Bankruptcy Essay

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Bankruptcy is the financial  and legal result of failure to pay off outstanding debts by a person  or an organization. It has become very common  all over the world  because  of rapid  economic  growth  and the problems  caused  by this. In recent  years, huge corporate bankruptcies have been witnessed,  such as the Lehman  Brothers  bankruptcy filing on September  15,  2008,  with  $639  billion  in assets and $619  billion  in debt.  Policy makers  have  tried  to find the best way to overcome the serious economic problems caused by the increasing number of bankruptcies.   While   the   United   States   has   adopted reforms designed to limit access to bankruptcy procedures, the  United  Kingdom  and  Japan  have implemented reforms  to encourage  more filings.

The terms bankruptcy and insolvency  are often confused,  but  there  is a subtle  difference  between them. While insolvency is a financial state of being unable  to repay  debts,  bankruptcy results  from  a legal  adjudication  that   stems  from  this  failure.

Contrary to  the  common  view, bankruptcy does not mean disappearance of the bankrupt company. It is a legal mechanism  that allows creditors  to take over  the  assets  of  the  debtor. The  main  aim  of modern   bankruptcy  procedures is  to  allow  the debtor  to have a new and fresh start and the creditor to be repaid.

In case of insolvency,  the  creditors  may  file a bankruptcy petition.  However,  bankruptcy is often initiated  by the debtor. Bankrupt debtors  generally have  some  assets  to  pay  off some  of their  debts. But these assets are not  enough  to pay off all the debts.  Bankruptcy  court  adjudicates  bankruptcy by appointing a trustee,  who  closes the company and  auctions  off the  assets.  Then,  the  appointed trustee  creates a list according  to which the creditors  collect  their  money  under  the  control  of the bankruptcy estate.


The  word  bankruptcy is derived  from  the  Italian banco rotto (“broken bench”). This term is formed from  the  Ancient  Latin  bancus  (for  “bench” or “table”)  and   ruptus   (“broken”).  In  the   early 1800s,  people  used  to  come  together  in marketplaces. Merchants would set up their businesses on either  tables  or  benches  in  these  common  areas. Even bankers  had a bench and operated their transactions on  it.  When  merchants or  bankers could  no  longer  afford  to  stay  in  business,  they broke their bench to declare to the public that their activities  were  ended.  Therefore,  the  meaning  of this  word  comes  from  the  habit  of breaking  the bench by bankrupts.

Some choose  instead  to  derive  the  word  from French  banque  (“table”) and  route  (“trace”) by referring  to the sign of a table left on the ground. Those  who  advocate  this idea take  the origins  of bankrupts to the Ancient Roman  mensarii or argentarii, who had their tabernae or mansae in certain public places. When they made off with the money  that  had  been entrusted to them,  they left the sign of their former  station  behind  them.


Bankruptcy used to be considered  a shameful  last resort. However,  later, its important role in solving serious  financial  problems  was accepted.  The rise of debt in recent decades has led to the creation  of bankruptcy systems  in  the  jurisdictions   of  many countries.   Even  countries   that   have  had   bankruptcy  systems for many years, such as the United Kingdom   and   the  United   States,  needed   major reforms in their jurisdictions because of the increasing levels of bankruptcy in recent years.

In Ancient Greece, if a man could not repay his debt,  his wife, children,  and  servants  were forced into  debt  slavery  till  the  creditor   recovered  the losses  through their  physical  labor.  Debt  slavery was limited to a period of 5 years, and debt slaves had  protection for life. But servants  of the debtor could be retained  beyond  5 years and even forced into  lifelong service. Unlike other  types of slaves, the masters  of debt  slaves could  not  kill them  or remove any of their limbs.

The roots  of U.S. bankruptcy laws  come from English laws dating from the 16th century. England first introduced a law (Act of Henry  VIII) related to the issue of bankruptcy in 1542. A criminal statute  was  directed   against   men  who   made   very prodigal   expenditures  and  then  failed  to  repay. Until the 18th  century,  debtors  were punished  by imprisonment in England.  In the 18th  century,  the development of debt  discharge  became  the  main point of interest. Thus, bankruptcy law, which was designed  to punish  the debtor, evolved into  a law that  protected the debtor  while encouraging  resolution of the outstanding debt. Modern laws focus less  on  punishment of  the  debtor   and  more  on rehabilitation of the person  or company.  So debtors will be able to manage their financial balances, and   the   economy   will  be  protected  from   the adverse effects of bankruptcies.

