U.S. Bankruptcy Law: History, Process, and Key Concepts

Introduction to Bankruptcy

Bankruptcy is a federal court process aimed at helping individual consumers and businesses eliminate their debts or establish a plan to repay them under the protection of the bankruptcy courts (Jackson 2006). Rather than disabling the debtor from settling his obligations, the process gives him the opportunity to meet or fulfill them. It first releases him from personal liability for all or some of his debts by preventing creditors from collecting those debts. Bankruptcy is now understood as a form of protection and a means to help the debtor make a fresh start. This concept took many years to evolve into its current form. In its earliest form, bankruptcy was a strict measure to remedy debtor fraud, which was then considered a crime (ABC Amega 2006). Rules and practices in those days were severe, and creditors treated debtors harshly.

History and Evolution of Bankruptcy Law

The concept of debtor default dates back to the time of the Code of Babylon's King Hammurabi in 1795 BC (ABC Amega 2006). The Code included early laws and rules for settling debts. In cases where the debtor could not repay, the creditor could take the debtor's child, wife, or slave — or even the debtor himself — into bondage until the obligation was met. In ancient Greece and Rome around 31 BC, indebtedness remained a crime. It was only during the reign of Augustus that a distinction was made between the debtor as a person and his debts. The laws of that era allowed the debtor to choose between surrendering his property or himself as repayment.

The history of bankruptcy law consists of three phases (Duhaime 2007). The first phase involved basic debt collection. The Roman Law of the Twelve Tables in 450 BC provided a method for dealing with debtors who could not repay their obligations. Table III established a process that first allowed the debtor 30 days to settle his obligation or have someone pay on his behalf. If the debtor failed, the creditor could bind him with a weight of 15 or more pounds, and could choose whether or not to feed him a pound of meal each day. On the third market day, the creditor could divide the debtor's body with other creditors. Under Roman law, however, a debtor who could not meet his obligation did not necessarily have to be cut into pieces; his creditor could instead have him imprisoned for life or sell him and his family into permanent foreign slavery. The concept of imprisonment was also adopted by parts of India, with the added provision that a creditor who took the debtor's wife would thereby cancel the debt. Under Charlemagne, the debtor had to surrender his possessions to escape imprisonment, and torture was outlawed, though imprisonment remained an option.

The second phase dealt with insolvent debtors and offered assistance to debtor-traders only (Duhaime 2007). Henry VII of England in 1542 issued a statute against those who willingly or unwillingly failed to remit their debts. The Lord Chancellor ordered the seizure of the insolvent debtor's property. The statute was later amended to protect only bankrupt debtors who were traders. The law of that time considered traders to incur only accidental losses and held that their inability to repay was not their fault. Other persons were not deemed to have the same standing and had no right to incur large debts they could not repay. The third phase extended financial assistance to any beleaguered debtor, regardless of the reason for his insolvency.

The law passed under Henry VII focused on the recovery of the creditor's investment and recognized that most insolvency was involuntary (ABC Amega 2006). Bankruptcy was treated as a criminal offense punishable by imprisonment, and debtors were said to have filled prisons to overflowing. Under Queen Elizabeth I in 1570, only creditors could initiate bankruptcy proceedings, and only traders or merchants qualified. All others were still imprisoned for the "crime." It was during the reign of Queen Anne in 1750 that a statute was issued for more humane treatment of honest debtors. Debtors who cooperated in bankruptcy proceedings could receive a discharge of their debt and even a monetary allowance from the estate for their positive participation. Fraudulent debtors who failed to cooperate, however, faced a penalty that increased from imprisonment to death. The 1732 Statute of George II was the bankruptcy law in effect in England around the time the United States Constitution was ratified. Though initially biased strongly toward creditors, a more enlightened attitude emerged by the middle of the 18th century. Bankruptcy remained a crime into the 19th century, and petitions from debtors did not exist. Under the Pennsylvania Bankruptcy Act of 1785, flogging of the convicted bankrupt debtor was permitted while he was nailed by the ear to a pillory, after which the ear was cut off.

Article I, Section 8 of the U.S. Constitution grants Congress the power to establish uniform laws on bankruptcy (ABC Amega 2006; Jackson 2006). President James Madison closely linked the regulation of bankruptcy to that of commerce. The federal government found it necessary to deter debtors from fleeing to another state to avoid their obligations. Early federal bankruptcy laws, beginning in 1800, were temporary responses to poor economic conditions. The first was enacted in response to land speculation and the depression of 1793, and bankruptcy proceedings remained an option available to creditors against debtors who were merchants or traders only. The 1800 Act was repealed for failing to curb debtor fraud.

