There are many half-truths, myths, and downright untruths associated with bankruptcy. Even with widespread accurate information available, these misleading beliefs persist. Hopefully, the information in this chapter will be enlightening for you and will provide you with an accurate view of how the entire process works.

The word bankruptcy is derived from two Latin words, bancus (a counter used by merchants) and ruptus (“broken”). In old Rome, anyone who was not able to pay their taxes could be removed from their business and replaced by a trustee to ensure that back taxes would eventually be paid. Properties were auctioned and sold by the trustee, who also determined which creditors received payment.

The first modern bankruptcy laws were put into place in England in the sixteenth century during the age of King Henry VIII. Considering the fact that this was a king who would behead his own wife, those falling on financial hard times had no to reason to expect mercy. People unable to pay their debts were likely to be sent to debtors’ prison, where their entire family also accompanied them. The change from prison to forgiveness often is assumed to be a sign of a more enlightened view of debt problems. The truth, though, is that the first bankruptcy laws were passed because the debtors’ prisons were full. The system wasn’t working. Under the first laws, some debts could be discharged, but creditors could continue to try and collect even after the filing. Bankruptcy trustees were even allowed to forcibly break into debtors’ homes and take property.

It may have seemed like progress to do away with prison, but the strong-arm practices of trustees were at times just as unpleasant. Debtors could be publicly ridiculed by being displayed in a pillory, having an ear cut off, or even being nailed to a slab of wood. Nasty stuff—but it explains how the disgrace and failure associated with bankruptcy had its roots in some very real public sentiments toward those who were not able to pay their debts. Today, debtors are not usually nailed up or publicly displayed, but the disgrace often remains. It was not until nearly halfway through the nineteenth century that a federal bankruptcy law was passed in the United States that began the modern process. A depression hit the country in 1837 and a few years later, in 1841, Congress set up the system still in place today. For the first time, individuals were allowed to file bankruptcy rather than the older system, in which creditors filed bankruptcy against someone as a method for getting payment. That law was repealed in 1843 after a constitutional challenge, and was not replaced until a new law in 1867. This was also repealed, in 1878.

If it seems that these laws were passed after economic hard times and then repealed during periods of recovery, you’re right. The economy turned downward once again in 1893, which led to the Bankruptcy Act of 1898. This law remained in effect until the modern day, with major changes made in 1938, 1978, and 2005. These overhauls fine-tuned the legislation and have continued a philosophical change. Bankruptcy is no longer meant as a form of punishment or retribution, but as an orderly system for discharging debts that people cannot afford to pay.

One important concept within this legal and philosophical body of law is that of the fresh start. For whatever reason, a person or company who was not able to pay their obligations is discharged in a bankruptcy proceeding. The sale of assets may provide partial relief to creditors, and the petitioner’s credit rating is going to be lowered at least for a while. In a process that seems dark, drastic, and hopeless, the person is entitled to a fresh start; another chance to restore good credit and financial health. It is quite a leap from sending whole families to debtors’ prison.

Start by evaluating your current financial health and answer these questions:

The poor financial habits described in the preceding points are typical of people who have never applied financial self-discipline. Part of the problem is lack of education for people entering the world of credit, but the larger part is a cultural and social tendency to live beyond our means and to push the problem forward instead of solving it.

There are four primary reasons that people file bankruptcy. These are:

In any of these circumstances, bankruptcy should be the path of last resort. No one should ever proceed lightly and without first trying to get debts under control. If you are left with no other choice, you are entitled to bankruptcy protection.

A second bankruptcy option is a Chapter 13 bankruptcy. This is a debt consolidation plan allowing the individual to restructure debt and repay it over a period of time, as long as five years in many cases. The court may even suspend interest on the debt. They require that a person’s income be adequate to afford the required repayment schedule. Included in the repayment may be late mortgage interest (but not principal), auto loans, medical bills, installment debt, and credit card balances. The court sets the monthly payment based on debt levels and income.

The third bankruptcy classification is Chapter 11, which is also a form of debt reorganization, but reserved for businesses. It is similar to Chapter 13 and may be used to save a struggling business at risk of failing.

In any of these situations, you need to consult with a qualified attorney to determine:

Why check with a financial expert first? If you go right to a bankruptcy attorney, you may or may not get good advice. Asking an attorney if you need an attorney is at times like asking a used car salesman if you need to buy a car. You need an objective evaluation of your situation as a starting point.

