In 1934, Judge Sutherland of the United States Supreme Court wrote one of the most important opinions in Supreme Court history when he outlined why Americans finding themselves facing unsurmountable debts have a right to a fresh start which naturally includes the discharge of burdensome debt. In the case of Local Loan v. Hunt, 292 U.S. 234 (1934), Judge Sutherland wrote as follows:
“One of the primary purposes of the Bankruptcy Act is to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunates.’ This purpose of the act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, umhampered by the pressure and discouragement of pre-existing debt…
When a person assigns future wages, he, in effect, pledges his future earning power. The power of the individual to earn a living for himself and those dependent upon him is in the nature of a personal liberty quite as much if not more than it is a property right. To preserve its free exercise is of the utmost importance, not only because it is a fundamental private necessity, but because it is a matter of great public concern. From the viewpoint of the wage-earner there is little difference between not earning at all and earning wholly for a creditor. Pauperism may be the necessary result of either…
The new opportunity in life and the clear field for future effort, which it is the purpose of the Bankruptcy Act to afford the emancipated debtor, would be of little value to the wage-earner if he were obliged to face the necessity of devoting the whole or a considerable portion of his earnings for an indefinite time in the future to the payment of indebtedness incurred prior to his bankruptcy.”
When you hear people speak out against individuals or families filing for bankruptcy, saying things like “people should honor their commitments and pay back those to whom they owe money and should never be able to escape that”, I think they are adopting a mindset that sounds superficially attractive (how could you adopt a moral stance that doesn’t involve making good upon promises?) but has certain flaws when applied to the world in which we live.
The first thing that comes immediately to my mind is the asymmetry that exists between an average or even especially dumb borrower and a lender. The person lending money for the car, the boat, or whatever the secured interest may be, has experienced (if not sophisticated) managers and lawyers draft documents that set the terms preferentially in favor of the lender. You don’t see too many borrowers scratch out a paragraph on page 59 of a loan document or fully realize the implications of a ballooning interest rate on a credit card application at the time they borrow the money.
If you owe $50,000 at a rate of 22%, and your annual salary is less than that, you’re going to carry that debt to the grave if you can’t get any relief. There comes a point at which a debt load becomes so overwhelming and burdensome that there is no realistic possibility that it can be paid off in your lifetime. Imagine what that does to your morale—how do you contribute in any way resembling your personal potential to society, your employer, your family if you know that there is no possibility that you will eliminate particular debts?
What if you did something stupid fifteen years ago, and have been making regular-ish payments on the debt since then, and still haven’t put a dent into it? At some point, and reasonable people disagree on where that point is, you have to stop looking backwards and look forward with fresh eyes toward a new beginning that is more likely to unleash human potential in a way that a perpetual burden will not.
About once a year or so, I go past Union Station in St. Louis, MO. There is a bench there that is hard to find if you don’t know where to look that is the exact spot where Walt Disney himself sat and cried when he was my age, feeling himself a failure for going bankrupt and not being able to make good on any of his promises to creditors. If he were not permitted a fresh start in bankruptcy, there would be no Disney Land, Disney World, Disney movies, Disney shareholders turning a few hundred shares of stock into million-dollar fortunes over the decades, no deep pockets for unique agricultural research, none of the millions of jobs created by Disney over the years, and no tax revenue for the U.S. treasury.
The benefits of encouraging business risk that leads to social innovation, the desire to channel human incentives to reach their full potential (which is more likely to occur when you create paths for individuals to avoid dying awash in debt), and the—shall we say, tenderness?—of the human spirit to give another human being a new chance after misfortune are the most compelling reasons why bankruptcy options should exist in a society.
That doesn’t mean there are no dangers that come with being too lenient. One of the biggest mistakes with America’s structuring of liability regarding debts is that there is very little accountability for taking wild risks or unnecessarily high debt as part of running a bank. You couldn’t pull that crap in Switzerland—there, bankers are personally liable for the losses of the banks they manage. If Swiss liability law existed in the United States, there’d be no Lehman Brothers, AIG, or Bear Stearns collapse because the bankers would have not only lost their stock holdings in the collapse, but creditors could have reached in and, say, force a Lehman banker to sell off his 10,000 share pharmaceutical fortune in Johnson & Johnson stock to help pay for losses at Lehman. When you hold people’s standard of living personally responsible, you will get conservative behavior out of people that you won’t get when the worst case scenario is that the common stock of a bank company becomes worth $0.
For the most part, I think the current bankruptcy code in the United States gets it right. If you want to file a Chapter 7 bankruptcy, it’s fair that you just about all of your debts wiped clean except for child support, DWI-related debts, and a few others. The real failure of the American system is that it is almost impossible to get student loan debt discharged in bankruptcy. Because loans for school are closer to riskless than they would be if they could be discharged in bankruptcy, the loans for higher education are higher to come by and this enables schools to raise tuition rates at 7-11% annually because the banking industry is ready to accommodate students that need to borrow. All student loan debts to get discharged, and banks will become much more discerning before granting loans, and it would halt the ability of schools to raise tuition at such lofty rates because the market of available students would significantly diminish.