A brief history of business bankruptcy in the U.S.

In medieval Italy, when a businessman did not pay his debts, it was the practice to destroy his trading bench. From the Italian words for broken bench, "banca rotta," comes the term bankruptcy.

Before the 20th century, rules and practices concerning bankruptcy generally favored the creditor and were very harsh toward the bankrupt. The focus was on recovering the investments of the creditors and almost all bankruptcies at this time were involuntary. In England, the first official laws concerning bankruptcy were passed in 1542, under Henry VIII. A bankrupt individual was considered a criminal and was subject to criminal punishment. Potential punishments ranged from incarceration in debtors prisons to the death penalty.

In the United States, early federal bankruptcy laws were temporary responses to bad economic conditions. The first official bankruptcy law was enacted in 1800 in response to land speculation. The economic upheaval of the Civil War caused Congress to pass another bankruptcy law in 1867. The 1867 law was the first to include protection for corporations. The Great Depression yielded much more bankruptcy legislation, in particular, the Bankruptcy Act of 1933 and the Bankruptcy Act of 1934. This legislation culminated with the Chandler Act of 1938. This Act included substantial provisions for reorganization of businesses. During the period from World War II through the 1970s, bankruptcy was not a major topic in the news. The Bankruptcy Reform Act of 1978 was passed in 1978 and took effect on October 1, 1979. This act substantially revamped bankruptcy practices. A strong business reorganization Chapter was created, Chapter 11 Bankruptcy.

On October 22, 1994, the Bankruptcy Act of 1994 (Public Law 103-394, October 22, 1994), the most comprehensive piece of bankruptcy legislation since the 1978 Act, was signed into law by President Clinton. The 1994 Act contains many provision, for both business and consumer bankruptcy, including: provisions to expedite bankruptcy proceedings, provisions to encourage individual debtors to use Chapter 13 to reschedule their debts rather than use Chapter 7 to liquidate; provisions to aid creditors in recovering claims against bankrupt estates; and creation of a National Bankruptcy Commission to investigate further changes in bankruptcy law. In November 1997, the National Bankruptcy Review Commission completed an extensive and detailed report on bankruptcy reform. These recommendations are still being debated by Congress.

Commercial receivership

A receiver or receiver/manager, under the Bankruptcy and Insolvency Act, is a person who has been appointed to take, or has taken possession of all or substantially all of:

• the inventory;
• the accounts receivable; or
• the other property of an insolvent company pursuant to a security agreement or an order of the court.

The Receiver or Receiver/Manager will take possession of the assets covered under the security or covered by the court order and will sell the assets. After paying any priority creditors and the costs of the receivership, the balance of funds is paid to the secured creditor.

In some cases there is both a receivership and a bankruptcy, for example, if it is advantageous for the federal bankruptcy laws to be utilized.

Business bankruptcies

A company can be placed into bankruptcy by:

• a creditor petitioning the company into bankruptcy through the courts;
• the directors assigning the company into bankruptcy;
• having a proposal to the creditors defeated at the first meeting of creditors;
• having a proposal annulled by the trustee on creditor instructions for non-compliance.

In a corporate bankruptcy the trustee takes possession of all the company's assets and he deals with all the creditors.

What happens to the company in a corporate bankruptcy?

Federal bankruptcy laws govern how Companies go out of business or recover from crippling debt. A bankrupt company, the "debtor", might use Chapter 11 of the Bankruptcy Code to "reorganize" the business and try to become profitable again. Management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court. Unfortunately, studies indicate that as few as 10% of all Chapter 11 bankruptcy cases result in an effective reorganization. Under Chapter 7, the company stops all operations and goes completely out of business. A trustee is appointed to "liquidate" (sell) the company's assets and the money is used to pay off debt, which may include debts to creditors and investors.

How does Chapter 11 Bankruptcy work?

The U.S. Trustee, the bankruptcy arm of the Justice Department, will appoint one or more committees to represent the interests of creditors and stockholders in working with the company to develop a plan of reorganization to get out of debt. The plan must be accepted by the creditors, note holders, and stockholders, and confirmed by the court.

Who Develops the Reorganization Plan for the Company?

Committees of creditors and stockholders negotiate a plan with the company to relieve it from repaying part of its debt so that the company can try to get back on its feet.

• One committee that must be formed is called the "official committee of unsecured creditors." They represent all unsecured creditors, including any bond or note holders that might exist.
• An additional official committee may sometimes be appointed to represent stockholders, if there are many.
• The U.S. Trustee may appoint another committee to represent a distinct class of creditors, such as secured creditors, employees or subordinated note holders.

After the committees work with the company to develop a plan, the court must find that it legally complies with the Corporate Bankruptcy Code before the plan can be implemented. This process is known as plan confirmation. This takes a few months or a few years.

What is Chapter 7 bankruptcy?

Some companies are so far in debt that it is determined they can't continue their business operations. They are likely to "liquidate" and file under Chapter 7. Their assets are sold by a court appointed trustee. Administrative and legal expenses are paid first, and the remainder go to creditors.

Secured creditors will have their collateral returned to them. If the company doesn't have enough money to repay them in full, they will be grouped with other unsecured creditors for any deficiency balance on the rest of their claim. Note or bondholders, and other unsecured creditors, will be notified of the Chapter 7, and should file a claim in case there's money left for them to receive a payment.

Stockholders do not have to be notified of the Chapter 7 case because they generally don't receive anything in return for their investment. But, in the unlikely event that creditors are paid in full, stockholders (or owners) will be notified and given an opportunity to file claims.