Bankruptcy law Summary

  • Last updated on November 10, 2022

Uniform bankruptcy laws are pivotal in a rapidly growing, credit-based economy. Their purpose is to grant equitable treatment to creditors and give debtors fresh starts. Without them, lenders have no assurance that their claims will receive just treatment in the event of borrower default. Borrowers, conversely, are reluctant to commit to a risky enterprise if the consequences of failure are too dire.

Historically, American legislators have upheld national goals of economic growth and social mobility by passing bankruptcy laws more generous to debtors than those in most European countries. America has been a nation of debtors from the outset, as its settlers borrowed to pay for their passage from Europe, to buy and clear land, to build and operate mills, to purchase slaves, and to gamble and drink. Inevitably, some investments went sour, and some individuals failed to prosper, leaving them to face the eighteenth century English legal system, which valued commerce and capital over human life.Bankruptcy;lawsLaws;bankruptcy

Legal bankruptcy was possible in colonial America, but it was not an attractive option. The law allowed seizure and sale of all a debtor’s assets, including furniture, his wife’s clothes, and the tools of his trade. In theory, debtors could be executed if they concealed anything of value from bankruptcy adjudicators. In practice, however, the handful of executions for debt in eighteenth century England involved massive corporate fraud. Although the total liquidation of debtors’ assets bought release from debtor’s prison, it did not result in cancellation of their debts. Creditors could renew collection efforts if a debtor’s circumstances improved.

Bankruptcy in the New Nation

After the American Revolution, most states continued to follow English bankruptcy law well into the nineteenth century. Because entrepreneurs in the infant republic relied heavily on English capital to expand their business ventures, they were poorly situated to press for more debtor-friendly laws, which could have discouraged English lenders. The terms granting the United States independence at the close of the revolution specifically provided for repayment of prerevolutionary debts to English merchants. State bankruptcy laws that gave preferential treatment to more recent American creditors, in violation of the treaty, were a nontrivial factor in the deteriorating Anglo-American relations that culminated in the War of 1812.

Most bankruptcies in America before the mid-nineteenth century were involuntary, brought by creditors. In contrast, most business bankruptcies since 1898 and virtually all personal bankruptcies have been voluntary, initiated by debtors.

The U.S. Constitution empowers Congress to enact uniform bankruptcy laws. Congress passed such laws sporadically during the nineteenth century, always in response to economic downturns that highlighted the problem of business failures involving creditors in different states. Advocates for industrial and commercial interests favored federal bankruptcy laws, while farming and states’ rights advocates in general opposed them. A key issue was whether a state law could discriminate against out-of-state creditors. The U.S. Supreme Court, in Ogden v. Saunders (1827)Ogden v. Saunders (1827), struck down a debtor-friendly New York state statute on the grounds that it impaired the obligation of interstate contracts. This decision left many individual provisions of state bankruptcy laws open to challenge.

The temporary federal bankruptcy laws passed in 1800, 1841, and 1867 were in effect for a total of sixteen years. Impetus for a permanent law grew during the 1880’s and coalesced during the Panic of 1893. The Bankruptcy Act of 1898Bankruptcy Act of 1898, sponsored by Jay Torrey, established the shape of bankruptcy in the United States for the next century. It provided for uniform, equitable distribution of assets to creditors, leaving the states to decide which assets were exempt, and it contained limited provisions for restructuring debts in bankruptcy. This act made individual bankruptcy more attractive to consumers. Since 1898, the proportion of bankruptcy filings brought by individuals, as opposed to businesses, has increased steadily. This increase reflects the more consumer-friendly laws passed beginning in 1898, but it also reflects an enormous rise in individual debt and a decline in the number of self-employed people operating family businesses.

