The concept and origin of bankruptcy law as it is now known in the United States originated in England. The first English bankruptcy law is generally agreed to have been enacted in 1542. Actually, bankruptcy was originally planned as a remedy for creditors - not debtors. During the reign of King Henry VIII., bankruptcy law allowed a creditor to seize all of the assets of a trader who could not pay his debts. Additionally, on top of losing all of one's property, the unfortunate debtor also lost his freedom and was subject to imprisonment for failure to pay his debts. This left the family of the debtor in the position of having to pay the debts in order to obtain the release of the debtor. As time progressed, however, so did the rights of debtors in England. In the 1700s, for example, debtors were often released from prison and many fled to the United States to live. Many immigrated to Georgia and Texas, which became known as debtors’ colonies. Finally, by the early 1800s in England, debtors were often released from prison and their debts discharged. However, for many years, bankruptcy continued to be a remedy favoring creditors, involuntary in nature and largely penal in character. It was generally used only against traders.
In ancient Greece, bankruptcy did not exist. If a man (since only locally born adult males could be citizens, all legal owners of property were men) owed and he could not pay, he and his entire household, whether wife, children or servants were forced into "debt slavery", until the creditor recouped losses via their physical labor. Many city-states in ancient Greece limited debt slavery to a period of five years and debt slaves had protection of life and limb, which regular slaves did not enjoy. However, servants of the debtor could be retained beyond that deadline by the creditor and were often forced to serve their new lord for a lifetime, usually under significantly harsher conditions.
Bankruptcy is also documented in East Asia. According to al-Maqrizi, the Yassa of Genghis Khan contained a provision that mandated the death penalty for anyone who became bankrupt three times.
The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of their business. There are two forms of bankruptcy that are in common practice. First, where a debtor surrenders his or her non-exempt property to a bankruptcy trustee who then liquidates the property and distributes the proceeds to the debtor's unsecured creditors. Second, the debtor retains ownership and control of its assets and is re-termed a debtor in possession ("DIP"). The debtor in possession runs the day to day operations of the business while creditors and the debtor work with the Bankruptcy Court in order to negotiate and complete a plan. Upon meeting certain requirements (e.g. fairness among creditors, priority of certain creditors) creditors are permitted to vote on the proposed plan. If a plan is confirmed the debtor will continue to operate and pay its debts under the terms of the confirmed plan. If a specified majority of creditors do not vote to confirm a plan, additional requirements may be imposed by the court in order to confirm the plan. Bankruptcy can also be classified by two types from the point of view of creditor and debtor. When creditors enforce bankruptcy, it is called compulsory and when debtor seeks protection from creditors, it is called voluntary.
In Islamic teaching, according to the Quran, an insolvent person should be allowed time to be able to pay out his debt. This is recorded in the Quran's second chapter (Sura Al-Baqara), Verse 280, which notes: "If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew."
Here are two ahadith of Prophet (PBUH) on the subject.
Narrated Abu Huraira
The Prophet said, "There was a merchant who used to lend the people, and whenever his debtor was in straitened circumstances, he would say to his employees, 'Forgive him so that Allah may forgive us.' So, Allah forgave him." Sahih Al-Bukhari 3.292
Narrated Abdullah ibn AbuQatadah
AbuQatadah demanded (the payment of his debt) from his debtor but he disappeared; later on he found him and he said: I am hard up financially, whereupon he said: (Do you state it) by God? He said: By God. Upon this he (Qatadah) said: I heard Allah's Messenger (peace be upon him) said: He who loves that Allah saves him from the torments of the Day of Resurrection should give respite to the insolvent or remit (his debt). Sahih Muslim 740
Narrated Salama bin Al Akwa
Once, while we were sitting in the company of Prophet, a dead man was brought. The Prophet was requested to lead the funeral prayer for the deceased. He said, "Is he in debt?" The people replied in the negative. He said, "Has he left any wealth?" They said, "No." So, he led his funeral prayer. Another dead man was brought and the people said, "O Allah's Apostle! Lead his funeral prayer." The Prophet said, "Is he in debt?" They said, "Yes." He said, "Has he left any wealth?" They said, ''Three Dinars." So, he led the prayer. Then a third dead man was brought and the people said (to the Prophet ), Please lead his funeral prayer." He said, "Has he left any wealth?" They said, "No." He asked, "Is he in debt?" They said, ("Yes! He has to pay) three Diners.', He (refused to pray and) said, "Then pray for your (dead) companion." Abu Qatada said, "O Allah's Apostle! Lead his funeral prayer, and I will pay his debt." So, he led the prayer. Sahih l-Bukhari 3.488A
Narrated AbuQatadah
The Messenger of Allah (peace be upon him) stood up among them (his companions) to deliver his sermon, in which he told them that Jihad in the cause of Allah and belief in Allah (with all His Attributes) were the most meritorious of acts. A man stood up and said: Messenger of Allah, do you think that if I am killed in the cause of Allah, my sins will be blotted out from me? The Messenger of Allah (peace be upon him) said: Yes, in the case where you are killed in the way of Allah, you were patient and sincere and you always fought facing the enemy, never turning your back upon him. Then he added: What have you said (now)? (Wishing to have further assurance from him for his satisfaction), he asked (again): Do you think if I am killed in the say of Allah, all my sins will be obliterated from me? The Messenger of Allah (peace be upon him) Said: Yes, if you were patient and sincere, and always fought facing the enemy, never turning your back upon him, (all your lapses shall be forgiven) except debt. Gabriel has told me this. Sahih Muslim 871
Narrated AbuSa'id al-Khudri
In the time of Allah's Messenger (peace be upon him) a man suffered loss in fruits he had bought and his debt increased; so Allah's Messenger (peace be upon him) told (the people) to give him charity and they gave him charity, but that was not enough to pay the debt in full, whereupon Allah's Messenger (peace be upon him) said to his creditors: "Take what you find, you will have nothing but alms." Sahih Muslim 738
Narrated Jabir ibn Abdullah
The Apostle of Allah (peace be upon him) would not say funeral prayer over a person who died while the debt was due from him. A dead Muslim was brought to him and he asked: Is there any debt due from him? They (the people) said: Yes, two dirhams. He said: Pray yourselves over your companion. Then AbuQatadah al-Ansari said: I shall pay them, Apostle of Allah. The Apostle of Allah (peace be upon him) then prayed over him. When Allah granted conquests to the Apostle of Allah (peace be upon him), he said: I am nearer to every believer than himself, so if anyone (dies and) leaves a debt, I shall be responsible for paying it; and if anyone leaves property, it goes to his heirs. Sunnan Abu-Dawood 1482
From the foregoing deliberations, it is clear that in Islamic Finance there is no concept of bankruptcy either forced or voluntary. It is the responsibility of the debtor to pay his debt and after his death it becomes the responsibility of the heirs, community and state in this particular order to arrange for payment of the debt of the deceased.
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