Bankruptcy is 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 repayment.
Once considered a shameful last resort, bankruptcy in the United States emerged 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. Despite congressional reforms, the number of bankruptcies has remained high. In 2008 a total of 1,074,225 individuals filed for bankruptcy, and bankruptcy courts saw a total of more than 1.1 million filings with businesses included.
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 as 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 who sought 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 with a realization that punishments such as imprisonment often were useless to creditors. Thus, a law that was first designed to punish the debtor evolved into a law that protected 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 the 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 (i.e., debtor or creditor) had Congress struggling for the next 40 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 for 80 years, thanks in part to numerous amendments, 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, 1994, and 2005, 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 medical bills, for example. But once a debtor or creditor seeks bankruptcy relief, federal law applies, overriding state law. This arrangement is dictated by the U.S. Constitution, which 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 (i.e., reorganization). The vast majority of bankruptcy filings in the United States involve liquidation, governed by Chapter 7 of the Bankruptcy Code. In a Chapter 7 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 that 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 11 or Chapter 13 of the Bankruptcy Code. Chapter 11 typically applies to individuals with excessive or complex debts, or to large commercial entities such as corporations. Chapter 13 typically applies to individual consumers with smaller debts.
Until 2005, many debtors preferred to file Chapter 7 bankruptcy because this option allowed them to discharge most of their debts. Congress, however, made it more difficult to file a Chapter 7 bankruptcy through the enactment of the Bankruptcy Abuse and Prevention Act of 2005 (Pub. L. No. 109-8, 119 Stat. 23). Under this act, a debtor who has primarily incurred consumer debt must pass the so-called means test to file a Chapter 7 bankruptcy. Courts calculate the means test by comparing the debtor's average income for the previous six months to the median income for households of the same size in the same state as the debtor. If the debtor's income is greater than the state's median, then the Code presumes that the debtor is abusing the bankruptcy system. If the debtor cannot overcome this presumption by showing other facts related to his or her ability to pay (e.g., loss of employment), then the debtor cannot file a Chapter 7 bankruptcy. The goal of the law is the force more debtors to file Chapter 13 bankruptcies, because debts in a Chapter 13 are not discharged in the same manner as a Chapter 7 bankruptcy.
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 arrangement 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 12 assists debt-ridden family farmers, who also may be entitled to relief under Chapters 11 or 13. When a local government seeks bankruptcy protection, it must turn to the debt reorganization provisions of Chapter 9.
Orange County Bankruptcy and Chapter 9 Seldom used, Chapter 9 attained notoriety in late 1994 following the bankruptcy of Orange County, California, in the largest municipal bankruptcy in U.S. 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 that was composed largely of derivatives that were based on speculation on the direction of interest rates.
The problem was made worse because the county had borrowed the money it was 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 9 protection on December 6, 1994.
Residents of the affluent county faced immediate repercussions. Close to 10 percent of the 15,000 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 a corporation files for bankruptcy. But negligent or not, corporations battling multiple lawsuits often rely on the traditional rationale supporting bankruptcy: It offers an opportunity to pay debts that otherwise might go unpaid.
Dow Corning Corporation and Chapter 11 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 19,000 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 11 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 11 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 12 In 1986, responding to an economic farm crisis in the United States, Congress designed Chapter 12 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 12 existed, family farmers found it difficult to meet the prerequisites of bankruptcy reorganization under Chapters 11 or 13, often because they were unable to demonstrate sufficient income to make a reorganization plan feasible. Chapter 12 eased some requirements for qualifying farmers.
Congress created Chapter 12 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. Thereafter Chapter 12 was extended several times. It expired in 2004, and the Senate voted for it to be extended. As of 2005, Chapter 12 became 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. § 152). 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 to 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 11 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 As of the early 2000s, 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.
Chapters 7 and 11 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, it 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 possibility reduces the likelihood that creditors will file involuntary bankruptcy petitions frivolously or abusively.
