Key Farm Bankruptcy Modification on the Horizon?

Overview

Under 1986 amendments to the Bankruptcy Act of 1978, Congress created Chapter 12 bankruptcies for “family farmers.” Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, Pub. L. No. 99-554, 100 Stat. 3105 (1986), adding 11 U.S.C. § 1201 et seq.  Chapter 12 became a permanent part of the Bankruptcy Code effective July 1, 2005.  Numerous requirements must be satisfied for a debtor to qualify for Chapter 12 relief.  One of those requirements, the “aggregate debt test” is the subject of a bill, H.R. 2336, that passed the U.S. House on July 25.  The legislation increases the maximum aggregate debt a debtor can have and remain eligible for Chapter 12.  It’s an important bill because of the economic struggles of many farming operations in certain parts of the country.  I have discussed those problems in other posts, such as this one:  https://lawprofessors.typepad.com/agriculturallaw/2018/03/chapter-12-bankruptcy-feasibility-of-the-reorganization-plan.html

The proposed increase in the Chapter 12 bankruptcy aggregate debt test - it’s the topic of today’s post.

Eligibility Requirements

To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.” 11 U.S.C. §§101(19A) & (21).  A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing, and whose aggregate debts do not exceed $4,411,400.  11 U.S.C. §18).  In addition, more than 50 percent of the debt must be debt from a farming operation that the debtor owns or operates.  Id.  H.R. 2336 proposes to increase the $4,411,400 amount to$10 million. 

Changed Nature of Agricultural Production

As noted above, Chapter 12 was added to the Bankruptcy Code in 1986.  At that time, much of agriculture was faced with a debt crisis when crop prices declined sharply, interest rates rose sharply, and farmland values, particularly in the Midwest, plummeted.  That toxic mix resulted in many farmers, some of whom were very good managers, finding themselves in a precarious economic position.  It was this environment that led to Chapter 12’s enactment and, at the time, it was estimated that 86 percent of farmers could qualify for relief under Chapter 12 .  At time of enactment, the aggregate debt limit for Chapter 12 was $1,500,000.  That debt limit did not increase until 2005 when it was increased to $3.237,000 via an inflation adjustment.  The current limit of $4,411,400 is the present inflation-adjusted limit. 

More Economics

According to U.S.D.A. data, total real farm sector debt has now reached the level it was at during the depth of the farm debt crisis in the early 1980s.  However, the increase has been particularly accelerated since 2009, with lenders shoring up their collateral positions by increasing debt on real estate to allow them to continue making loans to farmers. But that is only a short-term solution to a deeper problem.  Presently, U.S.D.A. data indicates that the current ratio for agriculture (a measure of the ability to pay bill from current assets – it is total current assets divided by total current liabilities) is 1.31.  That number indicates that many farmers are facing a liquidity crisis, and it is generally the position of ag economists that the ratio should be between 1.5 and 3.0.  

In addition, U.S.D.A. data also indicates that the working capital compared to the value of farm production is at .09, further supporting the notion that a liquidity crisis is looming for even more farmers.  Working capital is the amount of liquid funds that a business has available to meet short-term financial obligations.  It is calculated by subtracting current liabilities from current assets, and it provides the short-term financial reserves that are available.  In other words, it measures the ability of a farming operation to withstand a financial/economic downturn.  For healthy farm businesses, ag economists generally take the position that ratio should be in the 15% to 25% range. The current number of nine-percent means that ag operations are “burning” through working capital and are more vulnerable to financial stress.  

“Right-Sizing” the Farming Operation

With land increasingly used as collateral, if economic conditions in agriculture remain difficult, the ability of many farmers to stay in business will be further decreased.  Some will be forced to “right-size” their farms by selling assets.  But doing so has the very real potential of triggering significant taxes – both capital gain and ordinary income caused by depreciation recapture.  Historically, this was a very real problem for farmers filing Chapter 12.  The sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors.  Even though the priority tax claims could be paid in full in deferred payments, in many instances the debtor did not have sufficient funds to allow payment of the priority tax claims in full even in deferred payments. 

Congress addressed this problem with the 2005 Bankruptcy Act overhaul.  That law contained a provision allowing a Chapter 12 debtor to treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge.  The provision is now contained in 11 U.S.C. §1232, and it is immaterial whether the tax is triggered pre or post-petition.

Back to the Debt Limit

For the above-mentioned reasons, eligibility for Chapter 12 essential for a farmer to be able to deprioritize taxes associated with the sale of farm assets used in the farming operation and ultimately put together a reorganization plan that will allow the farmer to stay on the farm to continue production activities, make restructured loan payments and have some debt written off. 

While the Chapter 12 debt limit has only adjusted for inflation since 1986, farms have increased in size and capital needs faster than the rate of inflation.  This means that far less than 86 percent of farmers can satisfy the aggregate debt limit of Chapter 12 – the percentage estimated to qualify for Chapter 12 when it was enacted.  While Chapter 11 is an alternative reorganization provision, it does not contain the favorable tax rule of a Chapter 12, is more costly to file, has different “timing” rules, and contains an “absolute priority” rule that can severely limit the ability of a farmer to reorganize debts and remain in farming.  I discussed the absolute priority rule here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/farmers-bankruptcy-and-the-absolute-priority-rule.html.  In addition, for a farm debtor that has aggregate debt over the $4,411,400 limit, it’s not possible to file a Chapter 11, pay debt down beneath the threshold, and convert to Chapter 12. 

Conclusion

H.R. 2336 (and the companion Senate bill S. 987) is important legislation designed to restore the availability of Chapter 12 to farmers (but not family fisherman) that were intended to benefit from it when it was enacted in 1986.  If the original policy reasons justifying the enactment of Chapter 12 in 1986 remain, the debt ceiling should increase to reflect that rationale.  Senate rules are different than those in the House and a Senator’s objection to a bill can cause a bill to stall much more easily than in the House.  Presently, Senator Feinstein (D-CA) is objecting to the legislation on the basis that hearings have not been held.  However, she is mistaken on that point.  Hearings were held last year – on both the House and Senate bills.  Senator Durbin (D-IL) is also objecting for other reasons, and Senator Warren (D-MA) is believed to follow whatever Sen. Durbin does. 

At this point, interested farmers and others are encouraged to contact their Senators via email before Thursday of this week.  After Wednesday, the Senate is recessed.  This week will be a key week for many family farmers.