Law

Bankruptcy Isn't for Everyone. Maybe It Should Be.

People and companies can start fresh. Why not states and nations?

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Photographer: JB Reed/Bloomberg

Robert Morris was a signer of the Declaration of Independence, the chief financier of the American Revolution, the superintendent of finance (Treasury secretary, basically) of the early republic, one of Pennsylvania's first two U.S. senators, and, for a time, the richest man in the country. But in February 1798, after a huge bet on land on the western frontier and in the new “Federal City” on the Potomac fizzled and a financial panic ended creditors’ patience, he had little choice but to check himself into the debtors’ prison on Prune Street in Philadelphia. 1

The shock was felt across the country, especially two blocks away at Congress Hall. The U.S. Constitution had in 1787 explicitly called on Congress to establish “uniform Laws on the subject of Bankruptcies throughout the United States.” This would be good for the “regulation of commerce,” James Madison explained in Federalist Paper No. 42, “and will prevent so many frauds where the parties or their property may lie or be removed into different States.” But lawmakers hadn’t seen it as a priority, even after another famous financier, William Duer, had landed in debtors' prison after a financial panic in 1792.

Duer had been assistant secretary of the Treasury under Alexander Hamilton, but he was a controversial, unsympathetic figure. 2 Morris was a Founding Father. George Washington came to dine with him in prison, and Congress began to get serious about bankruptcy legislation. In April 1800, President John Adams signed the Bankruptcy Act into law. Morris’s own bankruptcy case commenced a little over a year later. Creditors proved $3 million in debts, which is $54.5 million of today’s dollars in purchasing power terms, according to MeasuringWorth.com. As a share of gross domestic product, though, it was equivalent to $109 billion today. In other words, a lot of money.

As Harvard Law School's Bruce Mann tells it in his book “Republic of Debtors,” from which almost all the fun historical details above were taken, the rest of the proceedings went like this:

After three months of questioning Morris before the commissioners, his creditors concluded that his remaining property would not even cover the costs of the proceedings. So they gave up. Morris received a discharge, without opposition, on December 3, 1801. The next morning he wrote his son, who had just won election to Congress as a Federalist from New York, “I now find myself a free Citizen of the United States without one cent that I can call my own.”

So this wasn't exactly a modern corporate bankruptcy, with the boss allowed to keep running the business as creditors are temporarily held at bay. In fact, the 1800 bankruptcy law differed little from English statutes that gave scant leeway to debtors. But Mann writes that application of the 1800 law was nonetheless more forgiving than standard English practice. U.S. courts and creditors did not necessarily view insolvency as a moral failure. Sometimes businesspeople took risks that didn't work out, and it was helpful to have a process to manage the unfortunate results, share the responsibility among creditors and debtors, and allow for fresh starts.

Not everyone in politics saw it that way, and in 1803 Congress repealed the law. It had been passed by a Federalist majority; in the 1802 election, the Jeffersonian Republicans (precursors of today's Democrats) had swept into power and were eager to do away with what many saw as a sop to urban commercial interests. Also, with memories of the Panic of 1796-1797 fading, the need seemed less pressing. Congress once again enacted bankruptcy laws in times of financial distress in 1841 and 1867, only to repeal them soon afterward. Bankruptcy remained an often-confused matter of state law and judicial interpretation until the passage of the Bankruptcy Act of 1898.

Since then, an orderly, more-or-less predictable bankruptcy process has been part of the American way of life -- and this country's relatively forgiving approach to bankruptcy has to some extent gone global. 3  

That's not to say there haven't been some big changes to U.S. bankruptcy law since 1898. During the financially distressed 1930s, Congress first added a provision allowing municipalities to declare bankruptcy, then rewrote the entire bankruptcy code. The latter reform made corporate bankruptcies less attractive by, among other things, requiring that an outside trustee be appointed to run the bankrupt company. Another major rewrite in 1978 took away that requirement, allowing the pre-bankruptcy management team to stay in charge. A boom in corporate filings followed.

Corporate Bankruptcy

U.S. business bankruptcy filings, by year

Source: American Bankruptcy Institute

Personal bankruptcy filings also rose after the 1978 reforms, and kept rising for decades. In response, Congress passed a law in 2005 that made it harder for individuals to get their consumer debts discharged. The result was a sharp decline in nonbusiness bankruptcy filings.

Personal Bankruptcy

U.S. nonbusiness bankruptcy filings, by year

Source: American Bankruptcy Institute

Such changes can have significant economic consequences. Making corporate bankruptcies easier helped corporations shed many of the promises they had made to workers about pensions and retiree health care -- which helped businesses survive but has been pretty terrible for lots of retirees. Making personal bankruptcies harder, one study found, led to 800,000 additional mortgage defaults and 250,000 additional foreclosures a year during the financial crisis.