States continued to regulate relations between debtors and creditors, though they could not discharge pre-existing debts or debts owed to citizens of another state. Because of these limitations and the Panic of 1837, a second federal bankruptcy law was enacted. It was a milestone: troubled debtors could file bankruptcy directly and receive a discharge, and the relief was extended to all debtors — not just merchants. This transformed bankruptcy from a creditor protection mechanism into a voluntary system of protection for debtors. As could be expected, this liberal measure facilitated fraud and abuse. Thousands of debtors were released, creditors received minimal dividends, and administrative fees ran high. The law quickly became unpopular and was repealed in 1843.

Congress passed the next bankruptcy act in 1867, following the Panic of 1857 and during the Civil War. All debtor classes were eligible, and voluntary petitioning was allowed. The law became controversial for permitting very lenient exemptions; a debtor could retain homestead property and thousands of dollars in personal property. It lasted longer than its predecessors but was repealed in 1878 due to widespread fraud and displeasure. An 1874 amendment introduced the composition agreement, which allowed the debtor to propose paying a certain percentage of his debt over time while retaining his property.

The Bankruptcy Act of 1898 was passed and remained in effect for 80 years, marking the beginning of permanent federal bankruptcy law. It continued to redefine bankruptcy in terms of debtor entitlement, banned farmers and wage earners from the process, and removed creditor approval as a condition for discharge. Problems such as the absence of a time limit between bankruptcies encouraged abusive debtors to incur debts without intending to repay them, declare bankruptcy, and discharge their debts repeatedly. Rather than repeal the law, Congress introduced amendments. The most comprehensive was the 1938 Chandler Act, which provided for business reorganization.

In 1970, Congress established the Commission on the Bankruptcy Laws of the United States to review existing law. On its recommendation, the Bankruptcy Reform Act of 1978 replaced the 1898 Act with the Bankruptcy Code under Title 11. The Act substantially altered bankruptcy practices, introducing strong provisions for business reorganization and personal bankruptcy. In the 1980s, the Act led to numerous legal controversies, amendments, and judicial clarifications. The Bankruptcy Amendment Act of 1980 addressed tax-related issues, while the Bankruptcy Amendment Act of 1984 restrained companies' right to terminate work contracts. Many bankruptcies were filed in the 1980s and early 1990s. "Prepackaged" techniques facilitated court work but also raised professional fees and wasted corporate assets.

President Bill Clinton signed the Bankruptcy Reform Act of 1994, which became the most comprehensive bankruptcy legislation since the 1978 Act. It provided for faster proceedings, encouraged debtors to reschedule obligations rather than liquidate, and helped creditors recover claims against bankrupt estates. The 1994 Act also created the National Bankruptcy Commission to investigate further modifications to the law. In April 2005, President George W. Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Many experts consider this the most extensive reworking of U.S. bankruptcy law since 1978. Its most important changes concern individual bankruptcy cases, small business bankruptcies, and cross-border insolvency cases (ABC Amega; Jackson).

General Concepts and Who May File

Bankruptcy is governed by the Bankruptcy Code, which became effective in 1978 (Empowerment Zone 2007). It was amended in 1994 and again in 2005. The 2005 amendments formed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which introduced major changes for consumer bankruptcies and a few restrictive provisions for business bankruptcies. All bankruptcy cases must be filed with the federal Bankruptcy Court, monitored by a federal Bankruptcy Judge appointed by the Circuit Court of Appeals. The Bankruptcy Judge may hear only bankruptcy cases. This is a specialized area of law with its own courts and rules.

Bankruptcy cases begin with the filing of a petition with the clerk of the Bankruptcy Court (Empowerment Zone 2007). The petition identifies the debtor and the relevant chapter of the Bankruptcy Code to be applied. At the time of filing, an estate is created and all of the debtor's assets become property of that estate. Everything before the filing is described as "pre-petition," and everything after it is described as "post-petition."

Most anyone may file for bankruptcy (Empowerment Zone 2007). However, if the court believes that the person seeking relief is abusing the law, it may deny the relief sought. Bankruptcy is a serious matter with long-term consequences. The debtor should assess his personal and family needs, evaluate his assets against his obligations, and consider alternatives before filing.

In general, participants in bankruptcy proceedings are the debtor, the bankruptcy judge, the creditors, and the trustee (Empowerment Zone 2007). The debtor — also called the petitioner — is the person seeking relief. The bankruptcy judge presides over hearings. Creditors are persons, business entities, or government agencies with monetary claims against the debtor. The trustee is a court-appointed person who represents the interests of all unsecured creditors, takes charge of the debtor's surrendered property, collects and liquidates it, investigates the debtor's financial affairs, examines proofs of claim, provides information to interested parties, and files required reports and tax returns.

