History of Bankruptcy in the United States

Down and out Victorian man
A Short History of Bankruptcy in America. Getty Images

Bankruptcy is a federal law that allows individuals and businesses to eliminate or reorganize debt. Bankruptcy pre-dates the founding of this great country, and it was certainly something on the founders minds at the time of the Revolutionary War.

Bankruptcy in the United States has had a long and varied history since the framing of the U.S. Constitution. Initially, the framers of the Constitution sought to model bankruptcy laws after English law on the subject.

However, since that time, the law has taken many twists and turns. 

The Framers actually provided for bankruptcy laws in the U.S. Constitution itself. This provision can be found in Article I, section 8, which gave Congress the power to: "…establish…uniform Laws on the subject of Bankruptcies throughout the United States." However, Congress did not immediately act on that power once the Constitution was ratified. It was more than ten years before Congress passed the first bankruptcy law. 

In the meantime, multiple states had established very extensive bankruptcy systems in the absence of a federal system. In fact, many of these systems were very pro-creditor and provided for the imprisonment of debtors!

Read more at Debtor's Prisons in British and U.S. History.

First Federal Bankruptcy Law

In 1800, Congress passed the first federal law relating to bankruptcy, called the Bankruptcy Act of 1800.

Similar to many state bankruptcy systems at the time, the Bankruptcy Act of 1800 was very creditor oriented and only permitted involuntary bankruptcies of merchant debtors. There were no provisions for individuals to file on their own. Some crafty debtors figured out that they could ask a friendly creditor to initiate the bankruptcy case.

However, due to many complaints of corruption and favoritism, the law was repealed just three years later. The states continued to run various bankruptcy systems in the absence of a federal law.

The Next Federal Bankruptcy Law

In 1841, after the financial panic of 1837, Congress passed another bankruptcy law, called the Bankruptcy Act of 1841. For the first time, this bankruptcy law permitted debtors to file their own voluntary bankruptcies without a creditor to initiate it. This was a revolution in insolvency law. In fact, a debtor could file for bankruptcy and receive a discharge of debt. In addition, any individual could be a debtor, not just a merchant as under the 1800 law. The power to grant the discharge and judge other matters relating to bankruptcy rested with the United States District Courts.

Unfortunately, however, creditors viewed the 1841 law as providing few payments to creditors and discharging too much debt for twoo many debtors. Accordingly, the 1841 law was repealed in 1843.

Third Time?

After another financial panic in the United States and the U.S. Civil War, the Congress decided to try again and passed the The Bankruptcy Act of 1867. The 1867 Act was very detailed and covered a variety of situations.

This law was the first to allow involuntary bankruptcies for any individual, not just merchants. The United States District Courts were required to appoint a "register in bankruptcy" in the performance of duties relating to bankruptcies. The registers were essentially the earliest bankruptcy judges.

Unfortunately, this law too failed in 1978, due to similar criticisms as prior laws.

1898

It was not until the year 1898 that Congress for the first time passed a bankruptcy law that became, essentially, permanent. With passage of the Bankruptcy Act of 1898, although amended and replaced multiple times, there have been no further periods of repeal and/or times when the federal government had no bankruptcy laws in effect.

Reform of 1978

After several amendments of the 1898 law, Congress passed the Bankruptcy Reform Act of 1978.

This law made comprehensive and sweeping changes to the bankruptcy system. This law brought into effect what is known as the "Bankruptcy Code." This law made a variety of changes, including drastically increasing the scope of the power of bankruptcy judges.

The Bankruptcy Reform Act of 1978 was again altered with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which introduced the Means Test for determining which individual debtors can qualify for Chapter 7 and which have to file a Chapter 13 case to obtain any relief. BAPCPA also introduced mandatory credit counseling and mandatory debtor education courses for individual filers.  

It has been a continual tug of war between various interests, mainly creditors and debtors. Although there are many other changes prior to and subsequent to the 2005 law, these are the major milestones in the history of bankruptcy in the United States. 

Updated by Carron Nicks October 2016.