Bankruptcy in the United States: A Brief History

Bankruptcy is a federal law that allows individuals and businesses alike an opportunity to eliminate or reorganize burdensome debt in the event that they are unable to repay it according to the original terms or schedule of a loan or bond issue. But where did this idea come from? Bankruptcy pre-dates the founding of this America, and it was certainly something on the minds of the founders at the time of the Revolutionary War. In this article, we will take a brief look back at the history of bankruptcy in the U.S.

Bankruptcy in the United States has had a long and varied history. Initially, the framers of the Constitution sought to model bankruptcy laws after English common law on the subject. However, since the founding of the U.S., the law has taken many twists and turns. 

The Framers actually provided for bankruptcy laws in the U.S. Constitution itself. This provision can be found in Article I, section 8, which gives Congress the power to "establish...uniform Laws on the subject of Bankruptcies throughout the United States." However, Congress did not immediately act on that power. It took more than ten years after the Constitution was ratified before Congress brought up the issue of bankruptcy. 

In the meantime, several states had established their own very extensive bankruptcy systems in the absence of a countrywide uniform framework. In fact, many of these systems were very pro-creditor and provided for the imprisonment of debtors! It wasn't until 1833 under federal law and for certain states until 1849 before the debtor's prisons were formally abolished.

First Federal Bankruptcy Law

In 1800, Congress passed the first federal law relating to bankruptcy, called the Bankruptcy Act of 1800. Similar to many state bankruptcy systems at the time, the Bankruptcy Act of 1800 was very creditor-oriented and only permitted involuntary bankruptcies of merchant debtors. There were no provisions for individuals to file on their own. Some crafty debtors figured out that they could ask a friendly creditor to initiate the bankruptcy case. However, due to many complaints of corruption and favoritism, the law was repealed just three years later. The states continued to run various bankruptcy systems in the absence of federal law.

The Next Federal Bankruptcy Law

After the financial panic of 1837, Congress passed another bankruptcy law, called the Bankruptcy Act of 1841. For the first time, this bankruptcy law permitted debtors to file their own voluntary bankruptcies without a creditor to initiate it. This was a revolution in insolvency law. In fact, a debtor could file for bankruptcy and receive a discharge of debt. In addition, any individual could be a debtor, not just a merchant as under the 1800 law. The power to grant the discharge and judge other matters relating to bankruptcy rested with the United States District Courts.

Unfortunately, however, creditors viewed the 1841 law as providing few payments to creditors and discharging too much debt for too many debtors. Accordingly, the 1841 law was repealed in 1843.

Third Times a Charm?

After another financial panic and the U.S. Civil War, Congress decided to try again and passed The Bankruptcy Act of 1867. The 1867 Act was very detailed and covered a variety of situations. This law was the first to allow involuntary bankruptcies for any individual, not just merchants. The United States District Courts were required to appoint a "register in bankruptcy" in the performance of duties relating to bankruptcies. The registers were essentially the earliest bankruptcy judges.

Unfortunately, this law too failed in 1878 under the same criticisms that befell earlier federal bankruptcy laws.

1898

It was not until the year 1898 that Congress for the first time passed a nationwide comprehensive bankruptcy law that became, essentially, permanent. With the passage of the Bankruptcy Act of 1898, although amended and replaced multiple times, there have been no further periods of repeal or times when the federal government had no bankruptcy laws in effect.

Reform of 1978

After several amendments to the 1898 law, Congress passed the Bankruptcy Reform Act of 1978. This law made comprehensive and sweeping changes to the bankruptcy system. This law brought into effect what is known as the "Bankruptcy Code." This law made a variety of changes, including drastically increasing the scope of the power of bankruptcy judges.

The Bankruptcy Reform Act of 1978 was again altered with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, BAPCPA was the result of years of study on how best to reform the bankruptcy system and introduced the Means Test for determining which individual debtors can qualify for Chapter 7 and which have to file a Chapter 13 case to obtain any relief. BAPCPA also introduced mandatory credit counseling and mandatory debtor education courses for individual filers. 

In recent years, the voices have become loud about the dire need for financial literacy for extreme cases of individual bankruptcy and for excess consumer debt that leads to those extreme cases. For now, it is only under the umbrella of community and social programs and not an imposed legal matter.

It has been a continual tug of war between various interests, mainly those of creditors and of debtors. Although there are many other changes prior to and subsequent to the 2005 law, these are the major milestones in the history of bankruptcy in the United States.