The Bankruptcy Law serves two main purposes (Consumer Education Center 2007). It provides creditors with some payment if the debtor can afford to pay. It also gives the debtor a fresh start by canceling many debts according to a court-determined schedule of discharges.

Of those types available to individuals, there is a liquidation type; a rehabilitation type for individuals or businesses; a rehabilitation type for individuals with regular sources of income; and a rehabilitation type for family farmers and fishermen (Consumer Education Center 2007). There is also a rehabilitation type primarily for business debtors or individuals with large debts and assets. The liquidation type and the rehabilitation type for individuals with regular income are the most important for consumers. Both types offer payments to the creditor, a discharge for the debtor, and supervision by a trustee.

The liquidation type involves surrendering some of the debtor's property in exchange for the discharge of many debts; the trustee sells his non-exempt property to pay creditors. Under the rehabilitation type for individuals with regular income, the debtor keeps his property but must commit to a three-to-five-year repayment plan, after which most unpaid debts are discharged. Under both types, creditors must stop collection efforts after the case is filed. The debtor is protected by an "automatic stay," a relief that is often temporary.

In the liquidation type, the debtor surrenders some property at the time of filing (Consumer Education Center 2007). The trustee uses the proceeds to pay creditors. If the debtor has no assets beyond what the law allows him to keep, he gives up no property. Approximately 90 days after filing, most debts are discharged. Some debts — such as child support payments, certain taxes, student loans, and loan collateral — are not discharged. Only debts listed at the time of bankruptcy are cancelled. The debtor is allowed to keep money earned and most property acquired after filing.

Under the rehabilitation type for individuals with regular income, the debtor pays some debts over time from current income according to a court-approved plan (Consumer Education Center 2007). He retains all of his property, exempt or not, and makes regular payments to the trustee, who distributes them to creditors. Payments follow a regular installment schedule proposed by the debtor, usually with the assistance of a lawyer. The repayment plan lasts until the debt is fully paid or for three to five years, after which the debtor is discharged from remaining debts.

The law allows a debtor to choose the type of bankruptcy to file for, but he must qualify (Consumer Education Center 2007). Liquidation-type cases are now more limited. An individual debtor with primarily consumer debts who seeks a liquidation discharge must submit to a financial investigation using a set formula called a "means test." The test is designed to force debtors with some repayment capacity to do so rather than receive a full discharge. It compares the debtor's excess monthly income against the amount of unsecured debt to determine how much he could pay under the rehabilitative type. If the test shows the debtor is capable of repaying, he will be ineligible to file for the liquidation type and must instead file under the rehabilitation type for individuals with regular income. Qualifications for the rehabilitative type include having a regular income and not exceeding $922,975 in secured debt or $307,675 in unsecured debt. Examples of secured debts include home mortgages and auto loans; examples of unsecured debts typically include credit card balances.

Bankruptcy imposes an injunction against creditors' collection activities (Consumer Education Center 2007). Creditors are obligated to stop pursuing and troubling the debtor — a protection termed the "automatic stay" (Johnsen 2003). The policy behind this is that the debtor is entitled to some breathing space while his assets are evaluated or while reorganization proceeds. A creditor who violates the automatic stay by continuing to pressure the debtor may be subjected to monetary sanctions or other penalties.

Discharging a debt means that the debtor no longer has the obligation to pay it (Consumer Education Center 2007). It prohibits the creditor from making further efforts to collect. However, a discharge does not cancel the indebtedness of a family member or friend who is also liable to the creditor. Moreover, property used as collateral for a loan may still be repossessed by the creditor. Not all debts can be discharged even when the debtor satisfactorily meets all requirements. Only debts owed and scheduled at the time the case was filed can be discharged; debts incurred afterward are not covered. Non-dischargeable examples include certain taxes, unscheduled debts, alimony, maintenance or support obligations, pre-petition fines and restitution, debts for injury or death, student loans, and condominium or cooperative fees. The creditor must ask the court to exempt these debts; otherwise, they will be discharged.

As of October 2005, the filing fee for either the liquidation or rehabilitative type was $274 (Consumer Education Center 2007). Some courts impose additional administrative fees. The filing fee may be paid in installments or waived if the debtor's income is demonstrably low. A debtor may need a lawyer to assist with the filing; attorneys charge a fixed fee that varies depending on the type of bankruptcy.