Bankruptcy Laws

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BANKRUPTCY LAWS. Any economic system that rewards success has to provide as well for failure. The major industrial nations have long had bankruptcy systems, though they differ dramatically in philosophy and in practice, to liquidate or revive failing businesses and to settle consumer debts when individuals become over-whelmed economically. Countries in transition from planned to free market economies have recognized that a bankruptcy structure is indispensable.

Article I, section 8, of the Constitution gives Congress the power "to establish … uniform laws on the subject of bankruptcies throughout the United States." Antecedents to that provision are found in eighteenth-century British common law and even in Roman law. Philosophically and politically, however, the genesis of the American bankruptcy system is found in the debtors' prisons of England and the colonies, where punishment and disgrace rather than repayment and economic rehabilitation were the principal focus.

For more than one hundred years, U.S. bankruptcy law has reflected a different approach. The U.S. Bankruptcy Code attempts to balance the rights of debtors with the rights of their creditors and, among creditors, balance their competing rights based on the security they hold for the debt and the nature of the underlying obligation. The Code determines which creditors will be paid in full, which paid in part, and which paid not at all.

The law also declares that some personal obligations are "nondischargeable" and must be paid regardless of bankruptcy. For individual debtors, these include tax obligations, criminal fines and penalties, alimony and child support, and student loans; corporations must pay administrative expenses, including some wage and benefit obligations to employees, if the company is to be permitted the chance to reorganize.

The U.S. Bankruptcy Code contains separate chapters and, often, separate procedures to handle financial failure. Chapter 7, which governs the liquidation of a debtor's assets, is chosen by about 70 percent of all individuals and half of all businesses filing for bankruptcy. The remaining chapters of the Code provide for reorganization—the readjustment of the debt, its full or partial payment, and the economic survival of the debtor in some form. For individuals who do not choose Chapter 7, economic reorganization is available in Chapter 13. Corporations and partnerships reorganize in Chapter 11, family farms in Chapter 12, and an occasional municipality or utility district in Chapter 9. By law, certain businesses are ineligible for bankruptcy protection—banks, insurance companies, and railroads, for example. When they become insolvent, they turn to state law or other federal statutes to resolve their obligations.

State law plays an important role even in a "uniform" federal bankruptcy system because state law most often defines contractual and commercial relationships. States also have their own legal procedures for business insolvencies that a debtor can elect although the state procedures are often less defined, less flexible, and less sophisticated than the federal bankruptcy system.

Bankruptcy Courts and Code

The Constitution establishes a federal judiciary in Article III. The federal bankruptcy courts are established under Article I, which limits the authority of the nation's more than 250 bankruptcy judges, and they are considered adjunct to the Article III federal district courts. Bankruptcy courts, which have broad authority under the Bankruptcy Code, are adjunct to the federal district courts and their judges serve fourteen-year terms. (Unlike the life tenure of federal judges.) Judges are appointed by the U.S. Courts of Appeals without confirmation by the U.S. Senate.

The Bankruptcy Code is complex. A business that hopes to reorganize under Chapter 11 must propose a plan of reorganization that, with rare exceptions, its creditors must vote to accept. In a Chapter 11 reorganization, the company will still be operated by the same management but will have creditor and court oversight and public disclosure of business results. In business insolvencies, secured creditors retain their security interests and the promise of a payment at least equal to the value of their collateral. Unsecured creditors generally receive a pro rata distribution that, by law, cannot be less than what they would have received had the company been liquidated.

Most Chapter 11 bankruptcies leave the equity hold-ers—in a public company, the shareholders—without any payment or dividend. In establishing payment priorities, the bankruptcy law dictates that equity holders be paid last and only if all of the other creditors are paid first and in full. Despite its complexity, a Chapter 11 reorganization can save jobs, provide at least a partial payment to creditors, and possibly maintain the business.

The current business bankruptcy provisions were largely fashioned in 1978 when Congress last enacted a comprehensive revision of the bankruptcy law. Perhaps the single most important part of the Code, unique to American bankruptcy, is the "automatic stay," a provision that automatically stops all pending litigation or legal proceedings against a company in Chapter 11. It brings all of those cases, in effect, into the bankruptcy court where all of a company's assets and its liabilities are consolidated and the claims against the company resolved to determine if it can survive.

Chapter 11 of the Bankruptcy Code has been a legal and economic success. Under the law's protection, major department stores, steel companies, airlines, and energy companies have restored themselves and are productive businesses today. Other countries are assessing their bankruptcy procedures, and some are moving from the automatic liquidation approach—which characterizes British business law, for example—to the American approach with its emphasis on saving the company and the jobs that it provides.

