A federally authorized procedure by which a debtor—an individual, corporation, or municipality—is relieved of total liability for its debts by making court-approved arrangements for their partial repayment.
Once considered a shameful last resort, bankruptcy in the United States is emerging as an acceptable method of resolving serious financial troubles. A record one million individuals filed for bankruptcy protection in the United States in the peak year of 1992, and between 1984 and 1994 the number of personal bankruptcy filings doubled. Corporate bankruptcies are commonplace, particularly when corporations are the target of lawsuits, and even local governments seek debt relief through bankruptcy laws.
The goal of modern bankruptcy is to allow the debtor to have a "fresh start," and the creditor to be repaid. Through bankruptcy, debtors liquidate their assets or restructure their finances to fund their debts. Bankruptcy law provides that individual debtors may keep certain exempt assets, such as a home, a car, and common household goods, thus maintaining a basic standard of living while working to repay creditors. Debtors are then better able to emerge as productive members of society, albeit with significantly flawed credit records.
History of U.S. Bankruptcy Laws
U.S. bankruptcy laws have their roots in English laws dating from the sixteenth century. Early English laws punished debtors who sought to avoid their financial responsibilities, usually by imprisonment. Beginning in the eighteenth century, changing attitudes inspired the development of debt discharge. Courts began to nullify debts as a reward for the debtor's cooperation in trying to reduce them. The public increasingly viewed debtors with pity, as well as with a realization that punishments such as imprisonment often were useless to creditors. Thus, a law that was first designed to punish the debtor evolved into a law that protected the debtor while encouraging the resolution of outstanding monetary obligations.
England's eighteenth-century insight did not find its way into the first U.S. bankruptcy statutes; instead, laws based largely on England's earlier punitive bankruptcy statutes governed U.S. colonies. After the signing of the Declaration of Independence, individual states had their own laws addressing disputes between debtors and creditors, and these laws varied widely.
In 1789, the U.S. Constitution granted Congress the power to establish uniformity with a federal bankruptcy law, but more than a decade passed before Congress finally adopted the Bankruptcy Act of 1800. This act, like the early bankruptcy laws in England, emphasized creditor relief and did not allow debtors to file for relief voluntarily. Great public dissatisfaction prompted the act's repeal three years after its enactment.
Philosophical debates over whom bankruptcy laws should protect (i.e., debtor or creditor) had Congress struggling for the next forty years to pass uniform federal bankruptcy legislation. The passage of the Bankruptcy Act of 1841 offered debtors greater protections and for the first time allowed them the option of voluntarily seeking bankruptcy relief. This act lasted eighteen months. A third bankruptcy act passed in 1867 and was repealed in 1878.
The Bankruptcy Act of 1898 endured for eighty years, thanks in part to numerous amendments, and became the basis for current bankruptcy laws. The 1898 act established bankruptcy courts and provided for bankruptcy trustees. Congress replaced this act with the Bankruptcy Reform Act of 1978 (11 U.S.C.A. § 101 et seq.), which, along with major amendments passed in 1984, 1986, and 1994, is known as the Bankruptcy Code.
Federal versus State Bankruptcy Laws
In general, state laws govern financial obligations such as those involving debts created by contracts—rental leases, telephone service, and medical bills, for example. But once a debtor or creditor seeks bankruptcy relief, federal law applies, overriding state law. This is because the U.S. Constitution grants Congress the power to "establish … uniform Laws on the subject of Bankruptcies throughout the United States" (U.S. Const. art. I, § 8). Federal bankruptcy power maintains uniformity among the states, encouraging interstate commerce and promoting the country's economic stability. States retain jurisdiction over certain debtor-creditor issues that do not conflict with, or are not addressed by, federal bankruptcy law.
Types of Federal Bankruptcy Proceedings
Federal bankruptcy law provides two distinct forms of relief: liquidation and rehabilitation, also known as reorganization. The vast majority of bankruptcy filings in the United States involve liquidation, governed by chapter 7 of the Bankruptcy Code. In a chapter 7 liquidation case, a trustee collects the debtor's nonexempt assets and converts them into cash. The trustee then distributes the resulting fund to the creditors in order of priority described in the Bankruptcy Code. Creditors frequently receive only a portion, and sometimes none, of the money owed to them by the bankrupt debtor.
Gambling WITH Bankruptcy Exemptions
In bankruptcy cases, individual debtors have the privilege of retaining certain amounts or types of property that otherwise would be subject to liquidation or seizure by creditors in order to satisfy debts. Laws protecting these forms of property are called exemptions.
Consistent with the goal of allowing the debtor a "fresh start," exemptions in bankruptcy cases help ensure that the debtor, upon emerging from bankruptcy, is not destitute. Exemption statutes generally permit the debtor to keep such things as a home, a car, and personal goods like clothes. Although exemptions inhibit the creditor's ability to collect debts, they relieve the state of the burden of providing the debtor's basic needs.
The bankruptcy code provides a list of uniform exemptions but also allows individual states to opt out of (override) these exemptions (11 U.S.C.A. § 522 [1993 & Supp. 2003]). Thus, the types and amounts of property exemptions differ greatly and depend upon the debtor's state of residence.
A debtor residing in a state that has not opted out is entitled to the exemptions described in the bankruptcy code. Examples of code exemptions are the debtor's aggregate interest of up to $15,000 in a home; up to $2,400 in a motor vehicle; up to $8,000 in household furnishings, household goods, clothes, appliances, books, animals, crops, and musical instruments; up to $1,000 in jewelry; up to $1,500 in professional books or tools of the debtor's trade; and certain unmatured life insurance policies owned by the debtor. The debtor also may claim an exemption for professionally prescribed health aids, such as electric wheel-chairs.
The majority of states have chosen to opt out of the uniform federal exemptions, replacing them with exemptions created by their own legislatures. Homestead exemptions, which excuse all or part of the value in the debtor's home, are the most common state-mandated exemptions. These are not uniform across states. For instance, Missouri mimics the federal government by placing a dollar limit on the exemption, but at $8,000, its cap is meager in comparison (Mo. Ann. Stat. § 513.475 [Vernon 2002]). The bordering state of Iowa limits the homestead exemption by acreage rather than dollar amount (Iowa Code Ann. §§ 561.1, 561.2 [West 1992]). Florida allows a homestead exemption without limits (Fla. Const. art. X, § 4(a)(1)). This lack of uniformity raises the question of fairness: bankruptcy laws are federal in nature, yet a debtor in Florida may have a significant financial advantage over a debtor in Missouri, owing to different exemption laws.
Despite the broad variance among states when it comes to bankruptcy exemptions, critics charge that even the uniform federal system can be grossly unfair. For example, assume two debtors, Arlene and Ben, each have estates valued at $28,000. Arlene, a dentist, has $15,000 of equity in her home. She has $8,000 worth of furniture and household goods. Her car is worth $4,000, and she owns dental tools valued at $1,000.
Ben is an art lover. He owns no car, no furniture, and no house, having chosen instead to spend his money on paintings and sculptures that are now worth $26,000. His clothes, musical instruments, and other household goods are worth $2,000.
Arlene and Ben have states of equal value, but when the federal exemption statute is followed, Arlene can claim $27,200 in exemptions, whereas Ben can claim only $16,300. Arlene receives exemptions worth $15,000 for her homestead, $8,000 for her household goods, $2,400 for her car, and $1,000 for her dental tools, and an $800 general exemption for property not covered by other exemptions. Ben may claim an $8,000 exemption for his art and other household goods, as well as a general exemption worth $8,300, which replaces his unused homestead exemption.
Critics suggest that one problem with exemption laws is that legislators must determine the property that will best enable the average debtor to remain self-sufficient following a bankruptcy. Unconventional debtors, such as Ben, frequently are penalized as a result. In addition, laws that place monetary limits on exemptions often do nothing to help the debtor achieve a fresh start. When the value of certain property is worth more than the exemption, it is said to be only partially exempt and must be completely liquidated. Following liquidation, the debtor receives the value of the exemption in cash from the liquidation proceeds. Thus, in the case of Arlene's $4,000 car, the bankruptcy trustee would sell the car and from the sale proceeds give Arlene $2,400, the amount of the exemption. Arlene could then spend the money on a tropical vacation instead of a replacement car, rendering the vehicle exemption law virtually meaningless.
