Bankruptcy Reform Act of 1978

Background — The Bankruptcy Act of 1898 and the Chandler Act of 1938

Before 1978, federal bankruptcy law rested on the Bankruptcy Act of 1898, the first long-term federal bankruptcy statute in the United States, which remained in effect for roughly eighty years after earlier federal bankruptcy statutes had proved short-lived. The 1898 Act created the office of referee in bankruptcy, an officer who handled the day-to-day administration of cases under the supervision of the district courts. During the Great Depression, Congress overhauled the 1898 statute through the Chandler Act of 1938, which organised its provisions into chapters tailored to different kinds of debtors, including Chapter X for corporate reorganisations, Chapter XI for arrangements, Chapter XII for real property arrangements, and Chapter XIII for wage earner plans.

The Chandler Act framework mattered to securities regulation because Chapter X gave the Securities and Exchange Commission, created four years earlier under the Securities Exchange Act of 1934, a special advisory function in the reorganisation of large corporations. In larger cases, the court referred reorganisation plans to the Commission, which examined them and filed an advisory report; the reports were advisory only, and the court retained the ultimate authority. The division of reorganisation law among several chapters was among the reasons reformers pressed for change.

The Road to Reform — The Commission on the Bankruptcy Laws

By the late 1960s, the bankruptcy system was widely regarded as outdated and poorly matched to modern commercial and consumer credit. In 1970, Congress created the Commission on the Bankruptcy Laws of the United States to study the subject and recommend changes. The Commission reported in 1973 and submitted proposed legislation, which became the starting point for several years of congressional debate.

One institutional change preceded the statute. In 1973, new Bankruptcy Rules adopted through the Supreme Court's rulemaking process redesignated referees as bankruptcy judges. Congress then passed the Bankruptcy Reform Act of 1978, and the President signed it on November 6, 1978. The Act repealed the 1898 statute and enacted Title 11, but most of its operative provisions were delayed until October 1, 1979.

Structure of the Bankruptcy Code

The Bankruptcy Code enacted in 1978 is organised into general chapters that apply across cases and operative chapters that supply the specific forms of relief. The general chapters contain the definitions and the rules on administration, creditors, the debtor, and the estate — including the automatic stay, the debtor's exemptions, the trustee's powers to recover certain pre-bankruptcy transfers, and the rules for allowing and prioritising claims.

In the 1978 Code, the principal operative chapters were Chapter 7 (liquidation), Chapter 9 (adjustment of the debts of a municipality), Chapter 11 (reorganisation), and Chapter 13 (adjustment of the debts of an individual with regular income). Chapter 7 provides for a trustee to collect and sell the debtor's non-exempt property and distribute the proceeds to creditors; individuals may receive a discharge of remaining debts, while a corporation in Chapter 7 does not. Chapter 9 provides a framework for municipalities, which may be debtors only if specifically authorised by state law. Chapter 13 allows individuals with regular income to repay debts over time under a court-approved plan. Chapter 11 became the principal vehicle for business reorganisation, and it is the part of the Code that most directly affects investors in corporate securities. Congress later added Chapter 12 for family farmers in 1986 and Chapter 15 for cross-border cases in 2005, and in 2019 it created Subchapter V of Chapter 11 for small business debtors.

The Bankruptcy Courts and the Northern Pipeline Decision

The 1978 Act established a United States Bankruptcy Court in each judicial district and gave it a broad grant of jurisdiction extending beyond the administration of bankruptcy cases themselves to related civil proceedings. The judges were to be appointed by the President with Senate confirmation to fourteen-year terms, rather than with the life tenure and salary protection that Article III of the Constitution provides to other federal judges.

That design did not survive constitutional review in its original form. On June 28, 1982, in Northern Pipeline Construction Co. v. Marathon Pipe Line Co., the Supreme Court held, by a vote of five to four, that the broad jurisdictional grant to the new bankruptcy courts violated Article III. A plurality of four justices concluded that Congress had impermissibly vested the essential attributes of the judicial power in judges who lacked life tenure and salary protection, and two additional justices concurred in the judgment. The Court stayed its judgment until October 4, 1982, to give Congress an opportunity to reconstitute the bankruptcy courts or adopt other valid means of adjudication without impairing the interim administration of the bankruptcy laws.

