Some Bankruptcy Law History: Debtor Benefits Are Always A Tough Sell (Part II, Early 1800s to 1978)

By: Donald L Swanson

Bankruptcy benefits for individual debtors are a tough sell—always have been.  That’s because no one likes bankruptcy—unless they need it.

But relieving people from debts in unfortunate circumstances is essential to our collective way of life in these United States.  That’s always been true.

What follows is the second of three installments on some history of bankruptcy laws through the ages, beginning with ancient times—and to the present in these United States.

Federal Bankruptcy Act of 1841

Unsuccessful efforts in these United States to pass a federal bankruptcy law occur throughout the 1820s and 1830s.  Such efforts are blocked by:

• southerners, who believe a bankruptcy law would favor commercial interests of the north; and
• those who believe such a law is unconstitutional as an insolvency law that impinges on the sovereign rights of states and their insolvency laws—asserting that the Federal Bankruptcy Act of 1841 is not, in actuality, a “bankruptcy” law at all.

Regarding southern interests v. northern commercial interests, Alexis de Toqueville makes the following observations from an 1835 downstream trip on the Ohio River:

• “Upon the left bank of the stream [to the south] the population is sparse; . . . the primeval forest reappears at every turn; society seems to be asleep, man to be idle, and nature alone offers a scene of activity and life”;
• “From the right bank [to the north], on the contrary, a confused hum is heard, which proclaims, afar, the presence of industry; the fields are covered with abundant harvests; the elegance of the dwellings announces the taste and activity of the laborers; and man appears to be in the enjoyment of that wealth and contentment which is the reward of labor”; and 
• “Upon the left bank [south] of the Ohio labor is confounded with slavery, while upon the right bank [north] it is identified with that of prosperity and improvement; on the one side it is degraded, on the other it is honored.”[Fn. 1]

Congress’s hand is forced in 1841 to pass a bankruptcy law by the devastating economic Panic of 1837.  The 1841 Bankruptcy Act passes by a very close vote:

• it is the result of “earnest pressure from debtors” facing debtors’ prison and who are in “utterly desperate” circumstances—the number of which is “estimated by some as high as five hundred thousand”; but
• opposition to the proposed bankruptcy Act centers on constitutionality concerns, explained by politicians of the time like this: the proposed bankruptcy law,
  • is the “most daring attack on the State laws and the rights of property and on public morals which the History of Europe or American has exhibited”; and
  • is a breakdown of “the line between the jurisdiction of the Federal Courts and the State Courts in the whole department of debtors and creditors . . . bringing all local debts and dealings into the Federal Courts at the will of the debtors.” [Fn. 2]

Nevertheless, the 1841 Bankruptcy Act becomes a watershed event in bankruptcy history by:

• authorizing, for the first time, a financially troubled debtor to (i) file a voluntary bankruptcy, (ii) claim basic exemptions, and (iii) obtain a discharge; and
• ending any serious dispute over constitutionality of a voluntary bankruptcy filing. 

After less than two years, however, Congress repeals the 1841 Act, due to unhappiness over, (i) many thousands of debtors receiving a discharge, (ii) minimal dividends to creditors, and (iii) high administrative fees.

Federal Bankruptcy Act of 1867 [Fn. 3]

The economic Panic of 1857, combined with the financial cataclysm of the American Civil War, lead to enactment of the Federal Bankruptcy Act of 1867.  Northern creditors push for the new law, hoping it will help them recover on claims against southern debtors.

New provisions in this Act include, (i) allowing corporations to file bankruptcy, (ii) requiring a debtor’s oath of allegiance to the United States, (iii) granting bankruptcy jurisdiction to U.S. District Courts, (iv) creating the office of a bankruptcy “register” (predecessor of referees and bankruptcy judges), and (v) establishing “assignees” to supervise liquidation of debtor assets (predecessors of bankruptcy trustees).

Debtors fare poorly under this Act—only a third of them receive a discharge, 

However, the 1867 Act provides these innovations:

• Debtors can choose state law exemptions over the much-less-favorable federal exemptions—this option survives a challenge at the U.S. Supreme Court under the uniformity requirement of the Constitution’s bankruptcy clause and remains a part of bankruptcy law to this day; and
• “Composition agreements” are added to the 1867 Act by an 1874 amendment (a forerunner of today’s plan of reorganization) in which debtors can propose (i) paying a percentage of debts owed, over time, (ii) in exchange for a full discharge of those debts, (iii) while retaining property.

This 1867 law is repealed eleven years later, based on such failings as small dividends, lengthy delays, high fees and expenses, and disappointment of northerner creditors over failing to collect from southern debtors. 

Federal Bankruptcy Act of 1898 [Fn. 4]

The financial panics of 1884 and 1893 highlight the inability of states to deal with national financial problems.  State receiverships back then, for example, come to be dominated by insiders and are subject to much abuse.

So, Congress steps in with a new federal bankruptcy law—in 1898.  This time, the law is for keeps—it remains in existence until replaced by the Bankruptcy Code in 1978, with no time gap between them.

The road to passage of the 1898 Act is anything but smooth, because the 1867 Act had created enormous hostility against any federal bankruptcy law of any sort.

However, necessity prevails: the financial panics of 1884 and 1893 expose the need for a federal bankruptcy law and the states’ incapacity to deal with widespread financial calamities.

While all prior bankruptcy laws were viewed as temporary measures, this 1898 Act is created (from the beginning) as a permanent law, without a sunset provided or contemplated.

The 1898 Act ushers in the modern era of favorable debtor treatment under U.S. bankruptcy laws.  Earlier laws, while ostensibly allowing a debtor’s discharge, undermine that discharge at every turn.  So, the 1898 Act removes many discharge impediments.

Much of the 1898 Act’s focus is on improving administration of bankruptcy cases with:

• the U.S. Supreme Court given power to make procedural rules, forms and orders;
• many case administration duties delegated to bankruptcy “referees” (which became bankruptcy “judges” in 1973);
• preference and fraudulent transfer avoiding powers given to trustees; and
• composition agreements authorized, in lieu of liquidation, based on (i) majority creditor consents (in both number and value), and (ii) court approval under a best interest of creditors test.

Conclusion

Bankruptcy laws enacted in these United States, prior to the bankruptcy Code, saw a steady progression of ideas and ideals to meet the needs of a drastically-expanding economy and the resulting credit needs.

Still, benefits for debtors are hard to come by and arrive, primarily, because of the urgencies and necessities imposed by persistently-recurring financial crises.

———————–

Footnote 1.  De Toqueville, “Democracy in America,” Chapter XVIII (1835)

Footnote 2.  Warren, “The Supreme Court in United States History,“Vol II, at 97-98 (1928), published by The Legal Classics Liabrary.

Footnote 3.  Tabb, “The History of the Bankruptcy Laws in the United States,” 3 ABI Journal 14 (1995), is the source of much information in this article.  

Footnote 4.  Bush, “The National Bankruptcy Act of 1898, with Notes, Procedure and Forms,” (1^st Edition, 1899), published by Banks Law Publishing Co.

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