1. The state of being actually or legally bankrupt.

2. The act or process of becoming a bankrupt.

3. Complete loss; -- followed by of.

The state of a person or firm unable to repay debts.

Investopedia Says:
If the bankrupt entity is a firm, the ownership of the firm's assets is transferred from the stockholders to the bondholders. Shareholders are the last people to get paid if a company goes bankrupt. Secure creditors always get first grabs at the proceeds from liquidation.

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The state of insolvency or inability to pay debts.

Bankruptcy courts deal with two broad types of cases: Voluntary Bankruptcy by debtors seeking a fresh start, and Involuntary Bankruptcy filed by a sufficient number of creditors, who believe the debtor has committed an Act of Bankruptcy by concealing assets or favoring one creditor over another. In both cases, the objective is a fair and equitable settlement of claims and distribution of assets. Filing a petition initiates an automatic stay against further debt collection until a debt is discharged, the petition is dismissed, or a repayment plan is accepted by creditors. Once a petition is filed, the bankruptcy remains on a debtor's credit bureau report for a 10-year period.

The Bankruptcy Reform Act of 1978, the first major revision in the bankruptcy code in four decades, brought about several important changes: the new code simplified the procedures for filing petitions, modified the absolute priority rule giving secured creditors seniority over other creditors, limited creditor rights to Set-Off claims against a debtor's assets, and expanded the powers of federal bankruptcy judges to decide cases. Amendments to the code in 1984 gave bankruptcy courts the power to dismiss so-called abusive petitions by debtors concealing assets. Amendments enacted in 2005 (the Bankruptcy Abuse Prevention and Consumer Protection Act) further modified the bankruptcy code to prevent abusive petitions. Individuals who have sufficient income to repay some of their debts (as determined by a "means test") must instead file a Chapter 13 bankruptcy petition.

The important chapters in the revised code are the following:

Chapter 7: called a Liquidation allows a court-appointed trustee with broad discretionary powers to distribute assets among creditors and arrange interim financing. In general, the trustee represents the interests of the unsecured creditors, or general creditors. If, however, there are no assets, the debt is discharged, and the creditors receive nothing.

Chapter 9: a rarely used section of the code, designed for adjustment of debts of a municipality. Also called a municipal reorganization.

Chapter 11: a Reorganization normally by a business, allowing the debtor (called a Debtor-In-Possession if no trustee is named) to maintain operating control, while restructuring debts and working out a repayment schedule acceptable to creditors. Creditor loans to Chapter 11 debtors are permitted under certain conditions.

Chapter 12: a new provision dealing with agricultural bankruptcies, allows small family-owned farms with debts under $1.5 million to repay obligations based on fair market value of the loan collateral.

Chapter 13: a debt repayment plan, called a Wage Earner Plan , filed by individuals earning regular income. The debtor files a budget with the court, and agrees to make partial payment (less than 100%) of obligations owed to creditors over a three- to five-year period, normally within three years. See also Composition; Cramdown; Discharge of Bankruptcy; Preference; Priority of Lien; Reaffirmation; Redemption; Voidable Preference.

The financial inability to pay one's debts when due. The debtor seeks relief through court action that may work out or erase debts.
Example: Carter lost his job but continued to live extravagantly on Credit. When accounts were overdue, Carter filed a bankruptcy petition. The court allowed him to pay creditors 10 cents per dollar of debt, payable over 3 years.

Situation in which a business' debt exceeds the fair market value of its assets. It is also a court action under which a debtor may be discharged for unpaid debts, in whole or in part, and in which creditors receive distributions of assets from the debtor's property under the supervision of the court. Chapter 11 of the Bankruptcy Law provides for reorganization in which the debtor remains in possession of the business and in control of its operation, while the debtor and creditors are allowed to work together. See also Bankruptcy (Personal).

Bankruptcy law was created initially to enable persons inundated with debt to have a new beginning. It is also designed to permit individuals and business entities to have additional time to pay and compromise existing debts without liquidating all assets. The U.S. Constitution, Article 1, Section 8(4) grants the power exclusively to Congress "[T]o establish… uniform laws on the subject of bankruptcies throughout the United States." The current Code is based on the Bankruptcy Reform Act of 1978 as amended. Bankruptcy Courts, under the supervision of U.S. District Courts, administer petitions under the statute.