Congress responded with the Bankruptcy Amendments and Federal Judgeship Act of 1984, Public Law 98-353, enacted on July 10, 1984. The 1984 statute conferred bankruptcy jurisdiction on the district courts and authorised them to refer bankruptcy matters to bankruptcy judges, who became judicial officers of the district court. It limited the bankruptcy judges' authority to bankruptcy matters and to core proceedings, with non-core proceedings generally requiring a district judge's final order unless the parties consent, and it changed the appointment process, so that bankruptcy judges are now appointed by the courts of appeals to fourteen-year terms. The operative framework of the 1978 Code remained in place.

The constitutional question has not disappeared. In Stern v. Marshall, decided on June 23, 2011, the Supreme Court held, again by a five to four vote, that although a bankruptcy court has statutory authority to enter final judgment on certain counterclaims, the Constitution prevented it from doing so for a state common-law tort counterclaim that was not resolved in ruling on a creditor's claim.

Chapter 11 — The Central Innovation

The most consequential substantive change in the 1978 Act was the creation of a single Chapter 11 reorganisation procedure that replaced Chapters X, XI, and XII of the Chandler Act. Under Chapter 11, a business debtor — whether closely held or a corporation with publicly traded securities — can continue operating while it negotiates a plan to restructure its obligations. The debtor ordinarily remains in control as a debtor in possession, with most of the powers of a trustee, unless the court appoints a trustee for cause, such as fraud, dishonesty, incompetence, or gross mismanagement by current management. Creditors and, where appropriate, equity security holders may organise in committees, and any party in interest may be heard on any issue in the case.

The debtor initially has the exclusive right to file a plan for 120 days after the order for relief, and exclusivity for soliciting acceptances continues for 180 days. A court may extend these periods for cause, but not beyond 18 months and 20 months, respectively. Creditors and shareholders whose rights are affected then vote by class. A class of claims accepts a plan when holders of at least two-thirds in amount and more than one-half in number of the allowed claims actually voted vote in favour; a class of equity interests accepts when holders of at least two-thirds in amount of the allowed interests actually voted accept.

A plan can be confirmed only if it satisfies the requirements of the Code. Each holder in an impaired class who has not accepted the plan must receive at least as much as it would receive in a Chapter 7 liquidation, and at least one impaired class of claims, not counting insiders, must accept. If an impaired class votes to reject, the plan can still be confirmed over its objection — a process known as cramdown — but only if the plan does not discriminate unfairly and is fair and equitable with respect to the rejecting class. For unsecured creditors, the fair and equitable standard incorporates the absolute priority rule: no class junior to a dissenting class may receive or retain property on account of its junior claim or interest unless the dissenting class is paid in full.

For investors, this means that the position of a security in the capital structure largely determines its fate. Secured creditors are entitled to the value of their collateral, general unsecured creditors share in what remains, and holders of preferred stock and common stock stand behind creditors. The credit risk of a corporate bond is therefore not only the risk that the issuer will default, but also the question of what the bondholder will recover if it does. The Code gives an indenture trustee a statutory right to be heard in a Chapter 11 case.

The Automatic Stay, Exemptions, and Avoiding Powers

Three groups of general provisions in the 1978 Code shape almost every case. The first is the automatic stay in Section 362, which takes effect when a petition is filed and generally halts collection actions, foreclosures, and lawsuits against the debtor and its property, giving the debtor breathing room and preventing a race to the courthouse among creditors. The stay has exceptions for certain securities, commodity, repurchase, and swap transactions that were expanded in 2005.

The second group concerns exemptions for individual debtors. Section 522 lets an individual protect specified property from creditors. A debtor may use a federal list of exemptions, which covers categories such as a residence, motor vehicles, and household goods, unless the debtor's state has opted out and requires its own exemptions instead. The state-law alternative generally depends on the debtor's domicile during the 730 days before the filing. The federal homestead exemption is adjusted periodically for inflation and stood at thirty-one thousand five hundred and seventy-five dollars as of April 1, 2025.

The third group consists of the trustee's powers to avoid certain transfers made before the case began. A trustee may recover preferences — transfers to creditors made on or within 90 days before the filing, or within one year for insiders, when the statutory conditions are met — and fraudulent transfers made within two years before the filing. The fraudulent transfer provisions reach both transfers made with actual intent to hinder, delay, or defraud creditors and transfers made for less than reasonably equivalent value while the debtor was insolvent or in comparable financial difficulty. For certain securities transactions, these powers are limited by the safe harbors discussed below.

