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  FO-07301     1998 To Order   

Bankruptcy: Chapter 12 Reorganization

Phillip L. Kunkel, Attorney
Scott T. Larison, Attorney
Hall & Byers, P.A.
St. Cloud, MN

Copyright  ©  1998  Regents of the University of Minnesota. All rights reserved.

Chapter 12 was added to the Bankruptcy Code in 1986. It is designed specifically for the reorganization of family farms. It is closely modeled after Chapter 13, that chapter of the Bankruptcy Code designed for wage earners, although it has a higher debt ceiling, and therefore applies to many more farm operations.

Chapter 12 is only available to persons who meet the definition of "family farmer" set forth in the statute. There are several tests that must be met in order to qualify as a family farmer. According to this definition, the farmer's debts cannot exceed $1,500,000. Eighty percent of this debt must arise from the farming operation. A farming operation includes "farming, tillage of the soil, dairy farming, ranching, production or raising of crops, poultry or livestock, and the production of poultry or livestock products in an unmanufactured state." For purposes of computing the debt ceiling, any debt on a homestead will not be included unless it was granted in connection with the farm operation. In addition to the debt ceiling, the statute also requires that the farmer debtors must have earned more than one half of their gross income from farming in the year prior to the filing of the Chapter 12 petition. The final requirement for eligibility is regular annual income. This income must be "sufficiently stable and regular to enable such family farmer to make payments" under a Chapter 12 plan.

A farm corporation or partnership will be eligible to file a Chapter 12 case if it meets four specific conditions. First, at least 50 percent of the stock or equity of the corporation or partnership must be held by one family, with that family conducting the farming operation. Second, more than 80 percent of the value the corporation or partnership's assets must be related to the farming operation. Third, the aggregate debts must not exceed $1,500,000 with not less than 80 percent of that arising from its farming operation. Finally, if corporate stock exists, that stock must not be publicly traded.

Since its enactment, there has been a substantial amount of litigation concerning whether a person is eligible for Chapter 12. Generally, the debtor must be actively involved in farming operations in order to be eligible. If merely renting out the farmland for cash rent, the debtor will not likely be found to be engaged in farming.

Initiating a Chapter 12 Bankruptcy
To initiate a Chapter 12 case, a farm debtor must file a voluntary petition with the court. The debtor must also file a schedule of assets and liabilities and a statement of financial affairs. The farm debtor remains in possession of the farm assets and actions by creditors are automatically stayed.

Within 90 days after filing the bankruptcy petition, the debtor must present a plan for repayment of debts to the Bankruptcy Court. A confirmation hearing to consider the plan will be scheduled soon after the filing of the plan. Chapter 12 specifically provides that, except for cause, confirmation hearings must conclude within 45 days after the filing of the plan.

Adequate Protection
Between the filing of the Chapter 12 petition and the confirmation hearing on the debtor's plan, the debtor will carry on the farm operation in the ordinary course of business. However, just as in a Chapter 11 bankruptcy, the debtor may not use cash collateral, such as crop or livestock proceeds, without either court or creditor approval. To obtain such approval, the debtor must provide the creditor who holds a lien on such property with "adequate protection." This protection prevents the creditor from being harmed by the debtor's use of the collateral. Similarly, a creditor may also be entitled to "adequate protection" if the creditor can show that the collateral is declining in value during the case. For example, the holder of a security interest in the farmer's equipment may claim a right to this protection for the continued use of the equipment and its depreciation in value due to such use.

Chapter 12 lists ways in which the debtor can satisfy this adequate protection requirement. Making cash payments or granting a secured creditor a replacement lien are two such ways. For real estate, the statute specifically provides that "reasonable rent customary in the community" is sufficient. The issue of whether a crop share arrangement would be acceptable in lieu of cash rent is not addressed. However, if this type of lease is customary, such an arrangement should be satisfactory.

Down-Scaling the Farm Operation
Another issue regarding the sale of collateral before the confirmation hearing concerns the liquidation of farm assets. Because scaling down the farm operation may be a necessary element to a successful reorganization, Chapter 12 provides that a debtor can liquidate secured assets without the permission of the secured creditor before the confirmation hearing. However, the secured creditor must be given notice and provided a hearing on such a sale, and the proceeds must be remitted to the secured creditor.

Appointment of Trustee
Although the Chapter 12 debtor is given broad authority to operate the farm business, Chapter 12 requires that a trustee be appointed. Where fraud or gross mismanagement on the part of the debtor is shown, a creditor or the trustee may move to have the trustee placed in control of the farm.

Although the farmer remains in control of the property, the trustee maintains important functions. Under Chapter 12 he or she is directed to:

  1. receive and be accountable for property and payments turned over by the debtor;

  2. object to the allowance of improper claims;

  3. make recommendations regarding the discharge of the debtor;

  4. provide information to interested parties;

  5. investigate the financial affairs of the debtor for cause;

  6. investigate the operation of the farm and analyze the feasibility of continuing the business;

  7. participate in valuation and confirmation hearings;

  8. ensure that the debtor makes timely payments under the confirmed plan.

The Chapter 12 trustee is paid by the debtor. In addition to the plan payments, the debtor must pay 10 percent of all such payments to the trustee. This payment must be made at the time of the plan payment. After payments under the plan have totaled $450,000, the trustee payment is reduced to three percent of the plan payment.