The Bankruptcy Act of 1800 in the United States emphasized  creditor  relief and  did not  allow  debtors  to  file for  relief voluntarily. Because of public disapproval, this act was repealed after 3 years. The first  modern  Bankruptcy Act in the  United  States came into effect in 1898  and became the basis for current bankruptcy laws. In 1934, the U.S. Supreme Court  ruled that  bankruptcy laws were designed to give debtors  a fresh start by removing previous financial   burdens.  The   goal   was   to   provide   a new  opportunity, which  was  no  longer  related  to former  mistakes.  The  Chandler Act of 1938  gave unique  authority to  the  Securities  and  Exchange Commission for the administration of bankruptcy processes.  The  Bankruptcy  Act  of  1941   offered debtors  more  protections and allowed  them to file for  bankruptcy relief voluntarily. The  Bankruptcy Reform  Act of 1978,  which  entered  into  force  in 1979,  replaced  the old bankruptcy laws and is still in effect today. This law made it too simple for consumers  and  companies  to  file for  bankruptcy and recover  their  debts.  The  Bankruptcy Abuse Prevention  and  Consumer Protection Act of 2005 made several significant changes to the U.S. Bankruptcy Code.  The  U.S. government designed the act to limit consumers’ access to and increase the cost of liquidation-type bankruptcy procedures. Chapter 7 of the U.S. Bankruptcy Act allows debtors to get rid of most of their debts, which usually leads to liquidation. Chapter 11 helps a business stay alive by encouraging  negotiation. Chapters 12 and 13 are reorganization programs designed  for  individuals. Chapter 12 is designed for owners  of family farms, while Chapter 13 is for everybody else. As of March 2015,   bankruptcy  filings  totaled   911,086  in  the United  States;  of  these,  Chapter 7  filings  totaled 596,867, while Chapter 13 filings totaled  306,729.

Personal Bankruptcy

Personal bankruptcy is a legal procedure for people who are unable to pay off their debts. Modern legal systems allow an individual  to declare  bankruptcy and include debt relief. Debt is the result of spending more  than  one’s income  in a certain  period.  If anybody  continues  to spend  more  than  his or her affordable  limit,   bankruptcy  will  be  inevitable. Some groups of society are more prone to debt problems  than  others.  For example,  young  people have been pointed  at as the most vulnerable  group. There   is  no   doubt   that   excessive  amounts  of consumer  credit  have  played  a significant  role  in bankruptcies. The increasing  debt problems  of households have led governments all over the world to create efficient personal  bankruptcy procedures. Personal bankruptcy procedures, which lead to partial or total relief of outstanding debt, have been the solution   to  depressing   debt  problems   in  Anglo-Saxon  jurisdictions. This solution  process  has also been  increasingly  common  in European countries as well as in the industrialized Asian countries.

In all modern  legal systems,  a key question  is why debtors  file bankruptcy. Unemployment, family breakdown, and  loss of financial  overview  are the    main    reasons    for   personal    bankruptcy. As national income  and  consumer  spending  rise, the  personal  debt  level increases.  When  personal debt  becomes  common,  household financial  distress rises. This situation is the chief antecedent  of high bankruptcy rates.

In countries  with bankruptcy systems that  offer less generous  relief,  fewer  debtors  file for  bankruptcy. When the legal system offers more generous relief,  more  debtors   file  for  bankruptcy. Ronald Mann,  who  has  conducted an  extensive  study  of variation in the levels of consumer  credit in several countries,  compares  the filing rates in several jurisdictions with a view to explaining what factors influence the different bankruptcy per capita rates. As of 2004, there were 930 filings per million residents  in  the  United  Kingdom,  1,300   filings  per million residents in Australia, 3,100 filings per million residents in Canada, and 5,500  filings per million residents in the United States. Personal debtors in the United  States file for consumer  bankruptcy more often than  those in other  countries.  This difference is not  because  they have a lax attitude to repayment of  debts  but  because  they  have  more debt. However, legal and cultural factors have influenced  filing behavior. For example,  when Canadians are overindebted, they seem to have a lower threshold of filing for bankruptcy than debtors  in  comparable situations in  other  countries. The easy access to bankruptcy in Canada, with low up-front payments  and  fewer  requirements for  a judicial determination, may be the reason  for this.

In the United States, people can use two different ways to file for personal  bankruptcy. It is possible to meet all or part  of the debt with the direct liquidation procedure under  Chapter 7. This way is suitable  for people  who  have large amounts of debt and insufficient income. The second way is suitable  for  people  who  have  enough  income  to repay their debt in a reasonable  amount of time. In this  situation, debtors  repay  all  or  part  of  their debt  according  to a payment  plan  under  Chapter 13.  In spite  of the  advantages of personal  bankruptcy,  it has negative  consequences  as it remains on one’s personal  credit  report  for 7 to 10 years. People  with  low  credit  scores  usually  face problems in obtaining loans, or higher interest rates are applied  to them due to their financial  risk.