Debtors may also take advantage of exemption laws by transferring assets before filing for bankruptcy protection. For example, Ben could sell nonexempt artwork and, with the proceeds, purchase a small condominium. He could then file for bankruptcy and claim a homestead exemption, increasing by $7,500 his post-bankruptcy estate.
Congress actually supports this type of pre-bankruptcy planning, permitting the debtor "to make full use of the exemptions to which he is entitled under the law" (S. Rep. No. 989, 95th Cong., 2d Sess. ). Still, courts view some pre-bankruptcy asset transfers as fraudulent, particularly when they involve large dollar amounts and there is evidence of intention to hinder, delay, or defraud creditors. Upon a finding of fraud, the bankruptcy court may deny discharge of the debtor's debts. But what constitutes a fraudulent transfer is often unclear and seemingly arbitrary.
Two bankruptcy cases from Minnesota exemplify the confusion surrounding fraudulent and nonfraudulent pre-bankruptcy transfers. The debtors in both cases were doctors who lost money in the same investment and who hired the same attorney to help them with their pre-bankruptcy planning. The outcomes of the cases differed significantly.
Before filing for bankruptcy, Omar Tveten liquidated most of his nonexempt assets, including his home. With the proceeds, he purchased life insurance and annuities valued at almost $700,000. Both the life insurance and the annuities were considered exempt under Minnesota law; however, the bankruptcy court held that the large amount converted was an indication of fraud and therefore refused to discharge Tveten's bankruptcy debts (Norwest Bank Nebraska v. Tveten, 848 F.2d 871 [8th Cir. 1988]).
Robert J. Johnson also transferred assets before filing for bankruptcy. Johnson converted nonexempt property into property exempt under Minnesota law: he purchased $8,000 in musical instruments, $4,000 in life insurance, and $250,000 in annuities from fraternal organizations, and he retired (paid off) $175,000 of the debt on his $285,000 home. The court focused on Johnson's claim for homestead exemption and in particular on the $175,000 mortgage payment made just before filing for bankruptcy. As the court in Tveten demonstrated, an unusually large asset transfer can indicate fraud. But in Johnson, the court held that the homestead exemption was valid, stating that the value of an asset transfer to homestead property, unlike the value of an asset transfer to property in another exemption category, is of little relevance because "no exemption is more central to the legitimate aims of state lawmakers than a homestead exemption" (Panuska v. Johnson, 880 F.2d 78 [8th Cir. 1989]).
Legal commentators have criticized the Tveten and Johnson decisions as being arbitrary and as providing no clear lines to assist debtors in pre-bankruptcy planning. Critics charge that the different outcomes are simply a result of different judges presiding at the initial bankruptcy court level, because the facts of the cases were so similar. Bankruptcy attorneys are frustrated by a lack of uniformity among court decisions that apply similar principles but reach different results, and also a lack of uniformity in exemption laws among states.
Indeed, forum shopping (searching for the most advantageous jurisdiction in which to file bankruptcy) is prevalent because of the wide diversity of state exemption laws. In re Coplan, 156 B.R. 88 (Bankr. M.D. Fla. 1993), illustrates the problem. The debtors, Lee Coplan and Rebecca Coplan, incurred substantial debt in their home state of Wisconsin before moving to Florida. After residing in Florida for one year and purchasing a house for $228,000, they sought bankruptcy relief and a homestead exemption under Florida law (West's F.S.A. Const. Art. 10, § 4(a)(1)), which allows an exemption for the full value of the homestead. The court found that the Coplans had engaged in a systematic conversion of assets by selling their home in Wisconsin and paying cash for their new home in Florida. This action was conducted, according to the court, solely for the purpose of placing the assets out of the reach of creditors. As a result, the bankruptcy court in Florida allowed a homestead exemption of only $40,000, the extent provided by Wisconsin law (W.S.A. § 815.20(1)). Yet other bankruptcy decisions have held that a conversion of nonexempt property to exempt property for the purpose of placing such property out of reach of creditors will not alone deprive the debtor of the exemption (see, e.g., In re Levine, 139 B.R. 551 [Bankr. M.D. Fla. 1992]).
Exemption is an integral part of bankruptcy law but a difficult area to navigate. Courts and legislatures must constantly determine whether exemptions constitute fair and just vehicles by which debtors can achieve a fresh start without getting a head start at the expense of creditors. Unfortunately for attorneys, debtors, creditors, and trustees, the laws regarding exemptions are inconsistent. Attempting to maximize the benefits granted by bankruptcy exemptions can be more of a gamble than a science.
Epstein, David G. 2002. Bankruptcy and Related Law in a Nutshell. St. Paul, Minn.: West Group.
Resnick, Alan N. 2002. Bankruptcy Law Manual. Eagan, Minn.: Thompson West.
When the debtor is an individual, once the liquidation and distribution are complete, the bankruptcy court may discharge any remaining debt. When the debtor is a corporation, upon liquidation and distribution, the corporation becomes defunct. Remaining corporate debts are not formally discharged, as they are with individuals. Instead, creditors face the impossibility of pursuing debts against a corporation that no longer exists, making formal discharge unnecessary.
Rehabilitation, or reorganization, of debt is an option that courts usually favor because it provides creditors with a better opportunity to recoup what is owed to them. Rehabilitative bankruptcies are governed most often by chapter 11 or chapter 13 of the Bankruptcy Code. Chapter 11 typically applies to individuals with excessive or complex debts, or to large commercial entities such as corporations. Chapter 13 typically applies to individual consumers with smaller debts.
Unlike liquidation, rehabilitation provides the debtor with an opportunity to retain nonexempt assets. In return, the debtor must agree to pay debts in strict accordance with a reorganization plan approved by the bankruptcy court. During this repayment period, creditors are unable to pursue debts beyond the provisions of the reorganization plan. This gives the debtor the chance to restructure affairs in the effort to meet financial obligations.
To be eligible for rehabilitative bankruptcy, the debtor must have sufficient income to make a reorganization plan feasible. If the debtor fails to comply with the reorganization plan, the bankruptcy court may order liquidation. A
debtor who successfully completes the reorganization plan is entitled to a discharge of remaining debts. In keeping with the general preference for bankruptcy rehabilitation rather than liquidation, the goal of this policy is to reward the conscientious debtor who works to help creditors by resolving his or her debts.
Farmers and municipalities may seek reorganization through the Bankruptcy Code's special chapters. Chapter 12 assists debt-ridden family farmers, who also may be entitled to relief under chapters 11 or 13. When a local government seeks bankruptcy protection, it must turn to the debt reorganization provisions of chapter 9.
Orange County Bankruptcy and Chapter 9 Seldom used, chapter 9 attained notoriety in late 1994 following the bankruptcy of Orange County, California, the largest municipal bankruptcy in history. A county of 2.6 million people with one of the highest per capita incomes in the United States, Orange County held an investment fund that was composed largely of derivatives that were based on speculation on the direction of interest rates. The problem was made worse because the county had borrowed the money it was investing. When interest rates began to climb in 1994, Orange County's leveraged investments drained the investment fund's value, prompting lenders to require additional collateral. The only way to raise the collateral was to sell the investments at the worst possible time. The result was a $1.7 billion loss. After consulting with finance experts and reviewing alternatives, county officials filed for chapter 9 protection on December 6, 1994.
Residents of the affluent county faced immediate repercussions. Close to 10 percent of the fifteen thousand Orange County employees lost their jobs. School budgets were slashed, infrastructure improvements were put on hold, and experts predicted that property values in Orange County would decline. Legal fees involved in a bankruptcy of this complexity are extensive, and officials did not expect Orange County to emerge from bankruptcy for several years.
Critics of current bankruptcy law argue that irresponsible debtors too frequently receive protection at the expense of noncreditors, such as the residents of Orange County. Victims who allege corporate negligence and sue for injuries from dangerous products also become unwilling creditors when a corporation files for bankruptcy. But negligent or not, corporations battling multiple lawsuits often rely on the traditional rationale supporting bankruptcy: that it offers an opportunity to pay debts that otherwise might go unpaid.