Requirements for the Chapter 12 Plan
The debtor is responsible for filing a plan for the fair repayment of debts and the reorganization of the farming operation. Unlike a Chapter 11 case, only the debtor is authorized to file a plan under Chapter 12. The plan may modify the terms of debt repayment of either secured or unsecured creditors. Moreover, the plan may provide for the curing or waiving of a default over a reasonable period of time. In addition, it may provide for the liquidation of farm collateral.

Beyond these powers, however, there are specific requirements which govern the acceptability of a Chapter 12 plan. Consistent with other chapters in the Bankruptcy Code, unsecured debts and secured debts are treated differently.

With regard to unsecured debts, two alternatives are available. Either the plan must provide for total repayment of the unsecured debt, or the debtor must agree to contribute all of his disposable income to the payment of these debts. Such repayment can be extended over a three year period; however, if cause for a longer repayment period is shown, the court may extend the term of the plan for up to five years.

If the plan does not provide for full repayment of unsecured claims, the debtor must agree to contribute his or her entire disposable income to the payment of this debt during the term of the plan. However, the statute specifically defines "disposable income," to include only that income which remains after all farm and living expenses have been paid. Again, the term of the plan must run three years or less, unless the court approves an extension. In no event may a plan run longer than five years. Under either alternative, the plan must offer unsecured creditors at least as much as they would receive through a Chapter 7 liquidation.

With regard to secured debts, there are also options. For the debtor's plan to be confirmed, the secured creditors must either approve the plan and retain the lien securing the claim while payments are made, or receive the collateral. If the debtors' plan provides for the repayment of a secured debt, the creditor's security interest remains intact during the repayment period. The amount of the debt will generally be reduced to the present value of the secured property. Thus, in certain situations it may be possible for the debtor to cash out the secured creditor by obtaining financing equal to the appraised value of the collateral. In this case, valuation may well be a disputed issue.

Instead of cashing out the creditor, the debtor's plan may provide for a repayment schedule which extends beyond the terms of the original secured debt. The plan itself is limited to five years, but there is an exception for specific long-term debt. Long-term debt may be paid over a period exceeding five years.

Under any such repayment plan, whether the term of the original debt is extended or not, the creditor's claim is reduced to the value of that collateral. However, the creditor must receive the present value of the collateral. The creditor is generally entitled to interest at a market rate based upon this value for the duration of the repayment plan. During the entire repayment term, secured creditors retain their security interest in the collateral.

Conversion and Dismissal
Chapter 12 specifically provides that a debtor may voluntarily convert a Chapter 12 bankruptcy case to a Chapter 7 bankruptcy or dismiss the case at any time. Creditors, however, may not seek the involuntary conversion of a debtor's Chapter 12 bankruptcy to a Chapter 7 bankruptcy unless fraud is shown in connection with the case, although they may seek the dismissal of the case. Chapter 12 provides that after notice and a hearing, the court may dismiss a case for cause, including:

  1. unreasonable delay or gross mismanagement;

  2. nonpayment of fees and charges required;

  3. failure to file a timely plan;

  4. failure to commence making timely payments under a confirmed plan;

  5. denial of confirmation of a plan and denial of a request for additional time for filing of another plan or modification;

  6. material default by the debtor with respect to a term of a confirmed plan;

  7. revocation of the order of confirmation and denial of confirmation of a modified plan;

  8. termination of a confirmed plan by reason of the occurrence of a condition specified in the plan;

  9. continuing loss to or diminution of the estate, absent a reasonable likelihood or rehabilitation; or,

  10. fraud in connection with the case.

Discharge of Debts
After completing all payments under the plan, a Chapter 12 debtor will receive a discharge of all debts that have been provided for in the plan except for long-term debt which extends beyond the life of the plan. In most cases, this means that the unsecured debt will be discharged at the end of the three or five year plan term. Any secured debt which extends beyond the term of the plan will remain until the repayment has been completed. Chapter 12 also provides for a hardship discharge which may be granted despite the debtor's inability to complete a plan. Such a discharge is granted if the failure to complete the plan is due to circumstances for which the debtor "should not justly be held accountable." It can only be granted, however, if the unsecured creditors have received at least as much as they would have received through a Chapter 7 liquidation and if modification of the plan is not feasible.

Tax Provisions
Legislation creating Chapter 12 did not create a separate tax entity for Chapter 12 debtors. The debtor does not have the option of filing a short tax year federal return. This option is available under both under a Chapter 7 and Chapter 11 bankruptcy. Because of this, the tax options offered by Chapter 11 are not available for a Chapter 12 debtor. For a discussion of these tax considerations, see another fact sheet in this series, Tax Considerations in Liquidations and Reorganizations. The taxable year of an individual debtor ends on the date of the order for relief unless the case is converted.

To order other publications in this series, contact the University of Minnesota Extension Service Distribution Center, 20 Coffey Hall, 1420 Eckles Avenue, St. Paul, MN 55108-6069, e-mail: or credit card orders at 800-876-8636 or (612) 624-4900 (local calls).

Titles include:

The fifteen publications are also available as a package: Farm Legal Series (PC-7291).

This publication is designed to provide accurate information in regard to the subject matter covered. It is published with the understanding that the authors and the University of Minnesota are not engaged in rendering legal, accounting or other professional services. If legal advice or other professional assistance is required, the services of a competent professional should be sought.



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