Bankruptcy
| Author | Jeffrey Lehman, Shirelle Phelps |
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A federally authorized procedure by which a debtor?an individual, corporation, or municipality?
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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 is emerging 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. Corporate bankruptcies are commonplace, particularly when corporations are the target of lawsuits, and even local governments seek debt relief through bankruptcy laws.
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.
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 forty 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 eighty 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, and 1994, is known as the Bankruptcy Code.
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 is because the U.S. Constitution 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.
Federal bankruptcy law provides two distinct forms of relief: liquidation and rehabilitation, also known as reorganization. The vast majority of bankruptcy filings in the United
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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.
In bankruptcy cases, individual debtors have the privilege of retaining certain amounts or types of property that otherwise would be subject to liquidation or seizure by creditors in order to satisfy debts. Laws protecting these forms of property are called exemptions.
Consistent with the goal of allowing the debtor a "fresh start," exemptions in bankruptcy cases help ensure that the debtor, upon emerging from bankruptcy, is not destitute. Exemption statutes generally permit the debtor to keep such things as a home, a car, and personal goods like clothes. Although exemptions inhibit the creditor's ability to collect debts, they relieve the state of the burden of providing the debtor's basic needs.
The bankruptcy code provides a list of uniform exemptions but also allows individual states to opt out of (override) these exemptions (11 U.S.C.A. § 522 [1993 & Supp. 2003]). Thus, the types and amounts of property exemptions differ greatly and depend upon the debtor's state of residence.
A debtor residing in a state that has not opted out is entitled to the exemptions described in the bankruptcy code. Examples of code exemptions are the debtor's aggregate interest of up to $15,000 in a home; up to $2,400 in a motor vehicle; up to $8,000 in household furnishings, household goods, clothes, appliances, books, animals, crops, and musical instruments; up to $1,000 in jewelry; up to $1,500 in professional books or tools of the debtor's trade; and certain unmatured life insurance policies owned by the debtor. The debtor also may claim an exemption for professionally prescribed health aids, such as electric wheel-chairs.
The majority of states have chosen to opt out of the uniform federal exemptions, replacing them with exemptions created by their own legislatures. Homestead exemptions, which excuse all or part of the value in the debtor's home, are the most common state-mandated exemptions. These are not uniform across states. For instance, Missouri mimics the federal government by placing a dollar limit on the exemption, but at $8,000, its cap is meager in comparison (Mo. Ann. Stat. § 513.475 [Vernon 2002]). The bordering state of Iowa limits the homestead exemption by acreage rather than dollar amount (Iowa Code Ann. §§ 561.1, 561.2 [West 1992]). Florida allows a homestead exemption without limits (Fla. Const. art. X, § 4(a)(1)). This lack of uniformity raises the question of fairness: bankruptcy laws are federal in nature, yet a debtor in Florida may have a significant financial advantage over a debtor in Missouri, owing to different exemption laws.
Despite the broad variance among states when it comes to bankruptcy exemptions, critics charge that even the uniform federal system can be grossly unfair. For example, assume two debtors, Arlene and Ben, each have estates valued at $28,000. Arlene, a dentist, has $15,000...
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