A Brief History of Bankruptcy

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A Brief History of Bankruptcy

Tracing the concept of debt forgiveness back all the way to the Old Testament, we see Moses referencing a Jubilee, or Holy, Year to take place once every fifty years. During that year, it was decreed that all debts would be eliminated and those Israelites that had sold themselves into slavery would be freed. In addition, the Jubilee Year called for all land that had been sold to revert back to its original owner. In Leviticus 25: 10-13, we see further explanation: "Consecrate the fiftieth year and proclaim liberty throughout the land to all its inhabitants. It shall be a jubilee for you; each one of you is to return to his family property and each to his own clan. The fiftieth year shall be a jubilee for you; do not sow and do not reap what grows of itself or harvest the untended vines. For it is a jubilee and is to be holy for you; eat only what is taken directly from the fields. In this Year of Jubilee everyone is to return to his own property."

Deuteronomy 15:1-2 increases the frequency of these debt forgiveness periods, asserting, "At the end of every seven years you must cancel debts. This is how it is to be done: Every creditor shall cancel the loan he has made to his fellow Israelite. He shall not require payment from his fellow Israelite or brother, because the Lord's time for canceling debts has been proclaimed."

Moving to ancient Greece, the notion of debt forgiveness was unknown. If a man owed a debt that he was unable to pay, his entire family­including any servants he may own became debt slaves. Some regions did protect such slaves from bodily harm and, further, limited the debt slavery period to a maximum of five years. Such mercies applied only to the family of the debtor, however, and not to his servants for whom treatment was much harsher.

The most widely-accepted theory on the origin of the word "bankruptcy" comes from a mixing of the ancient Latin words bancus (bench or table) and ruptus (broken). When a banker, who originally conducted his public marketplace transactions on a bench, was unable to continue lending and meet obligations, the bench was broken in a symbolic show of failure and inability to negotiate. As a result of the frequency of this practice in Medieval Italy, the current term bankrupt is commonly believed to spring specifically from the translation of banco rotto, Italian for broken bank. Others have speculated that the word's origin actually stems from the French expression banque route, table trace. This phrase relates to the metaphorical practice of only a sign left at the site of a banker's table once there and now gone. This practice involved those who fled quickly escaping with money that had been entrusted to them.

In England, the first official laws concerning bankruptcy were passed in 1542, under Henry VIII. At that time, a bankrupt individual was considered a criminal and, as such, subject to criminal punishment ranging from incarceration in debtors' prison all the way to the extreme sentence of death. The Sixteenth Century saw Spain's Phillip II declare four separate state bankruptcies in the years between 1557 and 1596. In fact, Spain became the first sovereign nation to declare bankruptcy. The early Eighteenth century saw a system of forward-thinking, positive reinforcement with the introduction of statute 4 Anne ch. 17. This statute provided that un-payable debts would be discharged to reward those debtors that agreed to pay what they could.

In the United States, early federal bankruptcy laws were temporary responses to bad economic conditions. The first official bankruptcy law was enacted in 1800 in response to land speculation. It was repealed in 1803. Similarly, in 1841, in response to the panic of 1837, a second bankruptcy law was passed. This law was quickly repealed in 1843. The economic upheaval of the Civil War caused Congress to pass another bankruptcy law in 1867, and that law was repealed in 1878. All of these laws contained some allowance for discharge of unpaid debts. The first two laws, those of 1800 and 1841, allowed only minimal discharge of debt; while the 1867 law was the first to include protection for corporations.

Before the 20th century, rules and practices concerning bankruptcy generally favored the creditor and were harsher toward the bankrupt. The focus was on recovering the investments of the creditors, and unlike now almost all bankruptcies at this time were involuntary. The practice of involuntary filings does continue to exist, with an option to convert to voluntary filing status, but is relatively rare.

Modern bankruptcy laws and practices in the United States emphasize rehabilitating (reorganizing) debtors in distress with a limited emphasis on punishing the debtor. The Bankruptcy Act of 1898 was the first to give companies in distress an option of being protected from creditors. The company could be put in an "equity receivership," a provision made much more formal and extensive in the United States during the 1930s. The economic upheaval of the Great Depression yielded additional bankruptcy legislation, in particular, the Bankruptcy Act of 1933 and the Bankruptcy Act of 1934. In a 1934 U.S. Supreme Court decision, the Court reveals that the primary goal of bankruptcy laws was to offer debtors a "fresh start" from financial burdens. In Local Loan v. Hunt, the Supreme Court asserts, "[I]t gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt."