Dow Corning Corporation and Chapter 11 Dow Corning Corporation was a major manufacturer of silicone breast implants used in reconstructive and plastic surgeries. In 1991, after receiving thousands of complaints of health problems from women with silicone implants, the U.S. food and drug administration banned the devices from widespread use. Women who had obtained the silicone implants in breast reconstruction or breast enlargement surgeries complained that the implants leaked, causing a variety of adverse conditions such as crippling pain, memory loss, lupus, and connective tissue disease. Dow Corning soon became a defendant in a worldwide product liability class action suit as well as at least nineteen thousand individual lawsuits.
Citing an inability to contribute $2 billion to a $4.2 billion settlement fund and pay for the defense of thousands of individual lawsuits, Dow Corning filed for chapter 11 bankruptcy protection in May 1995. The bankruptcy move halted new lawsuits and enabled the company to consolidate existing claims while preserving business operations. As a result of the filing, Dow Corning stalled its obligation to contribute to the settlement fund.
The Dow Corning strategy was similar to that employed in the mid–1980s by A.H. Robins Company, distributor of the Dalkon Shield intrauterine device for birth control. Like Dow Corning, A.H. Robins faced financial ruin owing to thousands of product liability lawsuits filed at the same time. Also like Dow Corning, A.H. Robins sought relief under chapter 11 of the Bankruptcy Code, which allowed the company time to formulate a plan to pay the many outstanding claims. A reorganization plan approved by the courts involved the merger of A.H. Robins with American Home Products Corporation, which agreed to establish a $2.5 billion trust fund to pay outstanding product liability claims (In re A.H. Robins Co., 880 F.2d 694 [4th Cir. 1989]).
On May 22, 1995, Dow Corning filed a request to stay all litigation against its parent companies, Dow Chemical Company and Corning Incorporated, so that company lawyers could concentrate on the bankruptcy reorganization. That move further threatened the chance of recovery for the plaintiffs seeking compensation for injury.
Family Farmers and Chapter 12 In 1986, responding to an economic farm crisis in the United States, Congress designed chapter 12 to apply to family farmers whose aggregate debts did not exceed $1.5 million. Congress passed the law to help farmers attain a financial fresh start through reorganization rather than liquidation. Before chapter 12's existence, family farmers found it difficult to meet the prerequisites of bankruptcy reorganization under chapters 11 or 13, often because they were unable to demonstrate sufficient income to make a reorganization plan feasible. Chapter 12 eased some requirements for qualifying farmers.
Congress created chapter 12 as an experiment, and scheduled its automatic repeal for 1993. Determining that additional time was necessary to evaluate the effectiveness of the law, Congress in 1993 voted to extend it until 1998. It was either extended or allowed to expire—then restored—eight times between November 1998 and January 1, 2004, when it expired again.
Federal Bankruptcy Jurisdiction and Procedure
Regardless of the type of bankruptcy and the parties involved, basic key jurisdictional and procedural issues affect every bankruptcy case. Procedural uniformity makes bankruptcies more consistent, predictable, efficient, and fair.
Judges and Trustees Pursuant to federal statute, u.s. courts of appeals appoint bankruptcy judges to preside over bankruptcy cases (28 U.S.C.A. § 152 ). Bankruptcy judges make up a unit of the federal district courts called bankruptcy court. Actual jurisdiction over bankruptcy matters lies with the district court judges, who then refer the matters to the bankruptcy court unit and to the bankruptcy judges.
A trustee is appointed to conduct an impartial administration of the bankrupt's nonexempt assets, known as the bankruptcy estate. The trustee represents the bankruptcy estate, which upon the filing of bankruptcy becomes a legal entity separate from the debtor. The trustee may sue or be sued on behalf of the estate. Other trustee powers vary depending on the type of bankruptcy, and can include challenging transfers of estate assets, selling or liquidating assets, objecting to the claims of creditors, and objecting
to the discharge of debts. All bankruptcy cases except chapter 11 cases require trustees, who are most commonly private citizens elected by creditors or appointed by the U.S. trustee.
The office of the U.S. trustee, permanently established in 1986, is responsible for overseeing the administration of bankruptcy cases. The U.S. Attorney General appoints a U.S. trustee to each bankruptcy region. It is the job of the U.S. trustee in some cases to appoint trustees, and in all cases to ensure that trustees administer bankruptcy estates competently and honestly. U.S. trustees also monitor and report debtor abuse and fraud, and oversee certain debtor activity such as the filing of fees and reports.
Procedures Today, debtors file the vast majority of bankruptcy cases. A bankruptcy filing by a debtor is known as voluntary bankruptcy. The mere filing of a voluntary petition for bankruptcy operates as a judicial order for relief, and allows the debtor immediate protection from creditors without the necessity of a hearing or other formal adjudication.
Chapters 7 and 11 of the Bankruptcy Code allow creditors the option of filing for relief against the debtor, also known as involuntary bankruptcy. The law requires that before a debtor can be subjected to involuntary bankruptcy, there must be a minimum number of creditors or a minimum amount of debt. Further protecting the debtor is the right to file a response, or answer, to the allegations in the creditors' petition for involuntary bankruptcy. Unlike voluntary bankruptcies, which allow relief immediately upon the filing of the petition, involuntary bankruptcies do not provide creditors with relief until the debtor has had an opportunity to respond and the court has determined that relief is appropriate.
When the debtor timely responds to an involuntary bankruptcy filing, the court will grant relief to the creditors and formally place the debtor in bankruptcy only under certain circumstances, such as when the debtor generally is failing to pay debts on time. When, after litigation, the court dismisses an involuntary bankruptcy filing, it may order the creditors to pay the debtor's attorney fees, compensatory damages for loss of property or loss of business, or punitive damages. This reduces the likelihood that creditors will file involuntary bankruptcy petitions frivolously or abusively.
One of the most important rights that a debtor in bankruptcy receives is called the automatic stay. The automatic stay essentially freezes all debt-collection activity, forcing creditors and other interested parties to wait for the bankruptcy court to resolve the case equitably and evenhandedly. The relief is automatic, taking effect as soon as a party files a bankruptcy petition. In a voluntary chapter 7 case, the automatic stay gives the trustee time to collect, and then distribute to creditors, property in the bankruptcy estate. In voluntary chapter 11 and chapter 13 cases, the automatic stay gives the debtor time to establish a plan of financial reorganization. In involuntary bankruptcy cases, the automatic stay gives the debtor time to respond to the petition. The automatic stay terminates once the bankruptcy court dismisses, discharges, or otherwise terminates the bankruptcy case, but a party in interest (a party with a valid claim against the bankruptcy estate) may petition the court for relief from the automatic stay by showing good cause.
The Bankruptcy Code allows bankruptcy judges to dismiss bankruptcy cases when certain conditions exist. The debtor, the creditor, or another interested party may ask the court to dismiss the case. Petitioners—debtors in a voluntary case, or creditors in an involuntary case—may seek to withdraw their petitions. In some types of bankruptcy cases, a petitioner's right to dismissal is absolute; other types of bankruptcy cases require a hearing and judicial approval before the case is dismissed. Particularly with voluntary bankruptcies, creditors, the court, or the U.S. trustee has the power to terminate bankruptcy cases when the debtor engages in dilatory or uncooperative behavior, or when the debtor substantially abuses the rights granted under bankruptcy laws.
Recent Developments in Federal Bankruptcy Law
Brought about by a surge in bankruptcy filings and public concern over inequities in the system, the Bankruptcy Reform Act of 1994 is one illustration of Congress's continuing effort to protect the rights of debtors and creditors. Consistent with Congress's goal of promoting reorganization over liquidation, the legislation made it easier for individual debtors to qualify for chapter 13 reorganization. Previously, individuals with more than $450,000 in debt were not eligible to file under chapter 13, and instead were forced to reorganize under the more complex and expensive chapter 11 or to liquidate under chapter 7. The 1994 amendments allow debtors with up to $1 million in outstanding financial obligations to reorganize under chapter 13.
The new law helps creditors by prohibiting the discharge of credit card debts used to pay federal taxes, or those exceeding $1,000 incurred within sixty days before the bankruptcy filing. In this way, the law deters debtors from shopping sprees and other abuses just before filing for bankruptcy. Creditors also benefit from new provisions that set forth additional grounds for obtaining relief from the automatic stay, and require speedier adjudication of requests for relief from the stay.
