Bankruptcy in America

John C. Smith
June 2005

The tension between debtors and creditors existed at the founding of our great Nation. In Article I, Section 8 of the United States Constitution, the Framers exclusively vested in Congress the power to “establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.” Voluntary bankruptcy was not known in this country at the adoption of the Constitution. Indeed, for the entire period prior to the Bankruptcy Act of 1898, the Nation was virtually without a federal bankruptcy law except for three short periods aggregating about 15 ½ years.

The Bankruptcy Act of 1898 established the modern concepts of debtor-creditor relations. The Act, which lasted 80 years, albeit with important amendments, was essentially a liquidation procedure as opposed to a program designed to rehabilitate a debtor. Although the Act provided for the extinguishment of a debtor’s obligations through discharge, it was silent as to how the discharge could be enforced. In the late 1960’s and early 1970’s, pressure increased for Congress to curb perceived abuses by creditors that effectively prevented assertion of the bankruptcy discharge.

Even worse for the debtor, in 1973 the Supreme Court decided that there is no constitutional right to obtain a discharge of one’s debts in bankruptcy. In United States v. Kras, the Court held that under the Bankruptcy Act, an indigent who filed a voluntary petition in bankruptcy but could not afford to pay the filing fee was not entitled to a discharge. The Court reasoned that although the elimination of a debtor’s financial burden to obtain a new start in life was important, bankruptcy was not the only method available to a debtor for the adjustment of legal relationships with creditors. It stated that however unrealistic the remedy may be in a particular situation, a debtor, in theory, and often in actuality, may adjust his debts by negotiated agreement with his creditors.

The Bankruptcy Reform Act of 1978 introduced sweeping changes in the judicial process pertaining to the administration of bankruptcy. The present Bankruptcy Code not only provides a procedure for liquidating the debtor’s estate under Chapter 7, it also gave businesses the option to reorganize under Chapter 11 and individuals with a regular income the ability to adjust their debts by plans making payments over a period of time under Chapter 13.

Since that time, lenders, particularly companies pitching credit-cards and home equity loans, have given credit to many who would not have qualified a generation or two ago. As borrowing by American families surged, credit-card companies, banks and their allies began to complain that the system was biased in favor of borrowers and too often protected deadbeats.

The Federal Reserve Board reports that Americans currently owe $2.12 trillion, not counting their mortgages--110% more than they did a decade ago. Yet their financial assets have risen 94% in the same period and their incomes have gone up by 65%. As the use of credit increased, so did the number of bankruptcy filings. Last year, 1, 590.00 million people filed for personal bankruptcy, up from 780,000 a decade earlier. According to an industry sponsored study in 1998, at least $40 billion in debt is discharged annually through personal bankruptcies.

Because the ability to obtain a discharge of one’s debts in bankruptcy is a legislatively created benefit, what Congress giveth it can also taketh away. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was signed into law by President Bush on April 20, 2005. Most of its provisions take effect six months after enactment (i.e. October 17, 2005).

A Wallstreet Journal article entitled “Sweeping New Bankruptcy Law to Make Life Harder for Debtors” predicts the law will swing the legal pendulum in favor of the creditors. While a complete discussion of the law is beyond the scope of this article, several important changes are worth mentioning. The new law requires people filing for bankruptcy to undergo credit counseling at their own expense within 180 days before filing, and will not grant a discharge unless they complete a personal financial management course after filing. Experts expect that new measures will make it harder for attorneys to represent debtors, and will raise the cost for debtors that want to use the services of an attorney to assist in filing bankruptcy. Filing fees will be increased for Chapter 7 filings and decreased for Chapter 13 filings, but fees can be waived for debtors who prove they cannot afford to pay. Creditors gain additional rights. The new law requires debtors to provide several new financial disclosures, and entitles creditors to request copies of the debtor’s most recent Federal income tax return. The new law also has other hurdles to make discharging debts more difficult. For example, the law makes it harder for debtors to wipe out credit-card bills and other loans that are not secured by a house or other asset, and requires the bankruptcy court to apply strict tests designed to force debtors with means to repay some of their debts.

Nor is the new bankruptcy law definitive. Efforts are already underway in Congress for passage of new legislative amendments. How frequently Congress feels the need to amend the Bankruptcy Code remains to be seen. One thing is certain--these are unsettled time in bankruptcy law. If you have questions or want to know your rights, we at DurretteBradshaw are ready to assist you.