Bankruptcy

by Todd J. Zywicki
About the Author
Bankruptcy is common in America today. Notwithstanding two decades of largely uninterrupted economic growth, the annual bankruptcy filing rate has quintupled, topping 1.5 million individuals annually. Recent years also have seen several of the largest and most expensive corporate bankruptcies in history. This confluence of skyrocketing personal bankruptcies in a period of prosperity, an increasingly expensive and dysfunctional Chapter 11 reorganization system, and the macroeconomic competitive pressures of globalization has spurred legislative efforts to reform the bankruptcy code.

History of Bankruptcy

Early English bankruptcy laws were designed to assist creditors in collecting the debtor’s assets, not to protect the debtor or discharge (forgive) his debts. The Bankruptcy Clause of the U.S. Constitution also reflects this procreditor purpose of early bankruptcy law. Under the Articles of Confederation, the states alone governed debtor-creditor relations. This situation led to diverse and contradictory state laws, many of which were prodebtor laws designed to favor farmers (see regulation). Like other provisions of the Constitution, the enumeration of the bankruptcy power in article I, section 8 was designed to encourage the development of a commercial republic and to temper the excesses of prodebtor state legislation that proliferated under the Articles of Confederation. As James Madison observed in Federalist number 42:

The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed into different States that the expediency of it [i.e., Congress’s exclusive power to enact bankruptcy laws] seems not likely to be drawn into question.

The primary purpose of the Bankruptcy Clause was to protect creditors, not debtors, and in fact, debtor’s prisons persisted in many states well into the eighteenth century.

During the nineteenth century, the federal government exercised its bankruptcy powers only sporadically and in response to major economic downturns. The first bankruptcy law lasted from 1800 to 1803, the second from 1841 to 1843, and the third from 1867 to 1878. During the periods without a federal bankruptcy law, debtor-creditor relations were governed solely by the states. The first permanent federal bankruptcy law was enacted in 1898 and remained in effect, with amendments, until it was replaced with a comprehensive new law in 1978, the essential structure of which remains in place today.

Because bankruptcy law intervenes only when a debtor is insolvent, nonbankruptcy and state law govern most issues relating to standard debtor-creditor relations, such as contracts, real estate mortgages, secured transactions, and collection of judgments. Federal bankruptcy law is thus a hybrid system of federal law layered on top of this foundation of state law, leading to variety in debtor-creditor regimes. Bankruptcy law is generally procedural in nature and therefore attempts to preserve nonbankruptcy substantive rights, such as whether a creditor has a valid claim to collect against the debtor in bankruptcy, unless modification is necessary to advance an overriding bankruptcy policy.

Bankruptcy Policies

Bankruptcy law serves three basic purposes: (1) to solve a collective action problem among creditors in dealing with an insolvent debtor, (2) to provide a “fresh start” to individual debtors overburdened by debt, and (3) to save and preserve the going-concern value of firms in financial distress by reorganizing rather than liquidating.

First, bankruptcy law solves a collective action problem among creditors. Nonbankruptcy debt collection law is an individualized process grounded in bilateral transactions between debtors and creditors. Outside bankruptcy, debt collection is essentially a race of diligence. Creditors able to translate their claims against the debtor into claims against the debtor’s property are entitled to do so, subject to state laws that declare some of the debtor’s property, such as the debtor’s homestead, to be “exempt” from creditors’ claims.

When a debtor is insolvent and there are not enough assets to satisfy all creditors, however, a common-pool problem arises (see tragedy of the commons). Each creditor has an incentive to try to seize assets of the debtor, even if this prematurely depletes the common pool of assets for creditors as a whole. Although creditors as a group may be better off by cooperating and working together to distribute the debtor’s assets in an orderly fashion, each individual creditor has an incentive to race to grab his share. If he waits and others do not, there may not be enough assets available to satisfy his claim. Bankruptcy stops this race of diligence in favor of an orderly distribution of the debtor’s assets through a collective proceeding that jointly involves anyone with a claim against the debtor. Once the debtor files for bankruptcy, all creditor collection actions are automatically “stayed,” prohibiting further collection actions without permission of the bankruptcy court. In addition, any collections by creditors from an insolvent debtor in the period preceding the debtor’s bankruptcy filing can be prohibited as a “preference.” One interesting policy option that is not currently allowed is to allow parties to solve the common-pool problem through contract and corporate law, making bankruptcy unnecessary.

