Understanding Bankruptcy: What It Is

Welcome to Understanding Bankruptcy, a series of seven columns to help you understand our modern bankruptcy system.

I am sure you have heard of bankruptcy, a legal process that can be used when a person or organization is unable to pay its debts. You may even have a rough idea of how it works. Perhaps you have known someone who has gone through the bankruptcy process.

However, if you are like most people, there is a lot you don’t know about bankruptcy, and when you hear or read about it, you may be confused as to what it really is and how it works.

In our culture, many people consider personal bankruptcy to be so shameful that even when they are deeply in debt, they will avoid bankruptcy for years, even at the cost of immense suffering both for themselves and their families. If they are ever forced into bankruptcy, they are so ashamed they don’t want anyone to know.

At the same time, it is common to hear about companies — often large, well-known companies — that enter bankruptcy, shed their debts, emerge from bankruptcy, and keep going as if nothing happened.

So how do we think about this? Is using bankruptcy shameful, or not? Is it a last ditch effort, only to be used reluctantly when everything else fails? Or is it a useful alternative to crushing debt, an important economic tool we should all understand?

The truth is, bankruptcy is an important part of our modern economic system, a complex set of procedures that took a long time to be developed and many more years to be fine tuned.

My goal in writing Understanding Bankruptcy is to teach you the basic concepts related to bankruptcy and explain why bankruptcy is so important. By the time you finish reading, you will be able to think about bankruptcy with knowledge and compassion. If, one day, you need to use bankruptcy for yourself or your business, you won’t be ashamed, and you won’t feel like a failure.

To start, we will discuss the basic ideas: What is bankruptcy? Why is it so important? How is bankruptcy used?

We will move on to cover the history of bankruptcy as an economic tool, followed by a discussion of how bankruptcy law has evolved, particularly in the United States. We will then do a quick survey of the various types of bankruptcy. Along the way, I will explain the important technical terms I want you to understand.

Once we have covered the history of bankruptcy and its basic principles, we will discuss the major types of bankruptcy in more detail, at which time I will explain how each type of bankruptcy can be used, particularly by individuals. We will then talk about student loans and how they relate to bankruptcy.

To complete Understanding Bankruptcy, I will explain what you are likely to experience should you ever need to file for bankruptcy yourself. I will then leave you with some thoughts as to the best way to think about the bankruptcy system and how it exists to serve us.

My overall goal is for you to come to understand that bankruptcy is an important — and interesting — economic tool, one that is crucial to the operation of a modern, healthy economy.

Author’s Note: As a reference aid, I have created a comprehensive glossary of bankruptcy-related terms. You can find it in the “Money and Economics” section of my website at harley.com

What Is Bankruptcy?

Money that is owed is referred to as “debt.” The person or organization that owes the money is called a “debtor.” The person or organization to which the money is owed is called the “creditor.”

Anything of value that is owned by a person or an organization and can be used to pay a debt or fulfill a financial obligation is called an “asset.” Examples of assets are money, real estate, cars, stocks, bonds, and so on. If a debtor owes more money than the value of his assets, we say that he is “insolvent.”

As an example, let’s say that Sam owes $55,000: $10,000 to Jack, $5,000 to Jill, $25,000 in federal income tax, and $15,000 to a credit card company. Sam is the debtor, with a total debt of $55,000. The creditors are Jack, Jill, the federal government, and the credit card company. If Sam’s assets are valued at less than $55,000, Sam is considered to be insolvent. This is another way of saying that everything that Sam owns, put together, would not be enough to pay back all that he owes.

It often happens that people, companies, or governments find themselves in a position where they are unable to pay their debts, and the debts are large enough to create a great deal of continuing hardship. Sometimes it is their fault; sometimes it isn’t. Regardless, in such cases, the law provides a remedy: bankruptcy.

“Bankruptcy” is a legal procedure that can be used by people, companies, and governments that are insolvent; that is, when they owe more money than they are able to repay. Bankruptcy allows a debtor to be released from all or part of his debts.

