02 March 2012 Written by  Mitiku Mada and Alemayehu Tilahun

Definition and Evolution of the Law of Bankruptcy

It is proper to define the term bankruptcy before delving into the discussion on the concept. Some literatures reveal that the term bankruptcy is used only for individual debtor's insolvency whereas the term liquidation is used for insolvency of business organization. However, many jurisdictions use the term bankruptcy interchangeably with insolvency and sometimes use bankruptcy as general term applied for natural as well as for legal persons.

Let us see the dictionary definition. A Dictionary of Modern Legal Usage traces the origin of the term and then defines it. It begins with shading light from where the term was coined and hence Bankruptcy in French or Latin bancus "table” plus ruptus "broken". This is literally to mean ‘broken table’, and then extended the three definitions as follows:

  • the fact of being financially unable to pursue one's business and meet one's engagements;
  • the fact of having declared bankrupt under a bankruptcy statute;
  • the field of law dealing with those who are unable or unwilling to pay their debts.

Some other literatures provide various accountancy definitions for the term insolvency. These are:

Balance-sheet insolvency

This has regard to the person’s assets and liabilities, and looks to see whether there is an overall net surplus or deficit. Under this definition, if assets minus liability show deficit (negative) that person is insolvent.

Commercial insolvency

This test is not concerned with the assets position, but with liquidity. It is some times called practical insolvency or insolvency on a cash-flow basis. Here, the person concerned may have substantial assets, but is unable to pay his debts as they fall due. This would happen when the wealth is tied up in property that is not readily realizable or which is over-spent in research and development for a new project, which is still on the drawing board.

Ultimate insolvency

Here, the concern is with the final outcome of the events. The debtor's assets have been sold for a value that is found appropriate given the prevailing state of affairs. In other words, the assets are to be sold for what they will fetch. Perhaps in a forced state, on a break-up basis the costs of realization and of administering the estate are taken into account.

It has been stated above, there are a lot of disparities among scholars and academicians with respect to the definition of bankruptcy. In any case, when these definitions are condensed to a conventionally acceptable definition, one can draw, possibly, two fundamental working definitions. These are: Bankruptcy is status of a person who has been made the subject of the application of bankruptcy law and who has been declared as bankrupt by a court of law. Bankruptcy is a situation whereby a person by his acts and conducts affords evidence of his inability to pay or his intention to avoid payment of his debts.

Little to say about the working definitions; in the first case it shows that the adjudication of a debtor as bankrupt in the competent court of law which has power to do so when the legal requirements are satisfied. The adjudication can be initiated by the interested parties as the laws of various jurisdictions may provide. The second definition reveals the conduct or acts of the debtor must show his unwillingness to pay his debts due. To exemplify this, the creditor may provide to the debtor execution order which he obtained from the court of law and he may fail to get payment from the debtor. In addition, criminal charge may be filed against the debtor for his fraudulent conduct as per criminal code for his tendency to defraud and this can also be a condition to evidence his conduct. The intention of the debtor could also be disclosed when he absconds and his whereabouts is not known.

It has been said that the terms insolvency and bankruptcy are interchangeably used in many literatures. However, one could be misled by the terms. To make distinction between the terms is of no importance for practical purpose. But for better understanding and academic purpose it is possible to draw distinction. Hence, with some reservation one can say, insolvency presupposes bankruptcy or bankruptcy is an outcome of insolvency. It is also possible to draw another distinction and one can also say that all insolvencies may not lead to bankruptcy and all bankruptcies are not an outcome of insolvency. This is because the course of business does not depend on solvency. If there is sufficient liquidity, a debtor can discharge his debts running his business on credit basis. A business may be prevented from paying creditors and still have more assets than liabilities. However, if it lacks liquidity then it is deemed to be in a state of bankruptcy. Liquidity is the status or condition of a person or a business in terms of his or its ability to convert assets into cash. It is the degree to which an asset can be acquired or disposed of without danger of intervening loss in nominal value.