The Great Depression produced a new round of bankruptcy reform legislation. There had long existed a special provision for railroads, the railroad receivership, which provided for a federal trustee to manage a bankrupt railroad with the aim of eventually selling it intact, often to the original bondholders, rather than liquidating its assets piecemeal. Bankruptcy reform legislation of 1933-1934 eliminated separate treatment of railroads and made reorganization and restructuring of debts, under the supervision of a United States trustee, an option for any corporation. The 1938 Chandler Act of 1938Chandler Act extended the restructuring option to the increasing numbers of bankrupt individuals who had no assets to liquidate but could pay some of their debt from future income.

Rates of bankruptcy filing, both individual and corporate, declined after 1938 and remained low during the 1940’s and 1950’s. Thereafter, individual bankruptcy rates rose steeply, peaking in 2004-2005. They dropped sharply following the 2005 bankruptcy reform act but have since risen in response to an economic downturn. The absolute number of business bankruptcies has not risen, but the dollar amounts in some recent business failures have been staggering.

In 1978, Congress enacted a uniform, comprehensive bankruptcy code incorporating the 1898 act, the Chandler Act, and other legislation. The new code’s provisions, outlined in more than two hundred pages of regulations, recognize four types of bankruptcy. Chapter 7 (bankruptcy)Chapter 7, total liquidation, can apply to individuals or businesses. With some notable exceptions (including child support, criminal restitution, and student loans), a person emerges from Chapter 7 free of debt.

Chapter Chapter 11 (bankruptcy)11 governs corporate reorganization in bankruptcy. In some cases, a United States trustee assumes control of the corporation during Chapter 11 reorganization; in others, the trustee merely supervises the operations. Chapter Chapter 13 (bankruptcy)13, often called “wage-earner bankruptcy,” applies to individuals and small businesses. In Chapter 13, an individual can retain assets but is required to submit a bare-bones budget and turn over all disposable income to the trustee, for a period of three or five years. At the end of that period, most remaining debts are discharged. Chapter 12 contains special provisions for farmers and commercial fishermen, and Chapter 15, added later, covers international bankruptcies.

Two trends during the 1980’s and 1990’s contributed to a public perception that there was widespread abuse of the generous provisions of the 1978 act. Those decades saw an explosion of consumer debt, fueled by the credit card industry and by inflated housing costs. A small number of highly publicized cases of students filing for bankruptcy to shed student loan debt before embarking on lucrative careers led first to a five-year waiting period before such loans could be discharged (1982) and later (1998) to complete exemption of federal student loans from bankruptcy discharge in the absence of undue hardship. The courts have always had the option, under the substantial abuse provisions of the 1978 act, of refusing bankruptcy protection to people who use credit cards profligately.

Corporate Bankruptcy After 1978

Although individual abuse of the 1978 bankruptcy law has been exaggerated, substantial corporate abuses slipped under the congressional radar. The intervening decades have seen the growth of a phenomenon known as strategic bankruptcy, in which a company’s management makes decisions enhancing short-term profits while incurring future obligations it intends to avoid through a Chapter 11 bankruptcy. Corporate executives and others with privileged inside Insider tradinginformation are able to sell their stock before the company files for bankruptcy, and they often retain their munificent salaries during reorganization. By contrast, labor contracts and pension plans, future benefits negotiated by employees as part of their compensation, are often destroyed by bankruptcy proceedings, and most stockholders, who have no advance warning, suffer when stock prices decrease dramatically in response to the company’s bankruptcy filing.

Deliberate strategic planning has been suspected in the 1982 bankruptcy of Johns-Manville, which liquidated most of its assets and then folded in anticipation of massive asbestos-exposure claims, as well as in the 1983 bankruptcy of Continental Airlines, in which generous provisions of a union contract were at stake. Reorganization during Chapter 11 proceedings allows a business to fire older employees and then rehire them under much less favorable terms.

