Apr 29

What Is Bankruptcy?


What is Bankruptcy?

by Brett Bodie

Short Version:

Bankruptcy has not always been available in the United States. Bankruptcy is a legal process that allows individuals, business entities, and municipalities to address debts they are unable to pay. There are different chapters of bankruptcy. Some chapters (9, 11, 12, and 13) allow the party to reorganize their debts. This usually consists of a plan that drastically alters what they have to pay and how they have to pay it. Chapter 7 cases are “liquidation” cases where individuals are granted a discharge (a legal injunction that absolves people of their debts). Despite the name, most individuals don’t have to lose any property in a Chapter 7. When corporations or other entities file Chapter 7, their assets are all liquidated and the entity does not receive a discharge.

What is Bankruptcy: A Short History of Bankruptcy In the United States:

Almost everyone has heard of bankruptcy, but very few people actually understand it. Bankruptcy is a legal proceeding where a Court determines that a person or business is bankrupt. Being bankrupt means a Court has judged you to be insolvent and unable to repay your obligations.

The roots of bankruptcy as a concept can be tied back to many sources. One source that people often point to is the Bible. The idea for the basics of forgiving insolvent debtors can be found in Deuteronomy 15:1-2 which states, “At the end of every seven years you must cancel debts. This is how it is to be done: Every creditor shall cancel any loan they have made to a fellow Israelite. They shall not require payment from anyone among their own people, because the Lord’s time for canceling debts has been proclaimed.” This idea was written about 3,500 years ago, but it contains the basic idea behind bankruptcy: at a certain point, creditors should forgive unpaid debts and free debtors from their burden.

Contrary to what many people believe, you do not have a Constitutional right to bankruptcy. The US Constitution does discuss bankruptcy in Article I, Section 8, Clause 4, but all it states is that Congress shall have the power to “establish … uniform Laws on the subject of Bankruptcies throughout the United States.” Although this gives Congress the power to create bankruptcy laws, nothing about it forces them to create bankruptcy laws; nor does it entitle any of us to the benefits of bankruptcy. In fact, during some parts of American history, there was no legal process for people to voluntarily file bankruptcy.

The first Bankruptcy legislation passed by Congress was the Bankruptcy Act of 1800 (2 Stat. 19), which only passed by one vote. This basic law authorized creditors to force merchant debtors into bankruptcy involuntarily. It only allowed a discharge if 2/3 of a Debtor’s creditors agreed to the discharge. Three years later, Congress repealed the Act for excessive cost and concerns about corruption. For the 30 years that followed, there were no national bankruptcy laws. Notably, during this time individual states did pass bankruptcy laws and this led the US Supreme Court case Sturges v. Crowninshield which dealt with the constitutionality of state bankruptcy laws that purported to discharge debts in other states.

The next major legislation passed by Congress was in 1839 (5 Stat. 321) and outlawed Debtors’ prisons in the United States. Not only were individuals not entitled to bankruptcy protection in 1839, but prior to 1839 Debtor’s prisons were perfectly legal. In fact, some notable founding fathers ended up in Debtors Prisons. Henry Lee III (father of Civil War General Robert E. Lee, former Governor of Virginia and member of Congress), James Wilson (one of the original signers of the Declaration of Independence), and Robert Morris (one of the founding fathers and a principal financier of the revolution) all served time in United States Debtors Prisons.

Two years later in 1841, Congress passed its next attempt at federal bankruptcy legislation with the Bankruptcy Act of 1841 (5 Stat. 440). This act granted federal district coruts jurisdiction over all bankruptcy matters and for the first time it allowed voluntary cases and extended bankruptcy relief to all individuals. It provided for a discharge of debts for any debtor who voluntarily turned over all assets and even laid out early versions of fraudulent transfer and preference recovery powers for bankruptcy commissioners. Unfortunately, the Act didn’t last long and two years alter in 1843 Congress repealed the act under pressure from creditors and citing the high costs of administration.

Twenty six years later, Congress tried for a third time and enacted the Bankruptcy Act of 1867 (14 Stat 517). This act included more precursors of modern bankruptcy law such as allowing judges to appoint bankruptcy registers and allowing debtors to claim federal or state exemptions. Two years after it was enacted, it was amended to include the possibility of an asset distribution plan. In 1878, after nine years, Congress again repealed the law citing corruption and cost.

Finally, twenty one years later, Congress passed the Bankruptcy Act of 1898 (30 Stat. 544), which was the beginning of modern bankruptcy law and provided the bankruptcy framework that would serve the Country for the next eighty years. The Bankruptcy Act of 1898 created bankruptcy referees to oversee the administration of bankruptcy cases. Similar to modern bankruptcy trustees, bankruptcy referees were incentivized to recover assets for creditors by allowing them to retain a percentage of the assets they administered. The Act allowed all individuals to voluntarily file for bankruptcy and entitled them to exempt some property. Originally, it allowed corporations to be placed into involuntary liquidating bankruptcy only, but voluntary corporate bankruptcy was added by amendment in 1910. In the mid 1930s, the law was again amended to allow for voluntary reorganization cases for corporations and municipalities. Congress repealed the amendments of the mid 1930s and replaced them with the more comprehensive Municipal Bankruptcy Act which was a precursor to modern Chapter 9 bankruptcy (municipality reorganization).

