Hitting Rock Bottom: The Evolution of Bankruptcy Protection

In medieval Padua, insolvent debtors were led to a small black stone, instructed to lower their pants in front of a hundred men, and prompted to beat their buttocks against the rock while shouting, “I surrender my assets!” And we thought Twitter was cruel.


This lurid ritual was considered an act of mercy: St. Anthony of Padua proposed the spectacle in place of perpetual imprisonment or torture by rope. While the “Stone of Revilement” is no longer used for demonstrations, it brings a whole new level of understanding to the phrase, “hitting rock bottom.” Italy was not alone in its shame sanctions. In France, there was the green cap. In England, the pillory. (Or, worse still, the severed ear.) Most of 17th century Europe agreed that bankruptcy was an evil act inspired by the likes of that old serpent, Satan. Considering its predecessors, the United States Bankruptcy Code is an astounding culmination of decency and taste. Where are the calls for a pound of flesh? Were American lawmakers unusually progressive, or did they simply have a greater appreciation for their own backsides? In our first article on bankruptcy, we trace the early development of bankruptcy protection in the United States, a rambling journey that spanned over two centuries.


Halted at the Gate

The Constitution allowed for the creation of a federal bankruptcy law, but no one bothered to develop one for over one hundred years. This delay was thanks in part to the growing divide between Thomas Jefferson and Alexander Hamilton, whose competing visions for the nation were immortalized in Hamilton’s “Cabinet Raps” on Broadway. Jefferson was very much a Founding Gardener: if he had it his way we would all be gentle yeoman farmers reading pastoral poems out on the verandah. Not quite an economic seer, Jefferson sought to curb the growth of cities and commerce. “Is Commerce so much the basis of the existence of the U.S. as to call for a bankrupt law?” asked Jefferson in 1792. Hamilton had more potential as a palm-reader. “A national debt, if it is not excessive,” he argued, “Will be to us a national blessing.” He envisioned an expansive credit system beyond the limitations of gold and silver, a national bank, and the domination of commerce and manufacturing. Bankruptcy was central to this vision, if only to encourage the speculative extension of credit. Ironically, Jefferson died with over $100,000 in debt, the modern equivalent of roughly 2 million. He inherited significant debts from his father-in-law and had a lifelong weakness for French wines (among a host of other European luxuries). But, at the time, involuntary bankruptcy — purely a creditor’s remedy — was presented as the only politically viable solution. Jefferson quaked at the idea of Northern creditors trampling Southern farmers’ livelihoods and potentially upending the fragile union.


The American economy was also highly regional at the time, reducing pressure for national bankruptcy legislation. The two leaders and their respective groupies gridlocked, and states were left to their own devices to deal with debtors.


Congress Plays Musical Chairs

A sudden stroke of modernist thinking didn’t occur overnight. Early colonialists were no less punitive than their English counterparts. They exported debtor’s prisons straight from the halls of Marshalsea, London’s infamous prison that haunted much of Charles Dickens’ work after his own father was interned. But a series of economic busts and booms led lawmakers to rethink popular attitudes. The 18th and 19th century had a number of financial panics, each of which filled debtor’s prisons with increasingly innocuous and high-profile characters. It was hardly palatable to see Robert Morris, the heroic “Financier of the Constitution,” rotting in debtor’s prison after the Panic of 1796. In response, Congress embarked on a frenetic game of musical chairs: every twenty years or so, a financial panic would seize the nation, Congress would pass a short-lived bandage act to relieve the stampede of debtors, and then, a few years later, get cold feet, rescind the law, and hold its breath until the next crisis. States, meanwhile, made their own reforms. Much to creditors’ disappointment, debtor’s prisons “rarely pried loose concealed property, and only sometimes prompted family or friends to pay off the debt.” The 1820s saw the slow decriminalization of debtors until federal debtors’ prisons were finally outlawed in 1833. State laws also provided increasingly generous exemptions for bankrupts: initially, protected items included only a debtor’s bed, Bible, and work tools. Southern and Western states often expanded this to include large homesteads, military arms, and a number of other personal items. To this day, Florida, thanks to its unlimited property exemption, is known as a “debtor’s paradise,” if one could only be convinced to move there.