The Code is divided into a number of chapters, the most important of which are Chapter 7 ("Liquidation"), Chapter 11, ("Reorganization"), and Chapter 13, ("Adjustment of Debts of an Individual with Regular Income"). The remaining chapters concern definitions, case administration, a discussion of creditors' claims, debtors' duties, estate of the debtor, U.S. trustees, municipal indebtedness, and debts of farm families.

Chapter 7: Liquidation

A Chapter 7 proceeding is "bankruptcy" as envisioned by most persons. The crux of such a proceeding is the collection and reduction to cash of all nonexempt assets owned by the debtor; the monies, to the extent available, are distributed to classes of creditors.

Petition. The proceeding is begun by the filing of a petition with the clerk of the Bankruptcy Court. The petition may be "voluntary" or "in-voluntary." A "voluntary" petition is one filed by the debtor individually or with the debtor's spouse. The filing of a voluntary petition operates automatically as an order of relief, which means that all nonexempt civil lawsuits and any other civil proceedings (e.g., foreclosures and sheriff's seizures) are suspended.

An involuntary proceeding may be begun by the filing of a petition as follows: (1) Where there are twelve or more creditors, then three or more creditors who are owed a minimum amount of $10,775 are required to file; or (2) if there are fewer than twelve claimants, then any one or more creditors with claims totaling at least $10,775 may file the petition. Farmers and nonprofit corporations are exempted from an involuntary filing. The court, after notice and hearing for cause, may require creditors filing an involuntary petition to post a bond to indemnify the debtor for damages in the event of a dismissal of the involuntary petition.

Creditor's meeting and appointment of a trustee. The debtor is required to file a list of creditors, a schedule of assets and liabilities, and a statement concerning details of the debtor's financial affairs. Within a reasonable time of filing of the petition, the court appoints an interim trustee and a first meeting of creditors is called. At such meeting, the debtor is required to undergo an examination under oath by the creditors. The creditors may then select a qualified person to act as trustee. If none is selected, then the interim trustee remains in such capacity. The duties of a trustee include collecting all assets owned by or owed to the debtor, examining and determining debts payable, accounting for all property received, instituting lawsuits if necessary to collect indebtedness due the estate, and reporting to the creditors at the final meeting of creditors.

Exemptions. The Bankruptcy Code is rather generous in its provisions concerning property the debtor may keep after filing for bankruptcy. The debtor is given the choice of choosing either exemptions provided by the laws of the state in which the debtor resides or exemptions permitted under the Code, whichever is more generous.

Under the Bankruptcy Act, a debtor may keep the following assets:

1. Debtor's interest up to $16,150 in realty used as a principal residence or as a burial plot
2. Debtor's interest in a motor vehicle up to $2,575 in value
3. Debtor's interest up to $425 in any one item or aggregate of $8,075 of unused exemption in household goods
4. Debtor's interest up to $1,075 in jewelry for personal, household, or family use
5. Debtor's interest in any other property up to $850 plus unused amount of the $8,075 exemption
6. Debtor's interest up to $1,625 in implements, professional books, or tools of the trade of the debtor or dependent
7. Unmatured life insurance contract owned by the debtor, except a credit life insurance contract
8. Debtor's interest up to $8,625 in unmatured life insurance
9. Professionally prescribed health aids for the debtor or dependent
10. Social Security, unemployment compensation, veteran's, disability, or illness benefits
11. Payments for losses payable under a crime victim's reparation statute; wrongful death benefits, life insurance proceeds; and award up to $16,150 arising from personal injury award.

Voidable transfers. In order to prevent certain creditors and insiders from gaining an unfair advantage over other creditors, the Code permits the trustee to set aside certain transfers of property made by the debtor that enabled the creditor to receive more than would otherwise have been received. A trustee, except for certain limited exceptions, may avoid the transfer of property of the debtor made to a creditor on account of an antecedent debt owed by the debtor made while the debtor was insolvent within 90 days before filing of the petition. If the transfer was made to an insider (to a relative, partner, or corporation with whom the debtor has a close relationship), then a transfer made within one year of filing may be avoided.