It looked as though the bankruptcy system would see more reform with the introduction of the Bankruptcy Reform Act of 1998. The act was a response to a report issued by the National Bankruptcy Review Commission, which recommended that the existing code be fine-tuned in order to provide incentives to debtors to file chapter 13 reorganization and to increase debt repayment. The report was issued in response to concern that debtors were taking advantage of the bankruptcy system, evidenced by the fact that a record number of consumers filed for bankruptcy during a time of economic prosperity.
But the Bankruptcy Reform Act of 1998 was never enacted, and it turned out to be only the beginning volley in one of the most tortuous paths any legislation has seen. The House of Representatives has passed a bankruptcy reform bill no fewer than seven times since 1998, with the Senate close behind, and yet bankruptcy reform has yet to be passed into law as of the time of this writing, despite the fact that President george w. bush and the majorities in the current House and Senate all currently favor some sort of bankruptcy reform.
All of the bankruptcy reform legislation introduced since 1997 shares the same main thrust. Individual debtors would be discouraged from filing under chapter 7, which allows them to liquidate their debts, and would be encouraged to file under chapter 13 instead. The filing under chapter 7 will be presumed abusive if the debtor is deemed able to pay a portion of his debts under a formula set forth in the Reform Act. Debtors who have an ability to repay a portion of their debts out of future income will be forced to reorganize under chapter 13.
The main criticism of all the bankruptcy reform acts that have been passed since 1997 is that they favor creditors at the expense of debtors who truly might not be able to pay, but who technically fail the means test that is used to determine whether they can make some form of repayment. But this criticism has not been the only reason why bankruptcy reform has not passed. For example, the Bankruptcy Reform Act of 2001 failed because a provision was included to prevent anti-abortion protesters from avoiding criminal fines by claiming bankruptcy. Anti-abortion legislators who otherwise would have supported the bill joined forces with opponents of the bill to defeat it. Another bankruptcy reform act passed in the House of Representatives by a vote of 315–113 in March 2003.
While Congress was considering bankruptcy reform, the U.S. Supreme Court handed down two decisions that further defined the limits of bankruptcy law. In Cohen v. De La Cruz 523 U.S. 213, 118 S. Ct. 1212, 140 L. Ed. 2d 341, a unanimous court held that where a debtor committed actual fraud and was assessed punitive damages, the debt would be not dischargeable because the Bankruptcy Code's prohibition against the discharge of fraudulently incurred debts is not restricted to the value of the money, property, or services received by the debtor. In Young v. U.S., 535 U.S. 43, 122 S. Ct. 1036, 152 L. Ed. 2d 79. The court held that three-year lookback period allowing IRS to collect taxes against a debtor was tolled during pendency of a debtor's earlier chapter 13 proceeding.
Apart from developments in the law, bankruptcy was much in the news during the opening years of the twenty-first century as an economic downturn forced many of American's most prominent companies into chapter 11 bankruptcy. In 2001, the energy-trading firm Enron filed for the biggest corporate bankruptcy in history, with $64 billion in assets. Less than a year later, telecommunications firm World-Com topped that record when it listed $104 billion in assets in its bankruptcy filing. Other prominent American companies filing for bankruptcy included retailer K-Mart, financial services firm Conseco, and United Airlines parent company UAL.
Anderson, Nick. 2003. "House Passes Bankruptcy Reform Bill For the 7th Time."Los Angeles Times (March 20).
Hubler, James T. 2002. "The End Justifies the Means: The Legal, Social, and Economic Justifications for Means Testing Under the Bankruptcy Reform Act of 2001." American University Law Review (October).
Jewell, Mark. 2002. "Conseco Bankruptcy Ranks Third in U.S." Associated Press (December 19).
Reid, Linda. 2001."Bankruptcy Reform Legislation"Arkansas Lawyer (fall).
"Bankruptcy." West's Encyclopedia of American Law. 2005. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1G2-3437700457.html
"Bankruptcy." West's Encyclopedia of American Law. 2005. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-3437700457.html
BANKRUPTCY. Bankruptcy is formally understood as the condition in which a debtor, upon voluntary petition or one invoked by his or her creditors, is judged legally insolvent and whose remaining property is administered by those creditors or distributed among them. The condition seems relatively straightforward: bankruptcy is legally recognized insolvency. In early modern Europe, however, it was a far more ambiguous state, freighted with the suspicion of fraud, distinguished from simple indebtedness, and, in some places, limited in its prosecution to certain trades or professions.
BANKRUPTCY AND THE INDIVIDUAL
Some of the earliest criminal codes make these associations and distinctions clear. The Discipline Ordinance, promulgated in Augsburg in 1537, ordered arrest and imprisonment of any individual unable to pay debts in excess of two hundred guldens. Should the defaulter flee—a generally recognized indication of fraudulent intent—his creditors were authorized to seize his property and person by whatever means necessary. The results were often acrimonious and violent free-for-alls, as in the infamous Höchstetter bankruptcy of 1527, in which the bankrupts languished and died in prison. While the creditors scrambled to recover what they could, a few, like the Höchstetters' partners the Fuggers, profited handsomely, but many others were ruined in the process.
Were a more mutually agreeable settlement reached, the bankrupt still faced a humiliating loss of status, a fatal derogation in an economy that functioned largely on the basis of personal relationships and reputation. The ordinance prescribed that he be stripped of his membership in the merchants' corporation, that his stall be removed from the privileged position of honest merchants at the base of Augsburg's watchtower, that he be prohibited from bearing arms in public, and that he be compelled to take his place with the women at the rear of public processions. Even his children could not escape his stigma: those born after the bankruptcy would be forbidden to wear the gold chain that was the emblem of established Augsburger merchants. Bankruptcy ordinances in 1564, 1574, and 1580 retained this emphasis on punishing economic crime.
The presumed connection between bankruptcy and fraud was echoed in other sources and other places. The Imperial Discipline Ordinance of 1548 spoke of "ruined merchants" who engaged in insecure—and, hence, fraudulent—credit transactions and suffered bankruptcy because of carelessness or waste. They were to be treated as common thieves. In England, the Tudor Act Touching Orders for Bankrupts of 1571 limited the term to indicate "traders" or "merchants" who "craftily obtaining into their hands great substance of other men's goods, do suddenly flee to parts unknown, or keep their houses, not minding to pay or restore to any their creditors, their debts and duties, but at their wills and pleasures, consume the substance obtained by credit of other men, for their own pleasure and delicate living, against all reason, equity and good conscience. . . ." Thus, bankruptcy existed in relationship to credit (which was considered a morally ambiguous entity), competence, and crime, all indicators of a crisis in the conduct and conception of business.
The passage of these laws constitutes a first response to the growing frequency of bankruptcies in early modern Europe. Beginning in the early sixteenth century, bankruptcy became a social evil that affected all levels of society and had extraordinary implications for both large and small economies. State profligacy, coupled with the unpredictable nature of economic growth, created conditions in which even the greatest commercial houses were not safe from default and failure. For the less well-connected or well-provided-for, insolvency and bankruptcy were common facts of life, the litigation of which left an unmistakable trail in most European archives. In 1560, the chronicler Paul Hektor Mair would record the names of twenty-six prominent Augsburg merchants who "became bankrupt and because of debts, sought sanctuary, fled the city, or suffered arrest until they settled and were released." Between 1529 and 1580, that number would rise to at least sixty-three and perhaps as many as seventy of the "great and famous commercial houses" of that city. Over the entire early modern period, Augsburg witnessed over 250 bankruptcies and countless insolvencies. Nor was the problem geographically limited. In England, according to one historian, "debt litigation dominated pleading in the courts of King's Bench and Common Pleas" from the mid-sixteenth to the mid-seventeenth century. From the mid-seventeenth to the mid-eighteenth century, no fewer than fifty-eight French merchants engaged in transatlantic trade suffered bankruptcy. Studies of the Parisian credit market for the same period reveal a noteworthy expansion of private borrowing coupled with periodic government defaults and interventions that would have resulted in waves of bankruptcies.