Enron’s Enron Corporationstrategy before 2001 involved plans to take advantage of Chapter 11 bankruptcy to shed obligations to employees and stockholders while shielding top executives from the consequences of fiscal irresponsibility. The fraud went much further than that, however, because the company had very few capital assets. Its value to investors lay almost entirely in income being generated by the month-to-month operation of the company. Enron’s deceptive accounting practices created the illusion of income where none in fact existed. When the company filed for bankruptcy, there were no assets to liquidate for the benefit of creditors and no future income to pay them either. Employees and stockholders were ruined financially, and at least a few of those responsible would be imprisoned.

The 2005 Bankruptcy Act

The first comprehensive overhaul of American bankruptcy laws since 1978, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) is, as the name suggests, mainly aimed at individual bankruptcies. A handful of provisions under Title XIV increase protections for employee wages and pensions in corporate bankruptcies. BAPCPA created a requirement for individuals to obtain credit counseling within ninety days before filing for bankruptcy and to complete a financial management course before receiving discharge. Attorneys and others who work with debtors find that the requirement, while not difficult to meet, accomplishes little.

The BAPCPA further constrains consumers by creating a means test to determine whether a person can file for Chapter 7 liquidation or must file under Chapter 13 and make payments into a plan for five years. If family income is above the median income for the state, a person is presumed to be able to make payments under a Chapter 13 plan.

These two provisions, as well as others, made filing consumer bankruptcy more complicated and expensive than it had been formerly and temporarily depressed the U.S. bankruptcy rate. Contrary to a popular perception that was reinforced by creditors and so-called debt-reduction companies, the 2005 law did not remove bankruptcy as an option for consumers overwhelmed by debt.

Real Estate in Bankruptcy

When it enacted BAPCPA, Congress did not envision that the ensuing three years would produce an explosion in consumer bankruptcies tied to the real estate market. Deregulation of financial markets coupled with soaring real estate values led many homeowners to enter into purchase or refinancing agreements secured by their homes. Lenders ignored the future ability of borrowers to repay the loans from their income, counting on appreciation of home values to recoup their investments in the event of sales or foreclosures. Further, most of these loans were bundled and sold to investors far from the homes’ locations. These lenders had neither the incentive nor the ability to work with individuals on the brink of default to prevent foreclosures that would hurt borrowers and lenders alike.

Declining home values and a generally stagnant economy after 2006 produced a chain reaction. Individual homeowners, unable to meet payments or to sell their homes for as much money as they owed on them, declared bankruptcy. The companies making the loans were also unable to sell them, and a number of such companies were themselves forced to declare bankruptcy.

Further Reading
  • Coleman, Peter J. Debtors and Creditors in America: Insolvency, Imprisonment for Debt, and Bankruptcy, 1607-1900. Frederick, Md.: Beard Books, 1999. Contains a wealth of information on sociological factors behind bankruptcy legislation.
  • Delaney, Kevin J. Strategic Bankruptcy: How Corporations and Creditors Use Chapter 11 to Their Advantage. Berkeley: University of California Press, 1992. Case studies of large corporations that use bankruptcy as part of a business plan.
  • Skeel, David A. Debt’s Dominion: A History of Bankruptcy Law in America. Princeton, N.J.: Princeton University Press, 2001. Thorough and scholarly, with coverage from the colonial period through the end of the twentieth century.
  • Sommer, Henry J. Consumer Bankruptcy Law and Practice. Boston: National Consumer Law Center, 2004. Aimed at attorneys, with a focus on individual bankruptcies under the 1978 bankruptcy reform legislation and its revisions.
  • Sullivan, Theresa, Elizabeth Warren, and Jay Westbrook. As We Forgive Our Debtors: Bankruptcy and Consumer Credit in America. Oxford, England: Oxford University Press, 1989. Based on a large study of consumer bankruptcies; focuses on economic trends and provides good treatment of women’s issues.

Chrysler bailout of 1979

Credit card buying

Enron bankruptcy

Great Depression

Incorporation laws

Supreme Court and contract law

WorldCom bankruptcy

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