The Securities Law Provisions of the Code

The 1978 Act paid close attention to the relationship between bankruptcy and securities regulation, and three provisions deserve particular attention.

The first is the role of the Securities and Exchange Commission. The Chandler Act had given the Commission an advisory function in Chapter X cases, a role that ended when the 1898 statute was repealed. In its place, Section 1109(a) of the Code provides that the Securities and Exchange Commission may raise and may appear and be heard on any issue in a Chapter 11 case, but may not appeal from any judgment, order, or decree entered in the case. The Commission thus retains a voice in Chapter 11 cases, including on the adequacy of disclosure, but without the power to appeal. Section 1109(b) separately gives parties in interest, including creditors, equity security holders, and indenture trustees, the same right to be heard.

The second is disclosure to creditors and shareholders who vote on a plan. Under Section 1125, acceptances of a plan may be solicited only after the holders receive a written disclosure statement that the court has approved as containing adequate information, meaning information of a kind and in sufficient detail that would enable a hypothetical investor of the relevant class to make an informed judgment about the plan. The Code provides that the adequacy of a disclosure statement is not governed by otherwise applicable nonbankruptcy law, rule, or regulation, although an agency or official responsible for enforcing such law may be heard on the question. Section 1125(e) also provides a safe harbor: a person who solicits acceptance or rejection of a plan, or who participates in the offer, issuance, sale, or purchase of a security, in good faith and in compliance with the applicable provisions of the Code is not liable for violating any law, rule, or regulation governing plan solicitation or the offer, issuance, sale, or purchase of securities.

The third is the exemption for securities issued under a plan. Section 1145 provides that, except for an entity that is an underwriter as the section defines the term, Section 5 of the Securities Act of 1933 and any state or local law requiring registration of the offer or sale of a security do not apply to the offer or sale, under a plan, of securities of the debtor, of an affiliate participating in a joint plan, or of a successor to the debtor, when those securities are distributed in exchange for a claim against, or an interest in, the debtor or principally in such exchange. The exemption extends to securities issued on the exercise of warrants, options, rights, or conversion privileges that were themselves issued under the plan, and the Code deems an offer or sale made in this manner to be a public offering. The statutory definition of an underwriter is deliberately broad, covering certain purchasers of claims who act with a view to distributing the plan securities, and the exemption does not protect them. The practical effect is that a reorganised company can issue new stock or debt to its creditors without the registration process that would otherwise apply.

Stockbroker Liquidation, Commodity Brokers, and the Securities Investor Protection Act

The 1978 Code also contained special liquidation provisions for firms whose business is handling other people's securities and commodities contracts. Subchapter III of Chapter 7 governs the liquidation of a stockbroker, and Subchapter IV governs the liquidation of a commodity broker. These subchapters recognise that a failed broker holds property belonging to its customers. The Code defines a customer by reference to a claim on account of a security received, acquired, or held in the ordinary course of the debtor's business as a stockbroker, and it defines net equity as the dollar balance in the customer's accounts after liquidating the securities positions as of the filing date, offset by amounts the customer owes the debtor.

These provisions sit beside the Securities Investor Protection Act of 1970, under which the Securities Investor Protection Corporation oversees the liquidation of failed broker-dealers that are its members. That Act directs that, to the extent consistent with its own provisions, a liquidation proceeding be conducted in accordance with, and as though it were being conducted under, the general chapters of the Bankruptcy Code and the first two subchapters of Chapter 7. The trustee's purposes are to deliver customer name securities to the customers entitled to them, to distribute customer property and satisfy net equity claims, to sell or transfer the debtor's business units where possible, and to liquidate the remaining business. The Securities Investor Protection Corporation advances funds to satisfy customer claims within limits of five hundred thousand dollars per customer, of which no more than two hundred and fifty thousand dollars may be for cash claims, and it protects customers against the loss of securities and cash held by a failed firm, not against losses from a decline in the value of their investments.