BANKRUPTCY AND GOVERNMENT
The relationship between public and private finance remains dimly understood, but the numbers and patterns of commercial or domestic failures in early modern Europe relate, in part, to a series of spectacular state bankruptcies. In an age when most princes struggled to live within their means, the monarchs of Spain and France, despite rising prices and ambitions, seemed to rule in virtual freedom from such limitations and developed extraordinary debts in pursuit of their policies. France declared bankruptcy in 1559 and defaulted on its short-term debts repeatedly during the reign of Louis XIV, subsisting otherwise on a fiscal system noted particularly for its corruption. Spain suffered bankruptcies in 1557, 1560, 1575, and 1596. The most spectacular, that of 1575, may be taken as emblematic of all. The decision of Philip II to suspend payments to his bankers can be seen as a watershed in his reign (and in Spanish power). The causes are not far to seek: the costs of political and military policies in the Mediterranean and the Netherlands during the 1560s and 1570s outstripped the crown's financial resources. Rather than effect economies, renegotiate terms, or redistribute the burden, Philip and his financial advisers opted to default, forcing a conversion of short-term debt to long-term debt that involved favorable interest rates and the forgiveness of certain obligations. This was a favorite tactic not only of the Spanish crown but also of the French in the early modern period. But in dealing with the bankruptcy of 1575, Spain's bankers (the Genoese above all) did not mildly concede as they did in 1560 (and, later, in 1596) but instead firmly resisted. They suspended all commercial credit to Castile, the fiscal heartland of Spain, and rejected the king's proposed terms. Although the immediate consequences were not fatal, the bankruptcy may be said to mark the beginning of Spanish decline. The suspension of commercial credit within Spain, and especially within Castile, permanently affected trade and, consequently, taxes. The loss also impinged on the effectiveness of Spanish armies in Italy and the Netherlands and led, most immediately, to the sack of Antwerp in 1576, likely rendering any suppression of the Dutch Revolt of 1568–1648 impossible. As important as this bankruptcy may be for the political history of the period, its economic consequences reach far beyond Spain's borders. In the 1577 settlement that ended the bankruptcy and restored Spanish credit, the bankers managed to avoid the worst consequences by recouping or transferring their losses (by calling in other debts). This became apparent in a wave of private failures that mark the interconnections between public and private finance and between larger and smaller commercial enterprises. In Augsburg, for example, 39 of the 63 sixteenth-century bankruptcies cluster around the Spanish defaults: 13 between 1559 and 1561, 14 between 1573 and 1576. Though it is impossible to attribute these and many other failures strictly to the fiscal chicanery of Philip II, their timing cannot be purely coincidental. Bankruptcies marked a shortage of credit—a crisis in money markets—that potentially reached from state treasuries to commercial countinghouses and from powerful bankers to humble artisans.
Of course, bankruptcies illuminate much more than the interconnections of early modern finance; they reveal some aspects of business practice. Early modern merchants, entrepreneurs, and financiers operated in an age of money scarcity and relied, therefore, to a very large extent on credit. Indeed, these men often traded within systems of interlocking credit, owing money to their suppliers or lenders and owed money by their customers and clients. Such systems could be quite fragile; one default could cause others, rippling across the entire network of relationships. In addition, they operated in an economy that lacked legal and fiscal institutions to ensure and enforce credit transactions. As a result, merchants, entrepreneurs, and financiers relied upon personal relationships and personal knowledge to reduce the risk of default. Being a close-knit community in most places, they often knew who was or was not a good credit source or credit risk. Where personal knowledge would not serve, intermediaries, such as notaries or goldsmiths, often arose, and used their own knowledge of persons (and their means) to mediate and facilitate credit exchange. Questions of reputation and risk, to say nothing of the issue of fraud, were a function of the transmission of information and touch the boundaries between economic and cultural history. They also touch the social history of economic life in early modern Europe. Merchants also depended on a wide range of organizations to reduce risk and reinforce reputations: they formed partnerships among themselves; they entered into collective agreements; they drew upon the resources of their families; they strengthened business agreements with confessional ties (by doing business with people of the same Christian creed). Finally, bankruptcies testify not just to the failures but also to the successes of early modern enterprise, a varying combination of fortune and misfortune, competence and incompetence, honesty and dishonesty. Bankruptcies give us a mirror image of business success; by showing us how merchants and manufacturers assessed risk and managed assets, we learn not only the circumstances of failure but also the conditions of success.
The early modern period supposedly witnessed what scholars have for more than a century generally described as the transition to modern capitalism. Insofar as this is true, bankruptcy reveals some of the continuities and discontinuities in an age of change. Credit played a central role in early modern bankruptcies, and the vitality and ubiquity of early modern money markets is one area in which modern capitalism differs less than expected from its pre-modern model. The personal nature of credit relations, given the institutional underdevelopment of early modern economies, constitutes a less well understood distinction from modern capitalistic practice. The interpretation of bankruptcy as a criminal act requiring restitution—which remained unaltered until the nineteenth century—raises fundamental questions about business reorganization and capital accumulation on the eve of the Industrial Revolution. The adversarial relationship between private and public finance, revealed strikingly in early modern state bankruptcies, may suggest that their modern symbiotic relationship had not developed. Bankruptcy teaches, finally, that "transition" may be too simple a term for what was a multifaceted, complex, and gradual process.
By the eighteenth century, the bankrupt replaces the monopolist as the quintessential image of ruthless, exploitative capitalism. Bankruptcies were common occurrences against which integrity offered no necessary protection. Yet moralizing tracts and popular periodicals elevated the bankrupt to the level of arch-villain of the local economy. It was a perfect measure of the ways economic principles had and had not caught up with economic practices. Given the importance of bankruptcy not only for the economic history of early modern Europe but also for its political, social, and cultural history, it is surprising that so little scholarship has been devoted to the topic.
See also Banking and Credit ; Capitalism ; Commerce and Markets ; Economic Crises ; Interest ; Taxation .
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Thomas Max Safley
SAFLEY, THOMAS MAX. "Bankruptcy." Europe, 1450 to 1789: Encyclopedia of the Early Modern World. 2004. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1G2-3404900089.html
SAFLEY, THOMAS MAX. "Bankruptcy." Europe, 1450 to 1789: Encyclopedia of the Early Modern World. 2004. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-3404900089.html
In 2005 the U.S. Congress enacted profound changes to the Bankruptcy Reform Act of 1978. Known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the amendments were designed to correct perceived abuses by debtors who allegedly took advantage of the pro-debtor tone and provisions of the 1978 statute. The emphasis has been shifted from a pro-debtor enactment to one favoring creditors.
The basic premise for enabling debtors to file for bankruptcy is to have a "fresh start" by permitting them to end their overwhelming debt and begin anew to rebuild their credit and engage in day-to-day activities without fear of creditors seizing their assets and imposing liens on their salaries. Congress had concluded that a sizable percentage of debtors had taken advantage of liberal Bankruptcy Code provisions and grossly abused their credit access. Thus, Congress imposed a number of roadblocks to the discharge of indebtedness while refraining from limiting creditors' persistent inundation of offers of credit to consumers—especially by credit card companies.
The Bankruptcy Code contains a number of chapters, including preliminary sections concerning procedural and administrative requirements and substantive chapters that detail requirements for debtors regarding liquidation, reorganization, or adjustment of debts. The most relevant chapters are 7, 11, and 13.
CHAPTER 7 LIQUIDATION PROVISIONS
The most significant change to the 1978 statute concerns consumer bankruptcy under the Chapter 7 liquidation provisions. Previously, debtors had the choice of filing for liquidation—which means that debtors are completely discharged from all indebtedness except for certain nondischargeable debts, after their assets have been reduced to cash and distributed to creditors—or filing a plan under Chapter 13 with the court for the payment of all or part of the indebtedness.
The act continues the choice but now requires consumer debtors electing to file under the act to initially secure credit counseling within 180 days preceding the filing and to provide a certificate from an approved non-profit budget and credit counseling agency concerning services provided to the debtors, including a copy of the repayment plan, if any. The act also continues to permit debtors to have their debts discharged, after compliance with the statute, and to possess a not-insignificant amount of assets upon termination of the proceeding.