In 1938, Congress passed the Chandler Act (52 Stat. 840) which again revised the Bankruptcy Act of 1898 and created the first “Chapters” of bankruptcy. Although there were minor revisions and amendments in the years that follow, the next significant change came with the Bankruptcy Reform Act of 1978 (92 Stat. 2657), which is the basis for the current bankruptcy code found Title 11 of the United States Code. The Bankruptcy Reform Act introduced sweeping changes including the establishment of bankruptcy courts and specific bankruptcy judges. The act provided that Bankruptcy Judges would be appointed to 14 year terms and have authority to rule on matters arising in or related to bankruptcy, but they are not article three judges. Later amendments to the Act revised bankruptcy Judge authority to cover “core” proceedings (a point which has become a major issue recently). The Act created Chapter 11 reorganizations and authorized a new version of Chapter 13 that included the “super discharge.” In 1986, Congress passed the Bankruptcy Judges, United States Trustees and Family Farmer Bankruptcy Act of 1986 (100 Stat. 3088), which created Chapter 12 reorganization cases for family farmers and made the US Trustee Program permanent. The Act was generally regarded as making it easier for Debtors to file bankruptcy and provided for more efficient administration of bankruptcy cases. In 1994, the Bankruptcy Reform Act (Public Law 103-394) expanded the ability of bankruptcy courts to hold jury trials and contained procedural revisions.

In 2005, Congress passed the most recent (and significant) change to the Bankruptcy Code, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). Despite the name, the legislation largely aimed to reduce perceived abuses by consumer Debtors and generally made filing for bankruptcy more difficult and complex. The most significant change BAPCPA introduced was Means Testing. For the first time, Congress created a hard line standard for determining eligibility for a particular chapter of bankruptcy. It also established a hard line “minimum” monthly payment for consumer restructuring plans. BAPCPA’s other major changes include: extended wait times between discharge, automatic dismissal for failure to provide certain forms and documents, requirements that consumer debtors complete credit counseling, audits (although these are sometimes suspended when federal budgets get tight), extension of non-dischargeability to private student loans, restriction of the “super-discharge,” reduction in the amounts for statutory fraud presumption, extended residency requirements for state exemption eligibility, limitations on new homestead claims and removal of the “ride-through” for debtors with secured loans who do not wish to reaffirm. The changes introduced by BAPCPA have been strongly debated with most consumer advocates and attorneys strongly opposed to its changes.

The current bankruptcy code is found in Title 11 of the United States Code. The bankruptcy code is separated into Chapters which each outline different methods of filing bankruptcy. Chapter 7 covers liquidation cases. Chapter 7 cases can be filed voluntary or involuntary (in rare circumstances, creditors can force a person or business into Chapter 7). In a Chapter 7 consumer case, a Debtor will schedule all of their assets, liabilities, income and expenses. A Debtor’s assets can be liquidated in a Chapter 7 case, but most of the type the Debtor is able to claim their property exempt. Chapter 7 consumer Debtors also have to complete the means test. If a Debtor’s income is too high (according to the Means Test), then their case is presumed to be abusive, and the United States Trustee’s Office will formally oppose their bankruptcy case. A Chapter 7 Debtor can rebut the presumption of abuse, although it is difficult to succeed in this type of case unless there is a clear and ongoing income change that has recently occurred. At the end of a Chapter 7 case, debtors are granted a discharge. A discharge is a legal injunction order which bars collection on any eligible debts. Some debts are not dischargeable by statute (some examples are recent income taxes, student loans, and domestic support obligations, among others). Any creditor can file a lawsuit against a Debtor (known as an adversary proceeding), to establish that their debt should not be discharged. The basis for having a claim survive bankruptcy are found in 11 U.S.C. §523. When a corporation files Chapter 7, it does not discharge their debts. Instead, Chapter 7 simply provides an efficient way for a corporation’s assets to be liquidated to repay their creditors. In a Chapter 13 case, consumer Debtors create a plan to restructure their debts over 3-5 years. Chapter 13 cases can be used to repay defaulted secured loans (such as mortgages or car loans) over time. They allow debtors to stop foreclosures, repossessions and other secured debt collection activities and then repay the arrears of the secured obligations over the life of the plan. Chapter 13 plans allow for “lien stripping” of unsecured junior mortgages and cram-downs of vehicle loans (lowering of the balance owed to the value of the vehicle). In a Chapter 13 case, debtors are not required to repay all of their creditors. Very often, a portion of the outstanding debt will be repaid while the remainder is discharged. Chapter 11 bankruptcy cases are reorganization plans for businesses. Although individuals are eligible for Chapter 11, it is normally used by corporations to restructure large debt obligations. Chapters 9 and 12 are specialized Chapters that allow for reorganization plans for municipalities and family farmers and fisherman, respectively.