Fraudulent transfers. The trustee may avoid a transfer of assets made by the debtor to any transferee within one year of filing the petition where such transfer was made to defraud creditors or where the transfer was made for less than its fair market value. The trustee is empowered to invalidate such transfer after having returned the amount paid by a good-faith purchaser.

Exceptions to discharge. Although the debtor has the right to keep certain property, the debtor is not discharged from all debts. The following sums continue to be due and owing even after relief is granted:

1. Taxes due three years prior to filing
2. Payment for property obtained under false pretenses
3. Monies owed to creditors the debtor failed to list or schedule
4. Monies obtained through fraud, embezzlement, or larceny
5. Alimony, maintenance, and child support
6. Monies owed for willful and malicious injury by the debtor
7. Government fines, penalties, or forfeitures incurred within three years
8. Money due to a government unit or nonprofit institution of higher education for an educational loan within seven years unless payment would impose undue hardship upon the debtor or the debtor's dependents
9. Debts not dischargeable under a prior bankruptcy proceeding
10. Judgments arising due to driving while intoxicated
11. Credit card debts and cash advances exceeding $1,075 incurred within sixty days of filing and debt incurred within sixty days of filing for purchase of luxury goods over the sum of $1,075 to any one creditor

Priority of distribution. All creditors are not treated equally. There are several levels of priority in the distribution of assets. A creditor with a security lien on property (e.g., bank mortgage) has priority over other creditors.

In descending order, the following unsecured creditors are entitled to the expenses and claims:

1. Administrative expenses incurred by the trustee
2. Post-petition credit extended to debtors
3. Claims up to $4,300 for wages, salaries, or commissions earned by an individual within ninety days of filing of the petition
4. Claims for contributions to employee benefit plans up to $4,300 for services rendered up to 180 days before filing of petition
5. Claims up to $4,300 for a person operating a grain storage or fish produce storage or processing facility
6. Claims by consumers up to $1,950 for deposits made for purchase, lease, or rental of property or for the purchase or consumer goods or services
7. Claims for alimony, maintenance, or child support
8. Income and other taxes due to governmental units
9. The remaining unsecured creditors

Chapter 11: Reorganization

One of the goals of the Bankruptcy Act is to allow a business to continue to operate, if possible, in order to prevent the inevitable discharge of employees from a bankrupt firm. Accordingly, Congress permits either a voluntary petition or involuntary petition under this Chapter. The proceedings may be commenced, with certain exceptions, by an individual or business entity, such as a partnership or corporation.

The debtor may file a voluntary petition within 120 days of the order of relief. An involuntary petition may be filed by the trustee, creditor's committee, creditor, and other interested parties if the debtor has not filed a plan within the said 120 days, or the plan filed by the debtor has not been accepted within 180 days.

The plan permits the debtor to remain in possession of the business unless there is fraud or gross mismanagement. The plan has to specify those claims or interests not impaired under the plan from those that will be so impaired. Each class of claims is to be treated equally unless the claimant otherwise consents. The plan may provide for the debtor to remain in possession; for certain assets to be transferred to other entities; for a consolidation or merger; for the sale of property subject to the rights of lienholders; for the satisfaction or modification of a lien; and other terms. The plan may impair a class of claims whether they are secured or unsecured.

The court must confirm the plan. Confirmation may be granted only if the plan complies with the statute, has been proposed in good faith, is not forbidden by law, is fair and equitable, has been accepted by at least one class of claimants, and confirmation of it is not likely to end in liquidation. A plan is fair and equitable as to secured claims if the holders thereof retain their lien on the secured property or receive equivalent value.

Collective bargaining agreements previously entered into by the debtor are subject to the plan. The plan must be offered by the debtor to the union and be discussed with the union; if there is no resolution, a hearing must be held by the court to determine whether a modification will be permitted.

Chapter 13: Adjustment of Debts of Individual With Regular Income

A gainfully employed person may be inundated with debts that cannot be paid in full but may be paid if that person were extended additional time to pay. Accordingly, Congress created a Chapter 13 filing that permits such a debtor with unsecured debts of less than $269,250 and secured debts of less than $807,750 to voluntarily file a plan that provides for the submission of earnings to a trustee, the payment in full of all allowable claims unless a creditor agrees otherwise, and the classification of claims with the same treatment of all claims within each class. The plan may modify the rights of holders of secured claims except holders of a security interest in real property used as a principal residence by the debtor.