Contrary to what many persons believe, the debtor being discharged in bankruptcy is able to retain a substantial amount of property (which would be double the sum if there is a joint filing). This is a further inducement to seek bankruptcy protection before being reduced to an impoverished condition. The assets that a bankrupt person may retain are:
- Interest in property held jointly or as tenants by the entirety if the tenant is exempt from the process under nonbankruptcy law
- Retirement funds pursuant to statute
- Debtor's aggregate interest up to $18,450 in value in real or personal property used as a residence, cooperative, or burial plot
- Debtor's interest in one motor vehicle up to $2,950 in value
- Debtor's interest up to $475 in any particular item or $9,850 in total value in household furnishings and goods, and various personal items, such as clothing
- $1,225 in value for jewelry for personal, family, or dependent use
- Any property up to $975 plus up to $9,250 of any unused amount of exemption
- $1,850 in any implements, professional books, tools of trade
- Unmatured life insurance
- Prescribed health aids
- Various other benefits and payments, such as Social security
Priority of Distributions
Not all creditors are treated alike with respect to the distribution of net assets that remain after the deduction of costs, expenses, and other indebtedness. The order of distribution of assets remaining is as follows:
- Secured creditors to the extent of their security on specific property (e.g., mortgage interest on real property)
- Unsecured domestic support obligations
- Administrative expenses
- Claims up to $10,000 earned by the creditor within 180 days of filing or cessation of business for wages, sales, or commissions
- Contributions to an employee benefit plan arising within 180 days of filing or cessation of business up to $10,000 per employee
- Claims of persons engaged in farming or fishing up to $4,925 each
- Other claims for rental, sale, or use of property or services rendered up to $2,225
- Certain claims by governmental entities including income and property taxes
- Claims for death or personal injuries arising from use of an automobile or vessel while debtor was intoxicated
- All other indebtedness
The act provides that certain debts may not be discharged since Congress has determined that bankrupt persons should continue to be responsible for such debts even if they cannot currently make payment. The reasons for the nondischargability of such debts include: the nature of the debt, policy reasons to protect the creditors (e.g., support obligations for one's family), and debts arising because of the debtor's misconduct. They are as follows:
- Taxes, including state and local taxes, and customs duty
- Money or other financial benefit received by reason of false pretenses
- Consumer debts incurred within ninety days before filing totaling more than $500 owed to a single creditor for luxury goods and services; cash advances of $750 from a single creditor within seventy days of filing
- Debts not listed
- Debt for fraud, embezzlement, and larceny
- Domestic support obligation
- Willful or malicious injury to another person or property
- Fines, penalties, forfeitures payable to a governmental entity, including for state and local taxes, that is not compensation for actual money loss, other than a tax penalty imposed before three years before date of filing of petition
- Educational benefit funded by government unless undue hardship; also, student loans payable to for-profit and nongovernmental entities
- For death or injury by auto, vessel, or an aircraft while intoxicated from drugs, alcohol, or other substance
- To a spouse or former spouse
- Fee or assessment due to condominium or coop
- Fee imposed on a prisoner
- Debts owed to a pension, profit-sharing, or stock bonus plan
- Violation of the federal securities laws
Dismissal of Petition for Abuse—The Means Test
The revised act mandates the dismissal of a Chapter 7 filing if the grant of relief would constitute an "abuse" of the act by individual consumer debtors. The tests that may be used by the Bankruptcy Court in dismissing a petition for abuse include a median income test and a means test. If the debtor's current monthly income exceeds the state's medium income for a family of equivalent size or if the debtor's monthly income less allowable expenses exceeds an amount allowed under the act for a family of equivalent size, then there is a presumption of abuse; otherwise, no such presumption may be inferred.
The court may also use noneconomic factors in determining if abuse does exist. The formulas presented are quite complex and may necessitate the services of professionals. Thus, the act seeks to require debtors able to pay their debts over time to adopt the provisions of Chapter 13 and pay all or a portion of the debt over a period of years rather than expeditiously having a clean slate to start anew. The debtor thus has extensive filing requirements, including the credit counseling certificate, pay stubs, and statements of pre- and postpetition income and expenses.
A previous source of abuse was that debtors could use either the act's exemptions or the exemptions provided in the state in which they resided, whichever was greater. Thus, certain states had homestead exemptions that permitted multimillion-dollar homes to be exempt from claims of creditors. The act now limits the exemption to $125,000 if there is an abuse in the filing or other defined bases.
The revised statute makes use of attorneys potentially very costly or otherwise inaccessible. The signature by an attorney on the bankruptcy petition is a certification that he or she has no knowledge, after a diligent inquiry, that the information on the schedules is incorrect. The effect of this provision is that an attorney has to make a detailed investigation of the debtor's finances and be ready to be subject to expenses of a trustee in making a motion to dismiss as well as to incur potential fines. Thus, many attorneys may refrain from representing debtors or significantly increase the fees they charge for services rendered because of the additional time required in assisting debtors, as well as the heightened potential liability for the attorneys.
After the assets are distributed, then the unpaid claims are discharged. Partnerships and corporations must liquidate under state law before or on completion of the proceeding. The debtor cannot file another Chapter 7 proceeding until the expiration of eight (formerly six) years.
Other Liquidation Provisions
There are separate liquidation provisions for stockbrokers, commodity brokers, and clearing bank liquidations. Also, municipal governmental bankruptcies are treated under Chapter 9 of the act.
CHAPTER 11 REORGANIZATION
The Bankruptcy Code recognizes that liquidating a company may entail the loss of jobs as well as other disruptive events. Accordingly, Chapter 11 seeks to permit companies to become solvent again by reorganizing themselves in such a way as to permit them to continue functioning as viable entities. Chapter 11 applies to individuals, partnerships, corporations, unincorporated associations, and railroads, although corporations are almost always the petitioners. It does not apply to companies that are regulated by other statutes, such as banks, savings and loan associations, unions, insurance companies, and brokerage firms.
The advantage to a Chapter 11 filing is that the debtor is permitted to remain in possession of the entity, which is especially important in business filings since the debtor may continue to operate the business. If the court believes there may be adverse circumstances, such as possible fraud or other dishonesty or gross mismanagement, then it may appoint a trustee or examiner to review the debtor's finances.
Once an order of relief is granted, the court will appoint a creditors' committee, which generally consists of the seven largest unsecured creditors. Their function includes appearances at court hearings, participation in the plan of reorganization, and asserting possible objections to the plan. As in Chapter 7, there is an automatic stay that prevents creditors from pursuing other judicial proceedings or collecting debts.
Chapter 11 permits the debtor to accept or reject executory contracts (contracts whose completion is to be accomplished in the future). The plan of reorganization is to be filed within 120 days after date of the order of relief. The plan sets forth the debtor's proposed new capital structure, designates the different classes of claims and interests, and proposes possible alteration of the rights of creditors, conversion of unsecured creditors to equity holders, sale of assets, and other items. The creditors are to receive a disclosure statement containing necessary information concerning the plan of reorganization. The creditors and interests are to accept or reject the plan before confirmation by the court. Confirmation requires that the plan be in the best interests of each class of claims and interests, and be feasible. If creditors object, the court is empowered to compel acceptance and participation.
CHAPTER 13 CONSUMER DEBT ADJUSTMENT
Chapter 13 applies to natural persons and is intended to allow the debtors to file a petition with the Bankruptcy Court in an endeavor to permit the debtors to become solvent by either extending the time to pay their debts or by a composition that permits the debtors to pay a sum less than the full amount to each of the creditors. Eligible persons are natural persons who have regular income and who possess noncontingent, liquidated, unsecured debts of less than $250,000 and secured debts of less than $750,000.
The plan of payment must be filed within fifteen days after the filing of the Chapter 13 petition. The plan must recite the debtors' finances, estimated income, and expenses with a payout over a three-year period (5 years if approved by the court). The advantages to debtors include continuation of possession of their property. The planned installment, which is made to the trustee, is to commence within thirty days of filing. The trustee is responsible for paying the creditors.
Objections to the plan may be filed by the creditors, which are then determined at a hearing. The court examines whether the plan was made in good faith, whether it is feasible (if the debtor will be able to make the proposed payments), and be in the interests of the creditors, that is, the creditors must receive at least what they would have received under a Chapter 7 liquidation proceeding.