Still, there's always going to be a tension in bankruptcy between discouraging profligacy and enabling the insolvent to make a new start. "Bankruptcy is a process that can't be approached with a simple moral frame or set of decision rules," Harvard law and business professor Mihir Desai writes in "The Wisdom of Finance," a lovely look at the real-world implications of key financial concepts that got me thinking about this subject (and steered me to Mann's history). 4 "Instead, it is a process of navigating deeply felt competing obligations."

What is definitely a problem is the absence of any bankruptcy process at all. In the U.S., one of the most controversial holes in the bankruptcy net is student debt, which, thanks to a series of ever-tighter restrictions adopted by Congress starting in 1976, is now so hard to get discharged that few try. The initial reasoning for this divergent treatment was that rising defaults would endanger student loan programs but, as an anonymous Harvard Law Review editor argued in 2012, 5  the resulting lack of incentive for lenders to adequately assess the risks of loans may have led to far worse problems.

Also unable to avail themselves of the bankruptcy process are U.S. states. As Kenneth Katkin of Northern Kentucky University's Chase College of Law explains, this is partly because the bankruptcy code doesn't explicitly provide for it and partly because the contracts clause of the Constitution seems to forbid it. 6 As pension obligations have weighed heavily on certain states, some have called on Congress to provide a mechanism to resolve their debt problems (because of the constitutional issues, the Supreme Court might have to weigh in as well). Bankruptcy would be "a fair, orderly, predictable and lawful approach to help struggling state governments address their financial challenges without resorting to wasteful bailouts," the odd couple of Jeb Bush and Newt Gingrich wrote in the Los Angeles Times in 2011. Congress did create a bankruptcy-like process last year for the struggling U.S. territory of Puerto Rico, but not having that in place years ago has surely made the island's debt problems much bigger and harder to resolve.

Banks and other financial institutions don't quite fit into the bankruptcy framework, either. At least, when a big one declares bankruptcy at a time of great financial stress, as Lehman Brothers did in 2008, things don't work out too well. The problem is that financial institutions are vulnerable to liquidity crises (aka bank runs) as every worried creditor tries to cash out at once. Without a big pool of money to calm creditors down, bank bankruptcies simply can't be orderly. Congress did create such a pool of money for banks in 1933 via the Federal Deposit Insurance Corp., but it (1) doesn't apply to bank-like entities that aren't technically banks and (2) isn't up to the challenge of winding down giant, global institutions. In 2008 and 2009, U.S. authorities improvised, with Congress approving the $700 billion Troubled Asset Relief Program and the Federal Reserve spending trillions of dollars on financial assets. The Dodd-Frank Act of 2010 created the Orderly Liquidation Authority, giving the FDIC more flexibility in winding down big financial institutions and the ability to borrow from the U.S. Treasury in doing so, but (1) there are those who doubt that this can really work and (2) the House of Representatives voted earlier this year to dismantle the authority and replace it with bankruptcy rules for financial corporations that, for the reasons discussed above, almost certainly wouldn't work.

Finally, there's no orderly bankruptcy process for nations -- a state of affairs that smart people occasionally decry. There's no ban on sovereign defaults, either, so a long list of countries have gone through the ad-hoc bankruptcies known as sovereign debt crises. These can be messy, but they're still better than what Greece has been enduring. The country has been effectively bankrupt for more than seven years, but its membership in the euro -- its lack of monetary sovereignty, in other words -- has prevented it from following much of the sovereign-debt-crisis playbook. 7 Meanwhile, a combination of euro-zone design flaws and political deadlock has thwarted serious debt reorganization, while the 25 percent decline in gross domestic product since the crisis began has rendered the country even less capable of paying what it owes. For want of a bankruptcy code, millions have needlessly suffered.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

  1. Prune Street is now Locust Street. The prison was at what is now the corner of Locust and Sixth.

  2. For an entertaining and quite uncharitable portrait of the man, I recommend David Liss's historical novel "The Whiskey Rebels."

  3. For a history of U.S. bankruptcy law since the early 1800s, I recommend "Debt's Dominion," by University of Pennsylvania law professor David A. Skeel Jr.

  4. Disclosure: Desai is a friend.

  5. Articles written for the Harvard Law Review by its student editors are always anonymous, which some people think is "dopey." Also, I know: Too much Harvard Law School! Sometimes it just can't be helped.

  6. Disclosure: Katkin was my college roommate. But I came across his explainer, in a Council of State Governments newsletter, entirely serendipitously (that is, I Googled something like, "Why can't states declare bankruptcy?"). Also: Yay! Not Harvard Law School!

  7. Yes, Greece could conceivably follow the playbook if it left the euro. But the political consequences of such a move are so uncertain and scary that it's understandable that its leaders have not taken the leap.

To contact the author of this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net

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