One of the most important rights that a debtor in bankruptcy receives is 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 7 case, the automatic stay gives the trustee time to collect and then distribute to creditors, property in the bankruptcy estate. In voluntary Chapter 11 and Chapter 13 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 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 13 reorganization. Previously, individuals with more than $450,000 in debt were not eligible to file under Chapter 13 and instead were forced to reorganize under the more complex and expensive Chapter 11 or to liquidate under Chapter 7. The 1994 amendments allow debtors with up to $1 million in outstanding financial obligations to reorganize under Chapter 13.
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 60 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.
It looked as though the bankruptcy system would see more reform with the introduction of the Bankruptcy Reform Act of 1998. The act was a response to a report issued by the National Bankruptcy Review Commission, which recommended that the existing code be refined in order to provide incentives to debtors to file Chapter 13 reorganization and to increase debt repayment. The report was issued in response to concern that debtors were taking advantage of the bankruptcy system, evidenced by the fact that a record number of consumers filed for bankruptcy during a time of economic prosperity.
Between 1997 and 2005, Congress considered several bankruptcy reform bills. In several instances, bills passed the House of Representatives but failed in the Senate. With Republicans in control of Congress and President GEORGE W. BUSH in office, Congress finally passed the Bankruptcy Abuse and Prevention Act of 2005. The main concern of the 2005 legislation was to make it more difficult for debtors to file for bankruptcy. The law had its desired effect. In calendar year 2003, a total of 1,625,208 individuals filed for bankruptcy, and 1,156,274 of these were Chapter 7 filings. In 2005, the year that the bankruptcy reform law was passed, a total of 2,039,214 non-businesses filed for bankruptcy. Of these, 1,631,011 were Chapter 7 bankruptcies. By 2007, two years after the bankruptcy law was passed, only 822,590 individuals filed for bankruptcy, with 500,613 filing under Chapter 7 and 321,359 filing under Chapter 13. However, bankruptcy rates increased in 2008 with the weakened economy.
Other provisions in the bankruptcy reform law included the addition of longer waiting periods between filings; requirements related to credit counseling before filing; expansion of exceptions to discharge; and limitations on the use of homestead exemptions.
While Congress was considering bankruptcy reform, the U.S. Supreme Court handed down two decisions that further defined the limits of bankruptcy law. In Cohen v. De La Cruz 523 U.S. 213, 118 S. Ct. 1212, 140 L. Ed. 2d 341, a unanimous Court held that where a debtor committed actual fraud and was assessed punitive damages, the debt would not be dischargeable because the Bankruptcy Code's prohibition against the discharge of fraudulently incurred debts is not restricted to the value of the money, property, or services received by the debtor. In Young v. U.S., 535 U.S. 43, 122 S. Ct. 1036, 152 L. Ed. 2d 79, the Court held that the three-year look back period allowing IRS to collect taxes against a debtor was tolled during pendency of a debtor's earlier Chapter 13 proceeding.
Apart from developments in the law, bankruptcy was much in the news during the opening years of the twenty-first century as an economic downturn forced many prominent U.S. companies into Chapter 11 bankruptcy. In 2001, the energy-trading firm Enron filed for the biggest corporate bankruptcy in history, with $64 billion in assets. Less than a year later, TELECOMMUNICATIONS firm WorldCom topped that record when it listed $104 billion in assets in its bankruptcy filing. Other prominent U.S. companies filing for bankruptcy included retailer K-Mart, financial services firm Conseco, and United Airlines PARENT COMPANY UAL. The economic downturn in 2008 and 2009 also led to a new wave of high-profile bankruptcies. Probably the most stunning were bankruptcies filed in 2009 by Chrysler and General Motors, two of the so-called Big Three U.S. automakers.
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Jewell, Mark. 2002. ''Conseco Bankruptcy Ranks Third in U.S.'' Associated Press (December 19).
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Kuney, George W. 2008 Mastering Bankruptcy. Durham, N.C.: Carolina Academic Press.
Debt; Debtor; Petition in Bankruptcy