The second bankruptcy policy is the provision of a fresh start for individual debtors through a cancellation, or “discharge,” of his debts in bankruptcy. Although many rationales have been offered for the fresh start, none is wholly persuasive, and none provides a compelling rationale for the current American rule that the debtor’s right to a discharge is mandatory and nonwaiveable. This requirement increases the risk of lending to the debtor, raising the cost of credit for all debtors and leading to the rationing and denial of credit to high-risk borrowers. Allowing debtors to waive or modify their discharge right in some or all situations might be more efficient and better for debtors because by modifying their discharge rights, debtors could get lower interest rates or other more favorable credit terms. Indeed, the American system is unique in providing a mandatory fresh-start policy.

Personal bankruptcy filing rates have risen dramatically over the past twenty-five years, from fewer than 200,000 annual filings in 1979 to more than 1.6 million in 2004. Personal bankruptcy filing rates were traditionally caused by factors such as high personal debt rates, divorce, and unemployment. But given the unprecedented prosperity during the past twenty-five years—a period of generally low unemployment, declining divorce rate, low interest rates and rapid accumulation of household wealth due to a booming stock market and residential real estate market—this traditional model of the causes of consumer bankruptcy filings has become increasingly untenable (Zywicki 2005b). Scholars have suggested that the decline in the stigma associated with bankruptcy, changes in the relative economic benefits and costs of filing bankruptcy (especially the relaxation of the bankruptcy laws in the 1978 Bankruptcy Code), and changes in the consumer credit system itself have made individuals more willing to file bankruptcy than in the past (Zywicki 2005b). In response to this unprecedented rise in personal bankruptcies and the underlying reason for it, Congress has proposed reforms to reduce the abuse and fraud of the current system. One suggested reform is to require high-income filers to repay some of their debts out of their future income as a condition for filing bankruptcy (Jones and Zywicki 1999).

The third bankruptcy policy is the promotion of the reorganization of firms in financial distress. A firm confronting financial problems might be worth more as a going concern than it would be if it was closed and sold piecemeal to satisfy creditors’ claims. A firm’s assets may be more valuable when kept together and owned by that firm than if they are liquidated and sold to a third party. Such assets could include physical assets (e.g., custom-made machinery), human capital assets (such as management or a specially skilled workforce), or particular synergies between various assets of the company (such as knowledge of how best to exploit intellectual property). Thus, maintaining the existing combination of assets as a going concern, rather than liquidating the firm, could make creditors better off. The railroads at the turn of the century exemplify this principle. Rather than liquidating them and selling off the various pieces for scrap (e.g., tearing up the tracks and selling them as scrap steel), reorganization kept the rail network in place and the trains rolling, and creditors were paid out of the operating revenues of the reorganized firm.

Other firms, however, may not be merely in financial distress. Some may be economically failed enterprises generating a value less than the opportunity costs of their assets. Economic efficiency, and concern for creditors, would require such firms to be liquidated and their assets redeployed to higher-valued uses. For instance, given the ubiquity and dominance of computers, it was obviously efficient to liquidate the venerable Smith-Corona typewriter company and allow its workers to retrain and its physical assets to be reallocated in the economy.

It is difficult to distinguish a firm in financial distress from an economically failed enterprise, and it is doubtful that the current reorganization system is very accurate at making the distinction. First, the decision whether to reorganize is made by a bankruptcy judge rather than by the market. The reorganization decision, therefore, is essentially a form of mini–central planning, with the bankruptcy judge making the planners’ decision whether to allow the business to continue operating or to shut it down. As such, the decision is subject to the standard knowledge and incentive problems that plague central planning generally (see friedrich august hayek). Second, the decision whether to file and with which court is made by the debtor himself and the debtor’s management staff, which will have obvious incentives to file in friendly courts and to push for reorganization and the preservation of their jobs. Third, the beneficiaries of reorganization efforts (incumbent management, workers, suppliers, etc.) have great incentives to participate in the bankruptcy case and to make their interests known to the judge. Secured creditors will accept a reorganization only if the company is worth more dead than alive. But unsecured creditors, who have no hope of recovering their investment if the company is killed, have an incentive to favor reorganization even if there is only a tiny probability that reorganization will work: a small probability of something is better than a certainty of nothing. Given the errors and inefficiencies inherent in the current system, some scholars have proposed replacing the current judicial-centered system or at least supplementing it with various market mechanisms. One such mechanism would be an auction of the assets of the company as a going concern (Baird 1986). Another would be ex ante collective contracts (such as provisions in a firm’s corporate charter) that would apply if the firm became insolvent and would put creditors on notice about the risks of dealing with a particular company, causing them to tailor their interest rates and other credit terms accordingly.

