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Understanding Bankruptcy

Updated on September 7, 2009

Bankruptcy in the United States

The Constitution gives Congress the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States" (Art. I, Sect. 8, Cl. 4). The first bankruptcy act, passed by Congress in 1800, was patterned on the English laws and aimed primarily against fraudulent debtors. It was repealed in 1803, after which for nearly 40 years insolvent debtors were subject to state laws. The second federal law on bankruptcy was enacted in 1841, a consequence of the panic of 1837. An improvement on the first in providing for voluntary bankruptcy, it was repealed in 1843 when state insolvency laws again came into force. Economic difficulties during and subsequent to the Civil War, with attendant moratorium laws, caused the enactment by Congress of a third bankruptcy law in 1874; it was repealed in 1878.

The panic of 1893 and ensuing hard times were the background for the passage by Congress of the Bankruptcy Act of 1898. Although frequently amended, its main provisions are still in effect and it forms the basis of modern American bankruptcy law. Of the various amending acts, those of 1933, 1934, and 1935 attempted to help honest debtors to rehabilitate themselves, specifically the corporations which, due to depression conditions, were solvent but unable to meet maturing obligations.

The Chandler Act of June 22, 1938, has been called "the first thoroughgoing revision" of the American bankruptcy statutes in four decades. One of its provisions, designed to protect creditors from exploitation in the settlement of corporation bankruptcy cases, allows them to obtain free legal assistance from the Securities and Exchange Commission. In other bankruptcy proceedings it authorizes the court to have the bankrupt examined by a federal attorney and, if his findings so indicate, to oppose the bankrupt's petition. Important changes are made in corporate reorganization procedure and the Securities and Exchange Commission participates in most such proceedings. In sum, the later amendments to the 1898 act made important additions to the original provisions, notably in the fields of special relief for farmers and wage earners and in railroad and corporate reorganizations. Relatively minor amendments to the Bankruptcy Act were made in 1939 and frequently thereafter.

Concurrently with the gradual development of federal bankruptcy law, many states have enacted laws relating to bankruptcy and insolvency. However, when any conflict occurs federal law supersedes state law under the supremacy clause of the Constitution.


Under the Bankruptcy Act, federal district courts exercise original jurisdiction in bankruptcy cases, with the courts of appeals and the U.S. Supreme Court acting successively on appeals. Most cases are handled wholly or in part by referees, who have powers equivalent to those of federal judges within this field. In the establishment of bankruptcy procedure, the general orders and forms promulgated by the Supreme Court have the force of law.

In addition to judges and referees, the administrative machinery of bankruptcy includes receivers or custodians, trustees, attorneys, and creditors' committees. A receiver may be appointed at any time after the filing of the petition in bankruptcy, which marks the beginning of the court's control over the assets of the debtor. It is the duty of the receiver to take possession of the debtor's property, in order to protect it and prevent loss, pending the qualification of a trustee. The trustee is an officer appointed by and directly representing the creditors. He obtains not only possession but also legal ownership of all assets of the bankrupt except those exempt under local law.

Types of Bankruptcy

The two main categories of proceedings available under the Bankruptcy Act are the "voluntary" petition, filed by the debtor himself, and the "involuntary" proceeding, filed against him by his creditors. Practically anyone with debts who has the legal capacity to make binding contracts may file a voluntary petition, regardless of his financial status.

Involuntary proceedings on the other hand can be filed only by three or more creditors, except where the total number of creditors is less than 12. The total of debts owed to unsecured creditors must be $1,000 or more. No person can be thrown into involuntary bankruptcy unless he is both insolvent in the bankruptcy sense and has committed an act of bankruptcy within four months prior to the filing of the petition against him. "Insolvent" and "act of bankruptcy" are technical terms, defined in the act.

"Insolvent" in the bankruptcy sense means not having enough property to pay one's debts. A similar term, 'insolvent," in the equity sense, is significant in connection with other provisions of the act. The latter type of insolvency consists of inability to pay debts as they mature, regardless of the amount of assets and liabilities.

Any act of bankruptcy, plus insolvency in the bankruptcy sense, may serve as a basis for an involuntary petition. The acts of bankrupt;y listed in the statute consist of the debtor's having: (1) disposed of or concealed, or permitted to be concealed or removed, any of his property with intent to delay or defraud his creditors; or (2) made or suffered a preferential transfer; or (3) while insolvent, allowed any creditor to obtain a lien on any of his property through legal proceedings or distraint, without having vacated or discharged such hen within a specified time; or (4) made a general assignment for the benefit of creditors; or (5) while insolvent, in either the bankruptcy or the equity sense, procured, permitted, or suffered, voluntarily or involuntarily, the appointment of a receiver or trustee to take charge of his property; or (6) admitted in writing his inability to pay his debts and his willingness to be adjudged a bankrupt.

Distribution of Property to Creditors

Once a bankruptcy proceeding has been started, by voluntary or involuntary petition, the property of the debtor (known as his estate) must be liquidated and the proceeds distributed in an orderly manner. The act expressly prescribes the priority which various kinds of unsecured debts shall have. Secured creditors are paid out of the proceeds of property on which they have valid liens, to the extent that such proceeds are sufficient. The rights of secured creditors in this respect are not affected by the priority rating of unsecured creditors.

In order to participate in the proceeds of a bankruptcy liquidation, an unsecured creditor must hold a claim which is "provable" under the express terms of the act. Typical examples of provable claims are open book accounts, promissory notes, and liabilities which have been reduced to judgment. Even a provable claim is not entitled to share automatically in the distribution of assets, but must be "allowed" by the court upon the fulfillment of certain requirements set out in the act, such as the filing of the claim within six months after the first date set for the first meeting of creditors.

The ownership of all property and assets of the debtor vests in the trustee as of the date of the commencement of the bankruptcy proceeding. Title to property which is exempt under the applicable state law or under nonbankruptcy federal law, however, is not vested in the trustee. Among typical state exemptions are homesteads, life insurance, tools of trade, and clothing. The estate of the bankrupt includes property acquired by inheritance within six months after bankruptcy.

Limitations on Debt Discharge

From the debtor's point of view, the primary object of the bankruptcy proceeding is to obtain a "discharge", the effect of which is to make certain debts unenforceable against him in the future. The discharge, if granted, is effective against all provable debts existing at the date of the filing of the petition, except as set forth in the act. Debts which are not provable cannot be discharged.

The categories of provable debts which are not affected by a discharge in bankruptcy are: (1) taxes; (2) liabilities for obtaining money or property by false pretenses or representations, for willful and malicious injuries to person or property, for alimony, for maintenance or support of wife or child, for seduction, for breach of promise accompanied by seduction, or for criminal conversation; (3) debts not scheduled in time for proof and allowance; (4) debts created by fraud, embezzlement, misappropriation or defalcation while acting as an officer or in any fiduciary capacity; (5) certain wages earned within three months prior to the commencement of the proceeding; and (6) certain debts due for moneys of an employee received or retained by an employer.

The statute provides various grounds for the denial of a discharge to a debtor. The grounds specified are that the bankrupt has: (1) committed an offense punishable by imprisonment, specified in Section 152 of the Federal Criminal Code; or (2) destroyed or failed to keep adequate books and records; or (3) obtained money or credit through a false written financial statement; or (4) fraudulently transferred property within one year of bankruptcy; or (5) obtained a discharge or composition settlement in a former proceeding within six years; or (6) refused to obey a lawful order or to answer a material question in a bankruptcy proceeding; or (7) failed satisfactorily to explain losses and deficiencies of assets.


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