Finding a qualified bankruptcy attorney can be tedious and discouraging. Many grind out hundreds of filings per month and know exactly what they are doing for the typical situation. But if you have any complex problems, you may need to pay extra for a higher level of expertise. For example, if you own any business interests or intellectual properties (such as royalty rights to a book), a run-of-the-mill bankruptcy attorney might not know exactly how the law works. The ugly truth is that many of your intellectual and investment properties can (and will) be sold by the trustee in a Chapter 7 filing. Special situations like that can be disastrous if the typical assumptions are applied in atypical situations.

John was a writer. He filed for Chapter 7 protection when the economy turned sour and he was no longer able to keep ahead of his growing credit card balances. He hesitantly hired a bankruptcy attorney who assured him that the process was fast, simple and automatic. However, after the discharge of debts, the trustee informed the attorney that he was going to sell all of the author’s royalties for books written before the filing date. This wiped out over 20 years of building a career. It was devastating. The attorney was taken by surprise himself. He had no idea that intellectual properties were subject to liquidation in bankruptcy. This attorney claimed to have completed hundreds of filings, but he simply did not know the law. The worst part of the entire agonizing process was that the trustee ended up selling the royalty stream to the author’s ex-wife.

To find a qualified attorney, you have to make a good match. If you do not have any investments or unusual properties and are just seeking a straightforward discharge, you can probably use a high-volume service. However, just as you need good financial advice when going through a divorce, you must have sound financial advice when filing bankruptcy. It is unlikely that a bankruptcy attorney also understands taxes, financial planning, and property issues. You either need to get high-level advice first, or find an attorney who is qualified to advise you in every area.

Choosing the wrong attorney can also lead to problems within the filing itself. For example, if you do not properly list exemptions, leave off some accounts in your list of assets, reaffirm existing debts, or file improperly, you could find yourself in noncompliance, putting the entire process at risk. If your attorney is not diligent in making sure that the process is done completely and thoroughly, you could find yourself unable to meet the requirements or filing deadlines. This is why a high-volume attorney is not the best choice in every case, and may be appropriate only for the most basic, simple, and straightforward filings.

When choosing an attorney, here are a few sources available to you:

Your list of initial questions in deciding which attorney to hire should include:

You should bring with you to this interview: copies of your latest credit reports, all of your most recent credit card statements, your mortgage statement, your income documentation, and current bank account statements. Also, bring your investment account monthly statement, if applicable. In other words, bring along all of your credit-related documents.

Your attorney should review all of your documents and explain how you should proceed. The decision about what kind of bankruptcy protection to seek should be based on your income, debt levels, and the types of debts. The attorney should then explain to you all of the legal issues and draw up the itemized filing documents.

Once all of the official forms are filled out and signed, you are expected to file the petition with the court. Chances are, you will also be required to provide between one and three years of tax returns as part of your petition. In a Chapter 13, the next step is called the meeting of creditors. This phase provides the chance for any of your creditors to file objections to the process, and also gives the trustee a chance to determine what is to be included or excluded in the bankruptcy filing. After this, the court reaffirms all of your debts by sending notification to all creditors, including deadlines for the final discharge. At the same time, a stay is put in place so that creditors are banned from continuing collection efforts, contacting you, and even sending out monthly statements.

It is even possible to file for bankruptcy protection without ever having a late payment on your record. If you move early—advised when there really is no other choice—it is actually possible to have the bankruptcy as the only negative item on your credit report. In this case, it is substantially easier to rebuild your good name and takes less time. The paradox of filing bankruptcy while also having excellent credit is not at all farfetched. In fact, if you know you are eventually going to be forced to make this choice, it is a rational decision to file early, rather than later when you are past due on all of your accounts.

The idea of filing bankruptcy is taboo in our culture. While, in some cases, it is a completely responsible and precautious step to avoid financial disaster, feelings of failure and hopelessness are often present. The best way to survive the experience is to recognize that going through bankruptcy does not make you a bad person or always lead to an unsuccessful future. It makes you one of the millions who have fallen under the financial bus during a difficult economic time. Many of those who would judge you negatively for going through bankruptcy might themselves be only one paycheck away from financial ruin. You are not alone.

I have taken you through many painful topics in the previous chapters: credit card problems, poorly vetted marriage, expensive divorce, collections, risks of buying real estate with the wrong expert help, foreclosure, and bankruptcy. These are the worst things that can happen to you and, short of ill health or the death of a loved one, they are the most devastating experiences a person can have. Know, also, that there are steps you can take to not only avoid these problems, but also to save your financial life during and after these negative experiences. In the next chapter, I conclude with some last words of advice and a summary of the financial defensive measures you can take today to ensure long-lasting financial health.