Origins of Bankruptcy

Origins of Bankruptcy

It is said that the term “bankruptcy” is rooted in Italian merchant markets wherein indebted peddlers who sold their wares on a bench had their benches broken. Banka rupta, or broken bench, became the symbol for indebtedness. Etymologically related to banking when bankers lent money and traded currencies on a bench, bankruptcy thematically started due to a broken bench.

Rooted in Article I, section 8 of the United States Constitution, the Bankruptcy Clause vests Congress with the power “[t]o establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.” The genesis of this provision is believed to be interstate commerce problems arising from the difficulties experienced by nonresident creditors attempting to collect interstate debts. The issue was that various states had different laws that made debt collection difficult. A bankruptcy regime would facilitate orderly debt collection.

Bankruptcy Today

The modern idea of bankruptcy as a fresh start for distressed debtors was not a central purpose of the bankruptcy law as originally enacted. Today the bankruptcy regime provides the honest but unfortunate debtor with the ability to get out of debt and start anew. Academics view modern bankruptcy as a debtor-friendly regime. In contrast, the framers of the Constitution did not view bankruptcy as a debtor tool; instead, they viewed it as a creditor tool that allowed for an orderly resolution of debt payment.

Common Law Bankruptcy

Like much of American jurisprudence, bankruptcy law was initially modeled after English Common Law. Common Law did not provide debtors with a fresh start after undergoing the bankruptcy process. In fact, debtors unable to pay debt as it became due were arrested and placed in debtor’s prison. Common Law bankruptcy was a tool for creditors who invoked a cause for action against a debtor for an “act of bankruptcy.” If a debtor found himself in prison, he was able to invoke an action for insolvency, which was an request for relief. Such relief was usually release from jail. In other words, bankruptcy was a creditor tool whereas insolvency was a debtor tool.

Such was the life of iconic Revolutionary War hero Robert Morris. English-born Philadelphia resident Robert Morris was pro-revolution and eventually became a major financier for the Continental Army. He was a signatory to the Declaration of Independence, the Articles of Confederation, and the United States Constitution. He was a speculator and capitalist who initially was a successful businessman. However, his fortune turned for the bad and in 1798 he was taken to debtor’s prison in Philadelphia.

Under Common Law bankruptcy, all bankruptcy was involuntary, which means that only the creditor can place the debtor into bankruptcy. This is how the constitutional Bankruptcy Clause was used from the founding of the U.S. until 1841. Moreover, there was no uniform federal law that regulated and applied the various bankruptcy provisions until 1898. Instead, bankruptcy law was mostly state law that was inconsistent across the states.

Consistency and Constitutional Challenge

As noted, the Constitutional language recognizing bankruptcy is “subject of bankruptcies,” which some interpreted to mean bankruptcy as the Founding Fathers perceived it. The United States Supreme Court regularly rejected such claims, arguing that the Founding Fathers only created the narrow clause for their times. They would have wanted an evolution of the bankruptcy clause to match the financial challenges of the times.

Voluntary Bankruptcy

Bankruptcy as we know it today can be traced back to the 1841 Bankruptcy Act. Prior to 1841, bankruptcy occurred because creditors forced bankruptcy upon debtors. Under the 1841 Act, a debtor, who was not a merchant, was allowed to file for bankruptcy voluntarily. This allowed for asset protection and an orderly distribution of assets.

Although Congress repealed the 1841 Act in 1842, the short-lived 1841 Act set forth the concept of voluntary bankruptcy. This idea was novel because it allowed debtors to use bankruptcy as a protection tool. This legacy lives today wherein the American bankruptcy regime, as opposed to many European countries, is a debtor-friendly regime.

Discharge

For consumer debtors, the most important feature of the bankruptcy code is the discharge. This means that a debtor can file for bankruptcy, perform the necessary Bankruptcy Code requirements, and receive a discharge of debts at the end of the term. In other words, a debtor can get out of debt by following Code guidelines and not paying creditors in full. The concept of discharge was codified by the 1898 Bankruptcy Act. Commentators point to the power held by populist and agrarian voters who influenced Congress at the time, even though American cities were seeing rapid urbanization in the late nineteenth century.

If you are in serious debt, then bankruptcy may be right for you. Contact the law firm of Melanie Tavare, an experienced Bay-area bankruptcy lawyer.