Borges, W., and Nathan, B. C. (2005, April 15). Bankruptcy abuse and consumer protection act of 2005: Significant business bankruptcy changes in store for trade creditors. Retrieved September 7, 2005, from http://www.nacm.org/resource/Bankruptcy-Actapr15-05.html
Davis Polk & Wardwell. (2005, June 2). Bankruptcy code and selected other provisions of the United States code. Retrieved November 28, 2005, from http://www.dpw.com/practice/code.blackline.pdf
Jeweler, Robin (2005, March 14). The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 in the 109th Congress. Congressional Research Service. Retrieved November 28, 2005, from http://www.bna.com/webwatch/bankruptcycrs4.pdf
Resnick, A., and Sommer, H. (2005). The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: With analysis. New York: LexisNexis/Matthew Bender.
Reynolds, J. (2005, August). Debtor relief or grief? The bankruptcy act of 2005. Retrieved September 8, 2005, from http://www.dcbar.org/for_lawyers/washington_lawyer/august_2005/bankruptcy.cfm
Roy J. Girasa
Girasa, Roy. "Bankruptcy." Encyclopedia of Business and Finance, 2nd ed.. 2007. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1G2-1552100031.html
Girasa, Roy. "Bankruptcy." Encyclopedia of Business and Finance, 2nd ed.. 2007. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-1552100031.html
Bankruptcy is a legal proceeding, guided by federal law, designed to address situations where a debtor—either an individual or a business—has accumulated obligations so great that he or she is unable to pay them off. Bankruptcy law does not require filers to be financially insolvent at the time of the filing. Rather, it applies a criterion in which approval is granted if the filer is "unable to pay debts as they come due." Once a company is granted bankruptcy protection, it can terminate contractual obligations with workers and clients, avoid litigation claims, and explore possible avenues for reorganization.
Bankruptcy laws are designed to distribute the debtor's assets as equitably as possible among his or her creditors. Most of the time, with some exceptions, bankruptcy also frees the debtor from further liability. Bankruptcy proceedings may be initiated either by the debtor—a voluntary process—or may be forced by creditors.
According to the Administrative Office of the U.S. Courts, in Fiscal Year 2005, 1.637 million bankruptcies were filed in federal courts, up from 1.277 million in FY 2000. Of these 32,406 were business bankruptcies (down from 36,910 in FY 2000). Bankruptcy statistics are dominated by personal filings; these have been increasing sharply in recent years due in large part to rapidly increasing levels of personal indebtedness.
This phenomenon has been responsible for a major overhaul of bankruptcy law in 2005. The legislation, known as The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) was signed into law on April 20, 2005 and became effective October 17 of the same year. The law was designed, in part, to eliminate the practice of serial bankruptcy filings by individuals to escape carelessly accumulated debt.
Types of bankruptcy are named after chapters of the bankruptcy code. Individuals may file under the provisions of Chapter 7 or Chapter 13.
CHAPTER 7 BANKRUPTCY
Under Chapter 7 bankruptcy law, all of the debtor's assets—including any unincorporated businesses that he or she may own—are fully liquidated. Assets deemed necessary to support the debtor and his/her dependents, such as a residence, may be exempted. This "liquidation bankruptcy" is the most common filing for business failures, accounting for about 75 percent of all business bankruptcy filings.
The federal bankruptcy court develops a full listing of the debtor's assets and liabilities. The court identifies assets deemed to be exempted, such as a family home, and then divides remaining assets among the various creditors; a trustee is appointed to oversee distribution of proceeds. Unpaid taxes receive top priority; secured creditors are usually considered next. After all assets are liquidated and distributed, the debtor is freed of all further obligations. John Pearce II and Samuel DiLullo note the pluses and minuses of this procedure in Business Horizons as follows: "This type of filing is critically important to sole proprietors or partnerships, whose owners are personally liable for all business debts not covered by the sale of the assets unless they can secure a Chapter 7 bankruptcy allowing them to cancel any debt in excess of exempt assets. Although they will be left with little personal property, the liquidated debtor is discharged from paying the remaining debt." The debts thus discharged exclude certain items which the debtor is required to pay despite the Chapter 7 filing. These include child support, alimony, recent income taxes, and student loans guaranteed by government.
The recently passed BAPCPA limits the ability of a debtor to file under Chapter 7. The debtor can only file for "liquidation bankruptcy" if his or her median income is below the state median income; if it is higher, and the person can afford to pay out $100 monthly to liquidate debt, he or she may only file under Chapter 13. The new law also mandates credit counseling ahead of filing in a government-approved program.
CHAPTER 13 BANKRUPTCY
An individual or business filing under Chapter 13 turns over his or her finances to the bankruptcy court and is then obliged to make payments at the court's direction. Whereas Chapter 7 is characterized by full discharge of debt, Chapter 13 results in a repayment plan. Debtors prefer Chapter 7 because it usually allows them to hold on to their equity but, after a brief time, all obligations except such as listed above (child support, alimony, etc.) are eliminated. Courts prefer filings under Chapter 13 if the individual has any ability to satisfy the debt over time, and BAPCPA now codifies this leaning of the courts by defining a "threshold"—the state median income and an ability to pay $100 a month toward the indebtedness.
Provisions of BAPCPA have made Chapter 13 filings more burdensome for filers. Under the old dispensation, Chapter 13 filers enjoyed more protection against legal actions by litigants intending to recover funds or to impose new costs. Filers were protected against evictions; under BAPCPA they no longer are. They may lose their driver's licenses. They must continue to respond to divorce and child-support actions. BAPCPA has also moved family members with financial claims (e.g., for child support, alimony) to the first rank of recipients, ahead of secured creditors. Like Chapter 7 filers, Chapter 13 filers are also required to participate in mandatory financial management education.
CHAPTER 11 BANKRUPTCY
In a bulletin titled Corporate Bankruptcy, the U.S. Securities and Exchange Commission summarizes why corporations file for bankruptcy under Chapter 11: "Most publicly-held companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 provides a process for rehabilitating the company's faltering business. Sometimes the company successfully works out a plan to return to profitability; sometimes, in the end, it liquidates. Under a Chapter 11 reorganization, a company usually keeps doing business and its stock and bonds may continue to trade in our securities markets."
Companies generally turn to Chapter 11 protection after they are no longer able to pay their creditors. Once a company has filed under Chapter 11, its creditors are notified that they cannot press suits for repayment (although secured creditors may ask the court for a "hardship" exemption from the general debt freeze that is imposed). Creditors are, however, permitted to appear before the court to discuss their claims and provide data on the debtor's ability to reorganize. In addition, unsecured creditors may appoint representatives to negotiate a settlement with the debtor company. Finally, creditors who feel that the debtor company's financial straits are due to mismanagement or fraud may ask the court to appoint an examiner to look into such possibilities.
Once a company asks for Chapter 11 protection, it provides the court, lenders, and creditors with a wide range of financial information on its operations for analysis even as it continues with its day-to-day operations; during this period, major business expenditures must be approved by the court. The business will also prepare a reorganization plan, which, according to CPA Journal contributor Nancy Baldiga, "details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection." Another important component of this plan is the disclosure statement, which presents projected business fortunes, proposed financial settlements with creditors and equity holders, and estimates of the liquidation value of the company. "The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation," wrote Baldiga.
The reorganization plan, if approved by the court and a majority of creditors, becomes the blueprint for the company's future. Principal factors considered in determining the feasibility of reorganization proposals include:
- Status of the company's capital structure
- Availability of financing and credit
- Potential earnings of the company after reorganization
- Ability to make creditor payments
- Management stability
- General economic conditions in the industry
- General economic conditions in geographic regions of operation
BAPCPA has also introduced a number of changes governing Chapter 11 filings related to leases, payments made immediately prior to the bankruptcy filing, improved ability of creditors to reclaim products, caps on wage claims applicable to the pre-filing period, and other matters.