Jay Torrey and the Debtor’s Discharge

The only force capable of passing the first lasting federal bankruptcy law was Jay Torrey, a hulking Wyoming rancher and commercial lawyer who would later lead a cowboy regiment of the so-called “Rough Riders.” Torrey’s stature was so renowned that one fawning newspaper said of him, “he weighs 240 pounds, measures four feet around the chest, and his biceps are of a size and hardness that challenge the admiration of every lover of muscular Christianity.”


In the late 1880s, Torrey was hired by a group of merchant creditors who were sick of getting jilted by debtors playing favorites. They found that every time a debtor ran into trouble, his family or local creditor was the first, and usually last, to get paid. Torrey relentlessly lobbied Congress on their behalf for over ten years before The Bankruptcy Act of 1898 was passed. His cheerful oration was so compelling that one Congressman remarked, “Colonel Torrey could start out with a petition to have the President hung and come in with a good fair line of signatures.” This law provided the basis for modern American thought about bankruptcy. Most significantly, the power of discharge was wrested from the hands of creditors and automatically granted unless the debtor had committed some sort of fraud. Previously, creditors had to agree to a discharge or extract a certain value from the estate before one was permitted. The committee report explicitly stated that “the granting or withholding of [discharge] is dependent upon the honesty of the man, not upon the value of his estate.”


Equity Receivership & The Railways

As lawmakers debated federal bankruptcy legislation, another pressing insolvency came to a head in the first great corporate failure of America: the railroads. The wild expansion of the railroads was marked by inefficiency, ill-planning, and corruption. Jay Gould, perhaps the robber baron most responsible for a national railroad system, was a master at bribery and openly bragged about the indiscriminate nature of his political donations: “In a Republican district, I am a strong Republican; in a Democratic district, I am Democratic, and in doubtful districts, I am doubtful.”


East and West Shake Hands at the Meeting of the Transcontinental Railroads, 1869

All of this is to say that by the end of the nineteenth century, nearly one-third of all railroads — which numbered over seven hundred — failed, and in some years nearly 20 percent of the nation’s track was operated by insolvent railroads. Former bankruptcy laws passed by Congress, such as The Bankruptcy Act of 1867, assumed that bankrupt corporations would simply be shut down and liquidated. The investment bankers who underwrote the railroads’ mortgage bonds scoffed at this solution: the whole value of a railroad property depended on its continued use. And so, they turned to the courts. Many judges felt compelled to come up with creative solutions to keep the railroads intact. “Otherwise,” one presiding judge concluded, “you have nothing but a streak of iron-rust on the prairie.” Chief among these solutions was the receivership certificate, which essentially moved suppliers to the front of the priority line. Receivership could take years to complete, but a railroad could only keep running with continuous shipments of coal and steel. These certificates eased suppliers’ fears and ensured their continued deliveries. Another useful trick was appointing a receiver to oversee the defaulted railroad’s property. In the same vein as an automatic stay, this protected the assets from prying creditors and provided breathing space for parties to try to reorganize. This technique was utilized by half of the major railroad companies by 1918, until the equity receivership technique was finally subsumed into federal bankruptcy law in 1938.


Bankruptcy for All

In our next article on bankruptcy, we will outline the upheavals bankruptcy law underwent throughout the 20th century in more detail. But the modern bankruptcy code underwent its most significant facelift in 1978, when much of the law was rewritten to make bankruptcy more attractive to both individual and corporate debtors alike. This was not the original intent of creditors: irate at the rise in personal filings during the 1950s and 60s (pale numbers by today’s standards), creditors pressed for more stringent reforms. No sooner had they initiated the process, however, did bankruptcy lawyers seize the moment to catapult their own careers. Congressman Robert Drinan, a participant in the debates over the 1978 Code, observed that it amounted to a “full employment bill” for lawyers. Indeed, individual filings rose from less than 300,000 in 1980 to over 1.5 million in 2002. This prompted a new crusade to save America’s soul from the shameless debtors abusing our system, never mind the fact that new economic growth is now beholden to expanding consumer credit. Rebecca Bloomwood, the fictional heroine of Confessions of a Shopaholic, was perhaps the first among us to recognize this strange paradox: “They said I was a valued customer, now they send me hate mail.” Bankruptcy may never become a fashion statement, but until late capitalism finds a new driver, shopping may remain our one clear patriotic duty.


About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.


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