The plan must be confirmed by the Bankruptcy Court. The court will do so if the plan was properly filed, fees were paid, the plan was made in good faith, and the value of property to be distributed allows holders of unsecured claims to receive no less than what they would have received under Chapter 7. As to secured claimants, the plan will be allowed where the holder of the claim has agreed to the plan, the plan provides that the holder retains the lien securing the property, and the value of property to be distributed is not less than the allowed amount of such claim. The debtor may, in the alternative, surrender the property securing the claim to the holder of the lien. Once the plan is confirmed and lived up to, the debtor will be discharged.

Future Trends

Because of intense lobbying efforts by banks and other creditors' organizations, there have been proposals for significant changes in the law, such as the Bankruptcy Reform Act of 2000. This act would make all exemptions federal in nature, so that debtors in one state are not treated more advantageously than those in another. Debtors would be required to undergo credit counseling before filing a petition. Substantially enhanced requirements of proof of inability to pay within a five-year period would be necessary. Credit card debts would undergo much greater scrutiny. Re sorting to Chapter 13 plans of payments would be made mandatory in some cases. Passage of such legislation appears to be dependent on the political party having control over both the Congress and the presidency.

Bibliography

Bankruptcy Code, Rules and Official Forms. (annual). St. Paul, MN: West Publishing.

Cowans, David R. (1998). Bankruptcy Law and Practice. New York: Lexus Publishing.

Epstein, David G., Nickles, Steve H., and White, James J. (1993). Bankruptcy. St. Paul, MN: West Publishing.

[Article by: ROY J. GIRASA]

noun

The condition of being financially insolvent: bust, failure, insolvency. See money.

Definition: inability to pay debts
Antonyms: richness, solvency, wealth

The legal process by which a person, business, or corporation is declared to be insolvent and unable to pay creditors.

For more information on bankruptcy, visit Britannica.com.

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.

Financial Relationships

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.

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—THOMAS MAX SAFLEY

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 repay- ment.

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 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 seeking 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 a realization that punishments such as imprisonment often were useless to creditors. Thus, a law at first designed to punish the debtor evolved into a law protecting 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 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, 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, thanks in part to numerous amendments, for eighty years, 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 doctor 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 seven of the bankruptcy code. In a chapter seven 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.

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 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 eleven or chapter thirteen of the bankruptcy code. Chapter eleven typically applies to individuals with excessive or complex debts, or to large commercial entities such as corporations. Chapter thirteen 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 twelve assists debt-ridden family farmers, who also may be entitled to relief under chapter eleven or chapter thirteen. When a local government seeks bankruptcy protection, it must turn to the debt reorganization provisions of chapter nine.

Orange County Bankruptcy and Chapter Nine

Seldom used, chapter nine 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 comprised largely of derivatives based on an incorrect speculation on the direction of interest rates. The problem was made worse because they had borrowed the money they were 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 nine 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 the 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 might otherwise go unpaid.

Dow Corning Corporation and Chapter Eleven

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 eleven 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 eleven 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 Twelve

In 1986, responding to an economic farm crisis in the United States, Congress designed chapter twelve 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 twelve's existence, family farmers found it difficult to meet the prerequisites of bankruptcy reorganization under chapter eleven or chapter thirteen, often because they were unable to demonstrate sufficient income to make a reorganization plan feasible. Chapter twelve eased some requirements for qualifying farmers.

Congress created chapter twelve 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. Should lawmakers decide the law is beneficial, they may grant an additional extension or make chapter twelve a permanent part of the bankruptcy code.

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 [1995]). 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 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 eleven 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.

Chapter seven and chapter eleven 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, the court 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 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 seven case, the automatic stay gives the trustee time to collect, and then distribute to creditors, property in the bankruptcy estate. In voluntary chapter eleven and chapter thirteen 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 both 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 thirteen reorganization. Previously, individuals with more than $450,000 in debt were not eligible to file under chapter thirteen, and instead were forced to reorganize under the more complex and expensive chapter eleven or to liquidate under chapter seven. The 1994 amendments allow debtors with up to $1 million in outstanding financial obligations to reorganize under chapter thirteen.

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.

See: petition in bankruptcy.

Legally declared insolvency, or inability to pay creditors.

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