SMALL BUSINESS CREDITORS
Small businesses facing a bankrupt client have few options to protect themselves. If the debtor is engaged in questionable or fraudulent business activities, the small business may use legal actions beyond simply waiting patiently for a bankruptcy court to act. In situations where the debtor has incurred debt only a short time before filing before bankruptcy, creditors can sometimes obtain judgments that put added pressure on the debtor to make good on that liability. In addition, noted the Entrepreneur Magazine Small Business Advisor, "the law provides for a '60-day preference' rule. This rule is designed to prevent debtors from paying off their friends right before they file bankruptcy while leaving others stiffed. The 60-day rule allows the court to set aside any payments made up to 60 days before the actual filing of bankruptcy. Creditors who have been paid must return the money to the bankruptcy court for it to be placed in the pot. Business owners should keep in close contact with their ongoing customers so that they will have a good enough relationship to know far in advance to avoid being caught up in this rule." Indeed, small business owners in particular should always be watching for clients/customers who show signs of being in financial distress. If such indications become present, the owner needs to determine the depth of that distress and whether his or her small business can withstand the likely financial repercussions if that client/customer declares bankruptcy. If a bankruptcy declaration would be a significant blow, then the business owner should weigh various alternatives to protect his/her business, such as cutting back on business dealings with the endangered company or tightening up credit arrangements with the firm.
Finally, advisors typically counsel small business creditors to file confirmations of debt with the court even if it seems highly unlikely that they will ever be compensated. This filing allows creditors to write off bad debts on their taxes.
ALTERNATIVES TO BANKRUPTCY
A company that runs into serious financial difficulties has alternatives to bankruptcy. It can liquidate the business on its own and make payments to its creditors. "Such action may be achieved efficiently if [the business's] creditors … are few … and the assets … can readily be converted to cash," wrote Pearce and DiLullo. "If the number of creditors is large and the assets are numerous and difficult or time-consuming to sell (such as real estate), the protection, structure, and authority of the court may be needed."
Another option is for the company to place liquidation of assets in the hands of a trustee who subsequently pays creditors. The principal advantage of this avenue, say Pearce and DiLullo, is that the assets are thus protected from individual creditors who might otherwise file liens on the assets. "Composition agreements," meanwhile, can be used in situations where creditors agree to receive proportional (pro rata) payments of their claims in return for freeing the debtor company from the remainder of its debts.
These alternative strategies may enable some business owners to avoid the stigma of bankruptcy. But Pearce and DiLullo note that pursuing these options involves considerable risk: "astute creditors will recognize such actions as precursors to bankruptcy and may modify their relationships with [the company], which could precipitate a bankruptcy filing. If creditors believe that continuing in business will result in reduced assets, they may force a bankruptcy in order to stop operations and preserve the existing assets to pay outstanding debts."
see also Business Failure/Dissolution
Administrative Office of the U.S. Courts. "Number of Bankruptcy Cases Filed in Federal Courts." Press Release, 24 August 2005.
Baldiga, Nancy R. "Practice Opportunities in Chapter 11." CPA Journal. May 1998.
"Checklist of Key Changes." FindLaw. Available from http://bankruptcy.findlaw.com/bankruptcy/bankruptcy-basics/key-changes.html. January 2006.
Pearce II, John A., and Samuel A. DiLullo. "When a Strategic Plan Includes Bankruptcy." Business Horizons. September/October 1998.
U.S. Securities and Exchange Commission. "Corporate Bankruptcy." Available from http://www.sec.gov/investor/pubs/bankrupt.htm. 8 December 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI
"Bankruptcy." Encyclopedia of Small Business. 2007. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1G2-2687200049.html
"Bankruptcy." Encyclopedia of Small Business. 2007. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-2687200049.html
bankruptcy, in law, settlement of the liabilities of a person or organization wholly or partially unable to meet financial obligations. The purposes are to distribute, through a court-appointed receiver, the bankrupt's assets equitably among creditors and, in most instances, to discharge the debtor from further liability. In the United States, bankruptcy is controlled by a federal law adopted in 1898 and amended several times, as by the Chandler Act (1938) and the Bankruptcy Reform Act (1978).
Bankruptcy proceedings may be voluntary (instituted by the debtor) or involuntary (instituted by creditors). The debtor may be insolvent—i.e., unable to pay all debts even if the full value of all assets were realized—or may become insolvent when current obligations mature. Bankruptcy is also permitted when the discharge of debts would otherwise be unduly delayed, e.g., if the debtor has fraudulently transferred property to put it out of a creditor's reach. When a person or corporation has declared or been adjudged bankrupt, preferred creditors (e.g., unpaid employees, or the federal government) are paid in full, and the other creditors share the proceeds of remaining assets.
The bankrupt individual receives more lenient treatment in the United States than in perhaps any other country, so that business initiative is not stifled by the threat of criminal or civil penalties following unintentional commercial failure. This ideal is evident in Chapter 11 of the bankruptcy code, which permits courts to reorganize the assets of failing businesses instead of ordering complete liquidation of these assets. The 1978 revision of the code made it easier for corporate management to remain in control of a company during reorganization. These more lenient provisions led to a rapid increase in filings in the 1980s and 1990s. In 2005 Congress passed a significant revision of the bankruptcy code affecting individuals, prompted in part by the increase in filings since 1978. Under the new law, it is harder for an individual to file a Chapter 7 bankruptcy, which extinguishes a person's debts, and it is easier for creditors to secure repayment of a debt over time. The changes were strongly supported by banks and credit card companies, but were also criticized by a number of bankruptcy experts for placing additional burdens on middle income families while not closing loopholes that benefit bankrupt corporations and wealthy individuals. Chapter 9 of the code provides for the reorganization of bankrupt municipalities.
See study by T. Jackson (1986).
"bankruptcy." The Columbia Encyclopedia, 6th ed.. 2016. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1E1-bankrupt.html
"bankruptcy." The Columbia Encyclopedia, 6th ed.. 2016. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1E1-bankrupt.html
57. Bankruptcy (See also Poverty.)
- Birotteau, César ruined by bad speculations and dissipated life. [Fr. Lit.: Greatness and Decline of César Birotteau, Walsh Modern, 58]
- Black Friday day of financial panic (1869). [Am. Hist.: RHDC ]
- Black Tuesday day of stock market crash (1929). [Am. Hist.: Allen, 238]
- green cap symbol of bankruptcy. [Eur. Hist.: Brewer Note-Book, 390–391]
- Harland, Joe drunk who loses fortune on Wall Street. [Am. Lit.: The Manhattan Transfer ]
- Hassan, Abu pretends to be dead to avoid debts. [Ger. Opera: von Weber, Abu Hassan, Westerman, 138–139]
- Henchard, Michael loses business and social standing through bad financial planning. [Br. Lit.: Mayor of Casterbridge ]
- Lydgate, Tertius driven deeper into debt on daily basis. [Br. Lit.: Middlemarch ]
- Panic of 1873 bank failures led to extended depression. [Am. Hist.: Van Doren, 267–268]
- Queer Street condition of financial insolvency. [Am. Usage: Misc.]
"Bankruptcy." Allusions--Cultural, Literary, Biblical, and Historical: A Thematic Dictionary. 1986. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1G2-2505500066.html
"Bankruptcy." Allusions--Cultural, Literary, Biblical, and Historical: A Thematic Dictionary. 1986. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-2505500066.html
bank·rupt / ˈbangkˌrəpt; -rəpt/ • adj. (of a person or organization) declared in law unable to pay outstanding debts: the company was declared bankrupt. ∎ impoverished or depleted: a bankrupt country with no natural resources. ∎ fig. completely lacking in a particular quality or value: their cause is morally bankrupt. • n. a person judged by a court to be insolvent, whose property is taken and disposed of for the benefit of creditors. • v. [tr.] reduce (a person or organization) to bankruptcy: the strike nearly bankrupted the union.
"bankrupt." The Oxford Pocket Dictionary of Current English. 2009. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1O999-bankrupt.html
"bankrupt." The Oxford Pocket Dictionary of Current English. 2009. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O999-bankrupt.html
"bankruptcy." World Encyclopedia. 2005. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1O142-bankruptcy.html
"bankruptcy." World Encyclopedia. 2005. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O142-bankruptcy.html
Hence as vb. XVI. bankruptcy (-CY) XVI.
T. F. HOAD. "bankrupt." The Concise Oxford Dictionary of English Etymology. 1996. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1O27-bankrupt.html
T. F. HOAD. "bankrupt." The Concise Oxford Dictionary of English Etymology. 1996. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O27-bankrupt.html
"bankruptcy." Oxford Dictionary of Rhymes. 2007. Encyclopedia.com. (June 26, 2016). http://www.encyclopedia.com/doc/1O233-bankruptcy.html
"bankruptcy." Oxford Dictionary of Rhymes. 2007. Retrieved June 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O233-bankruptcy.html