When a person or an organization initiates a bankruptcy procedure, we say that they “file” for bankruptcy.

The importance of bankruptcy is that it provides a way out of an otherwise hopeless position. As such, bankruptcy is an essential economic instrument, one that can transform an over-burdened individual back into a productive and useful member of society. Similarly, bankruptcy can also be used to restore the usefulness of governments or the profitability of companies.

The bankruptcy process is coordinated by a licensed professional called a “bankruptcy trustee” (or, more simply, a “trustee”), who works under the supervision of a bankruptcy court. As a general rule, trustees are hired by — and paid by — the person or organization filing for bankruptcy. In the United States, many bankruptcy trustees are lawyers.

Why Bankruptcy Is Important

When a debt is eliminated as part of a bankruptcy process, we say that the debt is “discharged.”

Once a debt has been discharged, the debtor is relieved of the obligation to pay the creditors, and the creditors are prohibited by law from taking any further action to recover the debt. In this way, an individual can continue to live his life free from the burden of oppressive debts. (This is often referred to as a “fresh start.”) Similarly, a company can stay in business, while reorganizing itself around a more favorable debt structure; and a government can return to providing essential services to its citizens.

The chance to discharge debt legally is a unique and crucial part of our economic system. To understand why, we only need to consider the alternative. That is, let us consider what happened to debtors who were unable to pay their debts before bankruptcy was invented.

Before bankruptcy, debtors who could not meet their obligations were subject to severe penalties. For example, in the ancient Greek city states and the early Roman Empire, a person who could not pay his debts would often be forced to become a slave to his creditor. (This is called “debt bondage.”)

A thousand years later, the treatment of debtors was still harsh. For example, in England, the first official laws regarding insolvency were passed in 1542, during the reign of King Henry VIII. These laws treated insolvent debtors as criminals, with penalties such as imprisonment and even death.

Even in more modern times, well into the 1800s, people who were unable to pay their debt could still be imprisoned. They were sent to “debtor’s prisons,” where they would be confined, often in a brutal and inhumane manner. As an example, in 19th-century England, a debtor could be accused by any of his creditors. Once this happened, the debtor would be given a short time to raise the money to pay off the debt. If the money was not forthcoming, the debtor would be imprisoned until the debt was paid.

If you are a fan of the novels of Charles Dickens, you may remember that several of his characters were sent to debtor’s prisons: Mr. Pickwick (Pickwick Papers, published in 1836), Micawber (David Copperfield, 1849), and William Dorrit (Little Dorrit, 1855). In fact, in 1824, when Dickens was 12 years old, his own father was sent to a debtor’s prison.

In the United States, federal imprisonment for unpaid debts was abolished in 1833, and around the same time for most of the states. In England, imprisonment for debt was not abolished until 1869.

By the late 1860s, the attitude toward indebtedness was beginning to change generally. For a long time, it had been recognized — for two important reasons — that a better system was needed to deal with debtors. The first reason was that imprisoning debtors, or forcing them into involuntary servitude, is an extremely severe punishment. For centuries, such punishments were considered appropriate because defaulting on one’s debts was seen as a serious moral failing. In modern times, however, it began to be recognized that it is common for people to acquire overwhelming debts because of circumstances beyond their control. In such cases, it is more appropriate to offer a compassionate solution to the problem.

An even more important reason for avoiding involuntary servitude or imprisonment for debtors is based on a practical observation: People who cannot work freely are unproductive. When such debtors are liberated from the burdensome demands of their debts, many of them will, once again, become useful and productive.

This is why, in the long run, it is more practical to allow people who are overwhelmed with debt to discharge their obligations and get back to work than it is to punish them. To be sure, there will always be those who are dishonest and take advantage of the system. However, in the aggregate, allowing overwhelmed debtors to go bankrupt is now recognized to be beneficial for the economy as a whole.

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