This legislation culminated with the Chandler Act of 1938, which included substantial provisions for reorganization of businesses. Also in 1938, Congress enacted Section 60e of the Bankruptcy Act and created a single and separate fund concept intended to minimize losses to customers by giving them priority over claims of general creditors.

The securities industry saw significant turbulence in 1969 and 1970­leading to voluntary liquidations, mergers, receiverships and bankruptcies of a substantial number of brokerage houses. In reaction to this situation, Congress enacted the Securities Investor Protection Act of 1970 in an attempt to quell the filings, restore investor confidence and upgrade financial responsibility requirements for registered brokers and dealers.

During the period from World War II through the 1970s, bankruptcy was not a major topic in the news. With the exception of railroads, there were not many notable business failures in the U.S. in that time. During the 1970s, there were only two corporate bankruptcies of prominence: Penn Central Transportation Corporation in 1970 and W.T. Grant Company in 1975.

The Bankruptcy Reform Act of 1978 was passed in 1978 and took effect on October 1, 1979. This act, which continues to serve as the uniform federal law that governs all bankruptcy cases today, substantially revamped bankruptcy practices. A strong business reorganization Chapter was created: Chapter 11. (This replaced the old Chapters X, XI and XII that had been created by the 1898 Act and amended by the Chandler Act.) Similarly, a more powerful personal bankruptcy, Chapter 13, replaced the old Chapter XIII. In general, the Reform Act of 1978 made it easier for both businesses and individuals to file a bankruptcy and to reorganize.

The 1978 Act, a major piece of legislation, started a number of legal controversies and many amendments and judicial clarifications of the 1978 Act were made during the 1980s. One pivotal event was a 1982 Supreme Court ruling that the Bankruptcy Court's enlarged jurisdiction, which was established by the 1978 Act, was unconstitutional. In layman's terms, the Supreme Court ruling stated that bankruptcy judges had been given too much power by Congress and their duties overlapped with those of other branches of the government. The 1982 ruling led to the Bankruptcy Amendment Act of 1984.

There were a number of other notable developments in bankruptcy rules during the 1980s. The 1978 Act did not cover tax related issues and this was addressed by the Bankruptcy Tax Act of 1980. The Tax Act clarified such things as tax loss carry-forwards and taxation rules when there is an exchange of equity for debt. A 1983 Supreme Court ruling challenged the ease with which companies could protect themselves from labor contracts while in bankruptcy. The Bankruptcy Amendment Act of 1984 limited the right of companies to terminate labor contracts.

In 1986, Chapter 12 was created for the adjustment of debts of a "family farmer" or a "family fisherman." According to the Administrative Office of the U.S. Courts, Congress instituted Chapter 12 "specifically to meet the needs of financially distressed family farmers. The primary purpose of this legislation was to give family farmers facing bankruptcy a chance to reorganize their debts and keep their farms."

During the 1980s and early 1990s record numbers of bankruptcies, of all types, were filed. Many well-known companies filed for bankruptcy, primarily Chapter 11 reorganization. Included were LTV, Eastern Airlines, Texaco, Continental Airlines, Allied Stores, Federated Department Stores, Greyhound, R.H. Macy and Pan Am. Several of these large cases, such as Maxwell Communication and Olympia & York, had the added complexity of involving the transnational insolvency rules of several different countries. These massive bankruptcies created challenges for the Court system.

New techniques, such as "prepackaged" and "pre-arranged" bankruptcies, allowed the Court system to handle the increased caseload of the late 1980s and early 1990s fairly efficiently. Such a prepackaged bankruptcy, also known as a "prepack," is a situation in which a company meets with its creditors to agree on the terms of a reorganization plan prior to filing the Chapter 11 Petition. In a standard filing, such negotiations are made after the bankruptcy filing. This prepackaged approach offers the potential benefit of a more time, cost-effective bankruptcy reorganization. Despite the use of pre-negotiated filings, there still remained substantial concerns about the level of professional fees and apparent waste of corporate assets in a number of bankruptcy cases. Recent initiatives to deal with these issues include the "fast track" approach to small and medium sized Chapter 11 cases being used in several districts.

