What is the History of American
Bankruptcy Law?

By Mark E. Henze

The concept of bankruptcy has existed since as far back as Old Testament times. In the Bible, Mosaic law instructs the Israelites to forgive the debts of other Jews every seven years (Deuteronomy 15: 1-2) together with a procedure for debtor redemption. Interestingly, the legislative history behind U.S. Bankruptcy law shows that some lawmakers have used this 7 year mandate as a reason to designate liquidation bankruptcy as “Chapter 7” and for allowing individuals to file a Chapter 7 bankruptcy every 7 years. There was even an argument that recent amendments restricting bankruptcy filings to every eight years are a violation of Jewish and Christian law.

Yet, in fact, the Israelites generally ignored this mandate for debt forgiveness – thus partly justifying God’s wrath. The first specific mention of the concept comes from Rome. In fact, the word "bankruptcy" is believed by some to have originated from a Latin term referring to bancus (a tradesman's bench) and ruptus (broken). Yet, there was little forgiveness involved. A broken bench (failure to pay debts) led to imprisonment and humiliation. This situation remained throughout medieval times and much of modern history. Even as late as the 1600’s the United States (and later Australia) was used as a debtor colony for Great Britain. This history was firmly engrained in the minds of our founding fathers at the time the Constitution was written.

Originally, bankruptcy laws (based on British common law) were more of a sword than a shield, initiated by creditors to prevent a debtor from simply moving from one state to another to avoid litigation and collection efforts. The debtor was stripped of everything and sometimes imprisoned if the debt was not paid in full. In 1833, the practice of imprisonment for debts was eliminated at the federal level and soon most states followed suit. Eventually, the pre-revolution colonies adopted a few more debtor-friendly provisions including allowing the debtor to keep some exempt assets. However, each state’s laws differed dramatically, myriad of local rules and procedures.

Although the Constitutional Congress spent little time debating the idea of a nationwide federal bankruptcy law, representative Charles Pinckney of Rhode Island had language inserted into Article I, Section 8 of the Constitution to authorize Congress to "establish . . . uniform Laws on the subject of bankruptcies throughout the United States." There was little discussion and no resulting objection or controversy. According to David Skeel in Debt’s Dominion: A History of Bankruptcy Law in America (2001), the only written evidence of the importance of the issue of federal regulation of bankruptcy is found in James Madison’s Federalist Paper #42 which “describes federal bankruptcy legislation as ‘intimately connected with the regulation of commerce (p. 23).’”

But initially, Congress did little. In 1800, 1841 and again in 1867, Congress passed bankruptcy laws, however promptly in 1803, 1843 and 1878 each of these laws was repealed. Except for the few years that these laws were in effect, debtors were required to return to the myriad of differing state laws – until the Railroads began to suffer financial difficulties. In 1898, Congress finally succeeded in passing a bankruptcy law that stuck. The Bankruptcy Act of 1898 remained for the next eighty years. This Act established the position of "bankruptcy referee," an officer of the district courts who oversaw bankruptcy cases and eventually evolved in today’s bankruptcy judges. Although the law focused on liquidations, it introduced the idea of reorganization for financially distressed businesses.

In the 1930’s, at the behest of the Securities & Exchange Commission headed by soon to be Supreme Court Justice William Douglas, Congress passed the Chandler Act of 1938. This created Chapters X and XI bankruptcies allowing both public and privately-held companies to reorganize themselves instead of liquidating their assets. The 1938 Act also significantly strengthened the authority and power of the bankruptcy referee.

Between the late 1960's and the late 1970’s, Congress worked on making major changes to the1938 Act. The final result was the Bankruptcy Reform Act of 1978. The 1978 Act created our current system of Chapter 7, 11 and 13 bankruptcies and made it significantly easier for businesses and consumers to reorganize under the “Code.” Yet, in 1982, with the new Code just underway, the Supreme Court struck down the 1978 Act holding that Congress overstepped its boundaries. During the ensuing chaos, Congress finally got busy and passed a series of amendments that finally created a legitimized “Bankruptcy Code.” Since that time, additional amendments created a national office of the United States Trustee, a subsidiary of the Department of Justice, which is charged with enforcing the Code and overseeing the administrative functions of bankruptcies.

In the late 1990’s, based upon alleged claims of rampant bankruptcy fraud, Congress began efforts to pass a Bankruptcy Reform Act with sweeping “reforms” that limited many of the debtor oriented provisions of the earlier Code. After many years of hot debate and intensive lobbying by unsecured creditor organizations, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was passed. This Act made substantial changes to debtor eligibility requirements for filing Chapter 7 consumer liquidation cases while also allegedly reigning in a variety of practices in Chapter 13 that were detrimental to creditors. Despite the claims that the changes would severely curtail the number of bankruptcy filings in the U.S., its effect has not been as dramatic as expected. Today, the number of filings is at nearly the same level as prior to the reform act and debate has been vigorous over whether the changes have done anything other than to serve the interests of credit card companies.

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