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Understanding Bankruptcy


Modern Bankruptcy Law
in the United States

Towards the end of the 19th century, economists and lawmakers began to realize that legally sanctioned bankruptcy had a far more important economic role than a mere temporary measure for difficult times. Slowly, people began to appreciate that being able to deal with overwhelming debt was of fundamental importance to the well-being of the economic system. This realization marked a turning point.

When the next U.S. bankruptcy law was passed in 1898, it become permanent. Although the law was revised from time to time (see below), it was never repealed outright. Having a permanent bankruptcy law led to a sea change in how insolvency was handled in the United States. Specifically, for well over a century, the United States has had a functional and accessible bankruptcy system.

Here is a summary of how the bankruptcy system developed.

1898: THE NATIONAL BANKRUPTCY ACT OF 1898 (known more simply as the BANKRUPTCY ACT) became the first permanent U.S. bankruptcy law. The Bankruptcy Act served as the basis of U.S. bankruptcy law for 40 years, until it was overhauled in 1938.

1933: The Bankruptcy Act was amended.

1934: The Bankruptcy Act was amended again.

In 1934, another crucial psychological milestone was reached when, for the first time, the U.S. Supreme Court definitively established that the purpose of bankruptcy was to provide the honest debtor with a second chance.

The case was Local Loan Co. V. Hunt (292 U.S. 234, 1934). Within the written opinion, Supreme Court Justice George Sutherland wrote:

"One of the primary purposes of the Bankruptcy Act is to 'relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.'

"This purpose of the act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt."

With this statement, the U.S. Supreme Court officially recognized the purpose of modern bankruptcy: to provide the honest debtor with a second chance. When you read about bankruptcy, you will almost always see this idea referred to as a "fresh start".

The importance of a fresh start is twofold: first, it enables debtors to retain their self-respect and mental health (which is good for the individual); second, it makes it far more likely that the debtor will, once again, become a useful and productive member of society (which is good for the economy).

The spirit of Mr. Justice Sutherland's statement (quoted above) manifested itself again four years later when the Bankruptcy Act was overhauled.

1938: The Bankruptcy Act was amended for a third time by the so-called CHANDLER ACT of 1938. This time there were two major changes. First, the law made it easier for individuals and companies to go bankrupt voluntarily. Second, there was a new alternative to total liquidation: a company in debt now had the option to reorganize its finances and stay in business.

With the passing of the Chandler Act, U.S. bankruptcy law became so stable that the next major change did not take place until 1978.

1978: The Bankruptcy Reform Act

The BANKRUPTCY REFORM ACT was another major overhaul of the entire bankruptcy system. Many of the changes, though significant, were technical and procedural, and we don't need to go into the details. There is, however, one important change I want to mention.

Before 1978, it was possible to discharge all student loans through bankruptcy. The new law changed that. Starting in 1978, government student loans could no longer be included as part of a bankruptcy. However, until 2005, it was still possible to discharge private student loans. We'll talk about bankruptcy and student loans in more detail later.

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