The early 1990s also witnessed a rise in the use of examiners and mediators, particularly in large cases. These professionals, who may have broad powers or may be restricted to focusing on specific issues, are expected to expedite the resolution of contentious matters and reduce the time and money expended on complex cases.

On October 22, 1994, the Bankruptcy Reform Act of 1994 (Public Law 103-394, October 22, 1994), the most comprehensive piece of bankruptcy legislation since the 1978 Act, was signed into law by President Clinton. The 1994 Act contains many provisions for both business and consumer bankruptcy, including the following: to expedite bankruptcy proceedings, to encourage individual debtors to use Chapter 13 to reschedule their debts rather than use Chapter 7 to liquidate and to aid creditors in recovering claims against bankrupt estates. This 1994 Reform Act also created a National Bankruptcy Commission to investigate further changes in bankruptcy law and other matters. In November 1997, the National Bankruptcy Review Commission completed an extensive and detailed report on bankruptcy reform.

On April 19, 2005, President George W. Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA) of 2005 into law. The U.S. Department of Justice asserts that the BAPCA "opens a new era in the history of bankruptcy law and practice." On October 17, 2005 the BAPCA became effective. As he signed the bill, President Bush declared, "Under the new law, Americans who have the ability to pay will be required to pay back at least a portion of their debts. Those who fall behind their state's median income will not be required to pay back their debts. The new law will also make it more difficult for serial filers to abuse the most generous bankruptcy protections. Debtors seeking to erase all debts will now have to wait eight years from their last bankruptcy before they can file again. The law will also allow us to clamp down on bankruptcy mills that make their money by advising abusers on how to game the system."

Passage of this bill came after nearly eight years of Congressional debate about the future of bankruptcy legislation. The new legislation substantially amended the Bankruptcy Code, and primarily affects consumer filings, making it more difficult for a person or estate to file for Chapter 7 bankruptcy. The BAPCA impacts business filers as well with the heaviest impact on smaller (those listing less than $2 million in debt) businesses. Specifically, the BAPCPA initiated a means test to determine if the filing will be made under Chapter 7 or Chapter 13. The BAPCA also necessitates that those filing for bankruptcy protection undergo credit counseling and, further, participate in personal financial management education. Additional changes include an increased emphasis on executive accountability and transparency of the bankruptcy process. The BAPCA also calls for more hoops to jump through before a Key Employee Retention Plan (KERP) can be implemented.

In addition to these significant changes and others, the BAPCA also increases the authority of and assigns the U.S. Trustee Program many new responsibilities, including the following: implementing the new "means test" to determine whether a debtor is eligible for Chapter 7 or Chapter 13, supervising random audits and targeted audits to determine accuracy, certifying entities to provide the credit counseling that an individual must receive before filing bankruptcy, certifying entities to provide the financial education that an individual must receive before discharging debts and conducting enhanced oversight in small business Chapter 11 reorganization cases. The Department of Justice explains, "Over the past few years, the U.S. Trustee Program’s civil and criminal enforcement efforts have strengthened the integrity of the bankruptcy system by providing consumer protection and combating fraud and abuse."

Most recently on December 1, 2007, amendments to the Federal Rules of Bankruptcy Procedure became effective following April 2007 U.S. Supreme Court approval. These amendments apply only to cases already pending as of the December 1st effective date and all of those cases filed after the effective. Among other changes the amendments make the following significant adjustments. First, an amendment to Rule 3007 (which is related to form and notice of a claim objection hearing). The new rule institutes formatting standards and the restriction of omnibus objections. Second, the amendment provides clearer disclosure as it relates to cash collateral and debtor-in-possession financing usage. This comes specifically in the form of changes to Rule 4001 (which relates to motions and stipulations for cash collateral and D.I.P. financing). The amended rule requires that specific terms and conditions be further detailed. Third, the amendment offers the addition of Rule 6003 (which provides certain limitations on first day orders). Fourth, the changes further amend Rule 6006 (which relates to the rejection of executory contracts and unexpired leases) to provide greater restrictions on omnibus motions. Fifth, these recent amendments adjust Rule 1014, allowing the Court to order a change in venue without separate motions filed by the Debtor or other interested parties.

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