Consumer Bankruptcy

Since the revision of the bankruptcy code in 1978, consumer bankruptcy law has become more complex and, for more and more American families and their creditors, more important. In 1980, there were 288,000 consumer bankruptcies; by 2002, the number had exceeded 1.5 million. Debate continues about the "cause" of this dramatic increase; however, it has paralleled the rise in consumer debt and, in particular, credit card debt. Congress changed some of the consumer bankruptcy provisions of the Code in 1984 and 1994, largely to the benefit of unsecured creditors. The framework for consumer bankruptcy, however, remains as it was in 1938 when Congress, in the wake of the Great Depression, passed the Chandler Act. That law gave consumers a procedural choice for personal bankruptcy. Chapter 7 is a relatively quick process in which the debtor's assets are liquidated (with some exemptions) and the proceeds distributed to creditors pro-rata. The debtor emerges with most, but not all, unsecured debts discharged (except taxes, student loans, and marital and child support obligations) and either surrenders the collateral for a secured debt (a house, a car) or arranges to continue to make current payments. While supervised by the bankruptcy court, the process is largely administrative. In more than 95 percent of the Chapter 7 cases, the debtor has no assets to distribute to creditors.

When individuals declare bankruptcy, federal law permits retention of some assets as "exemptions" because stripping a debtor of everything, leaving no assets for a fresh start, would be neither humane nor economically efficient. The bankruptcy code recognizes a homestead exemption and modest exemptions for household goods, medical devices, and a car. Federal law also permits the individual states to give debtors only the exemptions permitted by state law. The use of state exemptions, for example, permits residents in some states to shelter an unlimited amount of assets in a home, leaving their creditors empty handed. Other states provide no homestead exemption.

The alternative to Chapter 7 for consumer debtors is Chapter 13. Only about three in ten consumer debtors choose Chapter 13. Chapter 13 also has the debtor and creditors agree on a plan for installment payments of all or part of the debt. The debtor obtains a discharge of the unpaid debts only on the successful completion of the plan. Chapter 13 provides some unique incentives for consumers that, in most cases, make it easier to retain ownership of a home or a car. The debtor still must pay all of nondischargeable debts.

Maintaining the Balance

In the century that followed the 1898 Bankruptcy Act, the first comprehensive code, Congress has made significant changes four times. Each time, Congress attempted to maintain a balance between creditor rights and debtor rights. The goal, stated or not, of each change was to maintain the ability of the debtor, whether business or consumer, to make a "fresh start."

Since the 1960s, the consumer credit industry has crusaded for significant changes in the bankruptcy law to alter the balance between debtor rights and creditor rights, and the industry convinced Congress to change the Code to its advantage. In 2000, Congress adopted major changes in the law that would have made it more pro-creditor, but President Bill Clinton exercised his veto. Creditors want a "means test" that would eliminate the choice between Chapter 7 and Chapter 13. Creditors want consumers to be obliged to use Chapter 13 on the theory that at least some consumers could pay at least some of their debts.

The explosion of consumer debt in the 1990s has changed the profile of the American family in bankruptcy. With about 1.5 million families a year filing for protection under Chapter 7 or Chapter 13, it has become a "safety net" largely for middle-class families hit by unexpected illness, job layoff or downsizing, divorce, or another economic calamity beyond their control. Because the law always has been based on a code (like the tax and social security laws of the country), because it is a law that affects more families than most other federal laws, proposals will always be before Congress to change its terms. Always at stake will be the balance between debtor rights and creditor rights recognized when the framers adopted the Constitution in 1789.


Jackson, Thomas. The Logic and Limits of Bankruptcy Law. Cambridge, Mass.: Harvard University Press, 1986.

Mann, Bruce H. Republic of Debtors: Bankruptcy in the Age of American Independence. Cambridge, Mass.: Harvard University Press, 2002.

National Bankruptcy Review Commission. Bankruptcy: The Next Twenty Years. Final Report. Washington, D.C.; Government Printing Office, 1997.

Skeel, David A. Debt's Dominion: A History of Bankruptcy Law in America. Princeton, N.J.: Princeton University Press, 2001.

Sullivan, Teresa, Elizabeth Warren, and Jay Lawrence West-brook. The Fragile Middle Class: Americans in Debt. New Haven, Conn.: Yale University Press, 2000.

Tabb, Charles Jordan. The Law of Bankruptcy. New York: Foundation Press, 1997.

Warren, Elizabeth. Business Bankruptcy. Washington, D.C.: Federal Judicial Center, 1993.

Brady C.Williamson

See alsoCredit ; Credit Cards ; Frazier-Lemke Farm Bankruptcy Act .