enforce a contract to put a hit on someone or sell a child. In Texas at least, the courts will not enforce a gambling debt. While we believe generally in freedom of contract, there are some contracts which should not be enforced because they are bad. There are also some methods of enforcing contracts which are not allowed. Shakespeare notwithstanding, you cannot secure a debt with a pound of flesh or other body part. The reason is simple. If you could use a writ of execution to actually execute someone , the state would be implicated in using violence to enforce private contracts. Generally we think that is a bad idea.

Bankruptcy Laws and the Social Contract

Bankruptcy laws are an example of the state saying we will enforce private contractual rights but only so far. The power to enact uniform bankruptcy laws is one of the enumerated powers granted to Congress, but it is not a power which must be utilized or utilized in any particular form. For the first hundred years of the nation, bankruptcy laws were utilized to respond to specific crises and were often focused on punishing debtors rather than helping them. It was not until the Bankruptcy Act of 1898 that we had a permanent law which placed limits on how debts could be enforced.

The discharge and fresh start are based on the idea that a person who is faced with crippling levels of debt will not be a productive member of society and will not be able to take care of his or her family. Reorganization laws benefit society by preserving jobs, equitably distributing insufficient assets and minimizing loss of going concern value. Bankruptcy laws are not an example of government interfering with the right of private contract, but a limitation on the extent to which government will facilitate the right of private contract.

So, my argument is that bankruptcy is no more socialist than opening the courthouse to breach of contract suits. In either case, the state is lending its power to the enforcement of private agreements within defined limits.

That brings us to BAPCPA. How well does BAPCPA fulfill the social contract? I would argue that substantively, BAPCPA is a perfectly appropriate drawing of the boundaries of the social contract. The Means Test, limits on homestead exemptions and treatment of 910 vehicles are all ways in which lines are drawn in favor of more personal responsibility. However, there are many parts of BAPCPA which add burdens on the system with no corresponding benefits. Credit counseling and the Debt Relief Agency rules were intended to serve a consumer protection function, but do not in practice. The means test is so ambiguously worded that even the Supreme Court has difficulty figuring out what it means. It also encourages gamesmanship to arrive at a desired result. Sections 362 and 523 have had so many exceptions and clauses grafted onto them that it is impossible to read through them in one sitting.

Trying to Make Sense of An Imperfect Essay

I don't think that I have completely succeeded in tying the social contract ideas of Hobbes, Locke and Rousseau to private contracts and bankruptcy. However, I hope that I have at least suggested the following points:

1. Enforcement of private contracts does not involve man in a state of nature unhindered by the state, but rather involves the state intervening in the private affairs of men to further the common good.

2. Just as the state can act to enforce private contracts, so can the state place limits on the extent to which it will enforce private contracts.

3. When the state acts to limit the freedom of private contract, it does so based on improving the general welfare at the expense of some individuals.

4. Bankruptcy laws further the social contract when they advance some aspect of the general welfare, such as encouragement of risk taking, support of the family unit, preserving economic value or promoting individual responsibility.

5. Bankruptcy laws hinder the social contract when they impose costs without corresponding benefits or reward the use of resources to get around the policies that the laws were intended to promote.

1 comment:

Ron Satija said...

#5 points to your next post on Bentham and Mill, no?