Bankruptcy laws allow personal  debtors  to keep certain  assets, such as common  household goods. Thus, a basic standard of living is provided  while repaying  the creditors.  For this reason,  if a debtor has no wages and no property, it is called judgment proof,  meaning  a judgment  would  have no impact on his or her financial  situation.

Corporate  Bankruptcy

Corporate bankruptcies occur  when  shareholders exercise their  right  to default.  Because of the limited liability of shareholders, they can avoid meeting  all  their  debt  obligations. A limited  liability structure allows  the  assets  of  a  company   to  be considered  separate  from its owner. Thus, the personal  assets of the  owner  are  protected from  the bankruptcy process,  which  has  some  direct  and indirect  costs  for  companies.   Direct  bankruptcy costs are fees paid to lawyers, accountants, consultants,  and other  professionals involved in the process. Other  expenses that are directly related to the bankruptcy process and administration of this process are accepted  as direct costs of bankruptcy. Lawrence Weiss found that the average cost of bankruptcy is about  3 percent  of the  total  book assets and 20 percent of the market  value of equity in  the  year  prior   to  bankruptcy.  Bankruptcy is more  costly  for  small  firms  and  firms  that  have more growth  opportunities.

Indirect  bankruptcy costs  are  economic  losses incurred   during   the  bankruptcy  process.   These losses may be caused by inefficient decision making in a company  due to the required  approval of the bankruptcy court in business decisions. Additionally, focusing on the bankruptcy process instead  of the main  activities of the company  by managers  gives rise to inefficiency. Indirect  bankruptcy costs also include loss of consumers, loss of important suppliers, loss of key employees, and  missed investment opportunities. It is almost  impossible  to  measure the indirect  costs of bankruptcy.

The threat  of bankruptcy may minimize or discourage  debt financing.  Bankruptcy is more likely to  occur  for  leveraged  firms  that  are  unable  to make more interest and principal payments. Therefore,  cost of bankruptcy is an important factor of capital  structure. More  debt creates a larger tax  shield  but  leads  to  higher  bankruptcy costs. According  to the trade-off  theory  of capital  structure,  optimal  capital  structure will be determined by the  balance  between  benefit  of tax  shield and cost of bankruptcy. Tangibility is an important factor to determine  how serious the bankruptcy is. A company  with  more  tangible  assets is exposed  to less bankruptcy costs than  a company  with  more intangible   assets.  It  is  easy  to  convert   tangible assets to cash, but such a conversion  is difficult for intangible  assets. According  to Merton Miller, the supposed  trade-off  between  tax shields and bankruptcy  costs  looks  like  the  recipe  for  the  fabled horse and rabbit  stew. In other words, bankruptcy costs are unimportant compared with  tax  shields. But  some   other   scholars   reject   this   idea   and emphasize  the importance of bankruptcy costs.

The  bankruptcy process  in  the  United  States may be initiated  by the creditors,  but in the case of public  corporations,  it  is  usually  the  firm  that decides to file. Two procedures that  are commonly used are Chapters 7 and 11 of the Bankruptcy Act. The purpose  of Chapter 7 is to oversee the firm’s death,  while  Chapter 11  seeks to  nurse  the  firm back  to health.  Chapter 7 is used for small firms, and  it means  the end of the road.  Chapter 7 process is often  initiated  not  by the  firm  but  by its creditors.  Large companies  that  cannot  meet their debt obligations try to rehabilitate their businesses with the procedures described in Chapter 11.


  1. Brealey, Richard , Stewart  C. Myers, and Franklin Allen. Principles of Corporate  Finance, 10th  ed. Singapore:  McGraw-Hill Irwin, 2011.
  2. Mann, Ronald  “Making Sense of Nation-Level Bankruptcy Filing Rates.”  In Consumer Credit, Debt and Bankruptcy: Comparative and International Perspectives, J. Niemi, I. Ramsay, and W. C. Whitford, eds. Oxford: Hart  Publishing, 2009.
  3. Miller, Merton H. “Debt and Taxes.”  The Journal of Finance, v.32/2 (1977).
  4. Weiss, Lawrence A. “Bankruptcy Resolution: Direct Costs and Violation of Priority  of Claims.” Journal of Financial Economics, v.27/2 (1990).

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