The Code also contains an eligibility rule that is easy to overlook. Section 109(d) provides that only a railroad, a person that may be a debtor under Chapter 7 other than a stockbroker or a commodity broker, and certain other specified entities may be a debtor under Chapter 11. In other words, a stockbroker or commodity broker cannot reorganise under Chapter 11; it is liquidated. SEC Rule 15c3-3, the customer protection rule, which requires broker-dealers to safeguard customer cash and fully paid securities, and SEC Rule 15c3-1, the Net Capital Rule, which requires them to maintain minimum liquid capital, are the principal regulatory safeguards intended to reduce the risk of customer losses in a broker-dealer failure.

Financial Market Safe Harbors

Because securities, commodities, and derivatives markets depend on the finality of settlement and the ability of counterparties to close out positions quickly, the Code limits the powers that would otherwise let a trustee disrupt them. Section 546(e) is the best-known example: it provides that the trustee may not avoid a transfer that is a margin payment, or a settlement payment, made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, except under the actual-intent fraudulent transfer provision. Companion provisions protect certain repurchase agreement and swap agreement transfers, and other sections allow specified counterparties to exercise contractual rights to liquidate or terminate certain contracts despite the automatic stay. These protections have been expanded since 1978, including in the 2005 legislation.

Major Amendments Since 1978

Although the 1978 Act remains the foundation, Congress has amended the Code repeatedly. The 1984 act restructured the courts after Northern Pipeline, as described above. The Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, Public Law 99-554, enacted on October 27, 1986, created Chapter 12 for family farmers and made the United States Trustee program permanent. That program had begun as a pilot under the 1978 Act in eighteen judicial districts and was extended nationwide, except in Alabama and North Carolina. United States Trustees appoint and supervise private trustees in Chapter 7, 12, and 13 cases, review fee applications of professionals in Chapter 11 cases, and monitor cases for fraud and abuse.

The Bankruptcy Reform Act of 1994, Public Law 103-394, created a second National Bankruptcy Review Commission and expanded the bankruptcy courts' authority to conduct jury trials. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Public Law 109-8, was signed on April 20, 2005 and generally took effect on October 17, 2005. It introduced a means test for individuals filing under Chapter 7, which presumes abuse when the debtor's disposable income exceeds specified thresholds; required individual debtors to receive credit counselling before filing, generally within the preceding six months, and to complete a financial management course as a condition of discharge; added Chapter 15 for cross-border cases; and made substantial changes to the financial contract provisions.

The Small Business Reorganization Act of 2019 added Subchapter V to Chapter 11, effective on February 19, 2020, for small business debtors. Its debt limit was raised temporarily to seven and a half million dollars in March 2020 and, after extensions, that higher limit expired on June 21, 2024, after which the limit reverted to a lower amount, currently three million four hundred and twenty-four thousand dollars and adjusted periodically.

Outside the Bankruptcy Code, the Dodd-Frank Act of 2010 created the Orderly Liquidation Authority in Title II as a backup resolution regime for large financial companies whose failure would threaten financial stability. The Bankruptcy Code remains the primary framework for most financial companies, and Title II is available only where bankruptcy would be inappropriate for systemic reasons.

Examination Relevance and Key Takeaways

Candidates preparing for the SIE, Series 7, and Series 65 examinations should be comfortable with the creditor hierarchy in a corporate failure, the difference between liquidation and reorganisation, and the customer protection that the Securities Investor Protection Corporation provides. The 1978 Act is the source of the framework in which those concepts operate.

In summary: the Bankruptcy Reform Act of 1978, Public Law 95-598, was signed on November 6, 1978 and generally took effect on October 1, 1979; it repealed the Bankruptcy Act of 1898 and enacted the Bankruptcy Code as Title 11 of the United States Code, the most comprehensive revision of federal bankruptcy law since the Chandler Act of 1938; it replaced the former Chapters X, XI, and XII with a single Chapter 11 reorganisation procedure; it established bankruptcy courts in each district, a jurisdictional grant that the Supreme Court held unconstitutional in Northern Pipeline Construction Co. v. Marathon Pipe Line Co. in 1982, leading Congress to restructure the courts in 1984; it gave the Securities and Exchange Commission a right to be heard on any issue in a Chapter 11 case without a right of appeal, required court-approved disclosure before a plan is voted on, and exempted securities issued under a plan from Securities Act registration for holders who are not underwriters; it provided separate liquidation procedures for stockbrokers and commodity brokers that operate alongside the Securities Investor Protection Act and barred them from Chapter 11; and it has been amended repeatedly while remaining the foundation of United States bankruptcy law.