Definition of Bankruptcy under the Ethiopian Commercial Code

Book V of the Commercial Code under Article 969 and 970 defines, as to what bankruptcy is, in two different ways. As a principle, under Article 970 (1) the Code states that bankruptcy shall not result from mere suspension of payments, unless a judgment in bankruptcy is given or factual conditions are fulfilled in the way the law requires. The two situations provided to define bankruptcy are stated as follows: First, “Any trader who has suspended payments and has been declared bankrupt shall be deemed to be bankrupt.” Second, a sentence passed by a criminal court in respect of bankruptcy or any offence connected with bankruptcy not withstanding that suspension of payments has not been established by a judgment in bankruptcy shall be deemed to be bankruptcy of fact (emphasis added Article 970 (2) of the Commercial Code).

The first definitional provision indicates declaration of bankruptcy through judgment by competent court after investigation. To declare someone as bankrupt the main test is suspension of payments. This can be called judicial bankruptcy or legal bankruptcy. The second definition envisages the factual bankruptcy. In this case criminal court may pass sentence on the debtor even though suspension of payment is not proved by court as alleged by interested party. The offence under which the debtor is sentenced shall be connected with bankruptcy or in respect of bankruptcy.

What kind of offences are connected with bankruptcy or, in respect of bankruptcy, would be point of discussion to make the second definition more understandable? In this regard it is proper to refer to the Penal Code of Ethiopian. The 1957 Penal Code of Ethiopia provides ten provisions under Book VI Title II Chapter II. of The heading of this chapter reads "Offences Relating to Proceedings of Debt, Execution and Bankruptcy". For instance, if we see Article 683 within the same chapter; "a debtor subject to proceedings by way of execution against whom a declaration of default has been delivered, and who with intent to prejudice his creditors has reduced his assets, whether materially or fictitiously, is punishable with a simple imprisonment or in grave cases, with rigorous imprisonment not exceeding five years.” Also as provided under Article 684, if a debtor misappropriates or destructs property subject to pledge or lien to obtain profit or to procure a benefit to third party, or to cause damage to his creditors he will be punished. Hence, as exemplified, any debtor found guilty of related offences and sentenced, even though there is no proof of suspension of payment, the person is deemed to be under factual bankruptcy. The rationale behind this definitional provision could be to save the creditors from further damage and to secure their rights on the immediately existing properties.

Definition and Evolution of the Law of Bankruptcy

Bankruptcy law governs the rights of creditors, on the one hand and that of an insolvent debtor, who cannot pay his debts, on the other hand. The term was derived from the Renaissance custom of Italian traders, who did their trading on benches in town market places. Creditors literally "break the bench" of a merchant who fails to pay his debts. The term bancarotta (broken bench) thus came to apply to business failures.

Default or non-payment of debt has long been an essential feature of a system of promise enforcement, centuries before bankruptcy law became integral part of the collection scheme. The Holy Scripture (Bible) has the following evidence:

"At the end of every seven years you must cancel debts. This is how it is to be done: every creditor shall cancel the loan he has made to his fellow Israelite.  He shall not because the Lord's time for canceling debts has been proclaimed. You may require payments from foreigners, but you must cancel any debt your brother owes you. However, there should be no poor among you.” Deuteronomy 15:1-4

This Biblical Jubilee shows society's past attempt to balance rightful demands for payments with some possibility of escape. Closer reading of the scripture illuminates that there was cancellation of debts and discharge of debtor when he/she happened to be poor or unable to pay debt at the end of each seven years.