The economic costs of inefficient reorganizations can be substantial. First, in large reorganization cases, the direct costs of bankruptcy reorganization routinely exceed several hundred million dollars in professional and other fees. Second, there is an opportunity cost associated with retaining the current allocation of assets, even if temporarily. For instance, a failing business continues to occupy its current location and to retain its workers and assets, not only slowing the reallocation of these assets to higher-valued uses in other firms and industries, but also injuring consumers, suppliers, and others.

The Future of Bankruptcy Law

The past several years have seen concerted efforts to reform the bankruptcy laws to address many of the above concerns. The anomaly of skyrocketing consumer bankruptcy filings during an era of economic prosperity has spurred widespread support for efforts to reform the consumer bankruptcy system. A few such reforms would include requiring high-income debtors who can repay a substantial portion of their debts to do so by entering a Chapter 13 repayment plan rather than filing for Chapter 7 bankruptcy, limiting repeat filings, and limiting some property exemptions. The proposed bankruptcy reform legislation would also attempt to streamline and reduce the cost and delay of corporate Chapter 11 bankruptcy proceedings, especially as they apply to small business bankruptcies.

Comprehensive bankruptcy reform legislation has been proposed in every Congress since the late 1990s but, notwithstanding overwhelming bipartisan support in both houses, has not yet been enacted. One reason is that various politicians introduced extraneous but controversial political issues; another reason is that bankruptcy professionals oppose reforms that would reduce the number of bankruptcies filed and the expense of bankruptcy proceedings.

On the other hand, the increasing pressure of economic globalization and the increasing challenges of bankruptcies involving multinational corporations have created incentives for bankruptcy reform. As investment capital increasingly flows worldwide, globalization creates strong incentives for national economies to adopt efficient economic policies, including bankruptcy policies. The current American bankruptcy system rests on investors’ willingness to voluntarily continue to invest in American firms despite the danger that capital investment will be trapped in an expensive and inefficient reorganization regime if the firm fails. By contrast, some major economies, such as Germany and Japan, have introduced more flexibility into their bankruptcy systems. Although many commentators have advocated establishing a uniform transnational bankruptcy system by treaty, devising a scheme that would gain assent from member countries would be difficult. Also, such a regime would likely be subject to many of the same interest-group pressures that characterize the American regime. The competitive forces of globalization may generate, instead of a “top-down” global bankruptcy system, an efficient and spontaneous convergence of bankruptcy systems throughout the world.


About the Author

Todd J. Zywicki is a professor of law at George Mason University’s School of Law and a senior research fellow of the James Buchanan Center, Program on Economics, Politics, and Philosophy. He was previously the director of the Office of Policy Planning at the Federal Trade Commission.


Further Reading

Baird, Douglas G. Elements of Bankruptcy. 3d ed. New York: Foundation Press, 2001.
Baird, Douglas G. “The Uneasy Case for Corporate Reorganization.” Journal of Legal Studies 15 (1986): 127–147.
Jackson, Thomas H. The Logic and Limits of Bankruptcy Law. Cambridge: Harvard University Press, 1986.
Jones, Edith H., and Todd J. Zywicki. “It’s Time for Means-Testing.” Brigham Young University Law Review 1999 (1999): 177–250.
Rasmussen, Robert K. “A Menu Approach to Corporate Bankruptcy.” Texas Law Review 71 (1992): 51–121.
Skeel, David A. Jr. Debt’s Dominion: A History of Bankruptcy Law in America. Princeton: Princeton University Press, 2001.
White, Michelle J. “Economic Versus Sociological Approaches to Legal Research: The Case of Bankruptcy.” Law and Society Review 25 (1991): 685–709.
Zywicki, Todd J. “The Bankruptcy Clause.” In Edwin Meese et al., ed., The Heritage Guide to the Constitution. Washington, D.C.: Heritage Foundation, 2005a. Pp. 112–114.
Zywicki, Todd J. “An Economic Analysis of the Consumer Bankruptcy Crisis.” Northwestern University Law Review 99, no. 4 (2005b): 1463–1541.
Zywicki, Todd J. “The Past, Present, and Future of Bankruptcy Law in America.” Michigan Law Review 101, no. 6 (2003): 2016–2036.

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