Bankruptcy in the Making

"All bankrupts were insolvent, but few insolvents were bankrupt."¹ This statement was very true of those who lived and conducted business in the American Colonies and subsequently in the newly formed United States of America. In colonial America, where cash was an incredibly scarce commodity, the mercantile economy operated almost solely on credit. When an economy relies so heavily on credit, default is inevitable. In order to deal with the significant rate of default, each individual colony and/or state established its own collection laws and practices with the ultimate, but highly unsuccessful remedy being debtor's prison. The practice of committing debtors to debtor's prison, a practice adopted from England, quickly produced the same flaws which haunted the British system: that a debtor committed to prison cannot provide for himself, his family or become a productive member of society. Creditors remain frustrated and unsatisfied, debtor's and their families became wards of the social system and the economy was deprived of a potential entrepreneur. Recognizing the need for relief for debtors, several colonies and states made attempts at legislating insolvency laws. These laws which could allow a debtor to be freed from debtor's prison would not provide a discharge of the underlying debt allowing the debt to follow the debtor for the rest his life.

The concept of bankruptcy finds its origins in England of the 1500's. A statute passed during the reign of Henry VIII is regarded as the first bankruptcy law. This statute authorized the imprisonment of debtors, the seizure of their property and assets and distribution of the estate among the creditors. English law viewed debtors as criminals but the remedies of collections were kept outside the courts and in the hands of individual creditors.² Many of the early English bankruptcy laws served as a model for the Bankruptcy Act of 1800, the first American bankruptcy law and each modern bankruptcy law thereafter. As an example, upon commencing a bankruptcy under English law, the Lord Chancellor would appoint a bankruptcy "commissioner" to oversee the bankruptcy and liquidate the debtor's assets- this is clearly the origin of the modern Chapter 7 trustee.³ English law from 1705 created a discharge provision but only upon creditor consent. And a 1732 English law introduced the concept of allowing the debtor to keep a modest amount of property as "exempt" from his creditors.

Early American attempts at bankruptcy law, the Bankruptcy Acts of 1800 and 1841, were enacted at times of financial and economic panic in the early United States but did not survive the test of time. The Act of 1800 only lasted three years, and the Act of 1841 only two years.  But with each law, the United States moved closer to modern bankruptcy law as we know it today. The Bankruptcy Act of 1800 allowed creditors to file involuntary bankruptcies against their debtors in an effort to collect their debts in a proportioned amount. This system hints at the modern goal of leveling the playing field amongst the creditors competing over a debtor's estate. In fact, the Act of 1800 included provisions for bringing preferential payments back into the estate and avoiding fraudulent conveyances by the debtor.  The Act of 1800 was limited only to debtors having commercial debts and in excess of $1,000.00 - a significant amount for that time. This intentionally left the everyday destitute debtor without the potential for bankruptcy relief and the potential threat of debtor's prison.

The Bankruptcy Act of 1841 was expanded to allow for voluntary bankruptcies. During the Acts' two short years, 41,000 bankruptcy petitions were filed.⁴ The Bankruptcy Act of 1867 introduced a concept for a plan for distribution, provided both for voluntary and involuntary bankruptcies, and gave original jurisdiction over bankruptcies to the federal district courts.⁵

After the failure of the railroads and the resulting court-ordered receiverships, the Bankruptcy Act of 1889 was enacted and remained in effect for eighty-eight years. This Act created the "referees" who were appointed by the bankruptcy courts, who later became known as bankruptcy judges in 1973.⁶ Congress eventually passed several laws in the early 1930's and 1940's after the Depression, which made a move from pro-creditor bankruptcy to pro-debtor bankruptcy. By 1970, Congress took another pro-debtor step and enacted a law to allow the debtor to protect and enforce one's bankruptcy discharge.

On November 6, 1978, President Carter signed the Bankruptcy Reform Act of 1978, which governs bankruptcy law in the United States today, albeit with several amendments. This was the first bankruptcy act that was not put into place because of economic or financial downturn and was also the first that was not drafted or lobbied by creditors but by the bankruptcy community of lawyers. The most notable provisions from the Act of 1978 were the creation of the bankruptcy trustee and encouragement of debtors to utilize Chapter 13 reorganization.

Thomas Paine argued that "credit made freely available by paper money encouraged people to spend beyond their means, to consume rather than invest"⁷ Commerce, trade and manufacturing depends upon the availability of credit, and with the availability of credit comes the possibility of default.

¹ Mann, Bruce H.  Republic of Debtors: Bankruptcy in the Age of American Independence, 2002. Print.
² Tabb, Charles J. "A Brief History of Bankruptcy Law" (1995). Web.
³ Id.
⁴ Hansen, Bradley. "Bankruptcy Law in the United States". EH. Net. Encyclopedia, edited by Robert Whaples. Aug 14, 2001.
⁵ Tabb, Charles J. "A Brief History of Bankruptcy Law" (1995). Web.
⁶ Id.
⁷ Mann, Bruce H.  Republic of Debtors: Bankruptcy in the Age of American Independence, 2002. Print.