The medieval Italian cities enacted statues dealing with the collection and distribution of the assets of a debtor, especially merchants, who absconded or fraudulently caused insolvency. Life for the medieval debtor was likely to be nasty, brutish and short. Just as the charging of usury by money lenders was regarded as contrary to the laws of God, and was punishable according to both the church and the power temporal so also was falling into debt considered moral sin. In addition, medieval Spanish law restored the judicial cession bnorum, which is an ancient Roman law by which privilege given to debtors to alleviate his hardship by relinquishing voluntarily his assets to his creditors by petitioning a magistrate. The Site Partides, a codification published by authority of Don Alfonso X the wise king of Castile and Leona, during the second half of the 13th century, contained detailed provisions relating to insolvent debtors, applicable to merchants and non-merchants. The Site Partides is a Spanish Law which is the most important monumental code that was influenced by Roman and Canon law and by the customs of Castile.

Laws dealing with the property of absconding and fraudulent debtor, modeled after the statute of medieval Italian cities spread throughout Western Europe. Provisions of this type were adopted in the commercial centers of France, Brabant, and Flanders during the 15th and 16th centuries. Emperor Charles V, as count of Flanders, inserted stringent provisions for the repression of bankruptcies in his Decree for the administration of justice and good order in 1531. But these were measures designed for the protection of the individual creditors; more than 250 years were to elapse before the notion took hold of official collection and realization of a debtor's estate for the purpose of distribution among his creditors generally. This was introduced in the State of Hennery VIII (1542), which is the first bankruptcy statute to be enacted in England. As literature reveals, this statute was not a measure designed for the relief of debtors but was inspired by the Northern European models and entirely pro-creditors.

In France, national rules on insolvency and bankruptcy were inserted into the Ordinance du Commerce of 1673. The rules regulated both voluntary assignments for the benefit of creditors made by indebted merchants and the proceedings, and effects following from bankruptcy. It was interpreted to restrict bankruptcy proceedings to merchants only, and laws of many other countries followed the French lead. Thus, in Spain the limitation of bankruptcy to merchants was adopted by the ordinance of Bilbao, which were sanctioned in 1737 and subsequently applied in Latin American countries, especially in Argentina.

As has been said earlier, ancient legislations were entirely restricted to persons engaged in commerce. The restriction of bankruptcy legislations to persons engaged in commerce created a need for liquidation proceedings applicable to other debtors.On that basis, a Spanish jurist of the 17th C, Salgado de Somoza, elaborated detailed rules for the initiation and conduct of voluntary liquidation proceeding which were "concourse of creditors"  or a suit or remedy to enable creditors to enforce their claims against an insolvent or failing debtor. His tract, entitled Labyrinthus Creditorum, influenced the course of Spanish law and also had great impact on the common law of the German States. As a result, Spanish law developed two classes of liquidation proceedings, one for merchants and the other for non-merchants. Spanish law in that respect was the model for the legislation in Portugal, Argentina, Brazil and other Latin American countries. Other nations, including Australia, Germany, England, the United States and nations influenced by English law brought the case of both merchants and non-merchants under their bankruptcy laws.

Around the 19th C, as time went on, the trend against debtor who fails to pay his debt was changed. Another assumption came into play, which was that the debtor could be honest but unfortunate. And hence, bankruptcy laws should widen their umbrellas not only to creditors but also should direct the focus of their concern to relieving the honest debtor from the burden of oppressive indebtedness and permitting him a fresh start. This is in effect freeing him from obligations and responsibilities consequent up on business misfortune which he cannot satisfy by his own efforts. Thus, the already existing legalistic approach was abandoned in favor of the economic approach aiming at debtor’s rehabilitation and corporate reorganizations. In recent times, however, a great effort has been made to remove the disgrace attached to bankruptcy. Even the terms ‘bankrupt’ and ‘bankruptcy’ (or their equivalents in other languages) are less used and less frequent in the statutory languages. Modern French Legislations, for example, totally suppress the traditional term “faillite for liquidation proceedings and restrict it to special procedures entailing the imposition of disqualifications on insolvents guilty of commercial misconduct.

Last modified on Wednesday, 02 May 2012 13:05