What is the purpose of bankruptcy?
It should be noted that bankruptcy does not provide relief solely for entrepreneurs and business people. It also offers protection to individuals who fall hopelessly into debt because of job loss, unexpected medical expenses, or even poor financial choices (for instance substantial credit card debt.) Bankruptcy allows a person several options: Under Chapter Eleven of the Bankruptcy Act, the bankrupt can restructure his debt and be relieved of collection attempts by his creditors. The bankrupt must offer a plan which his creditors approve and must faithfully observe the terms. Under Chapter Seven, the bankrupt's debts are discharged (with the exception of non-dischargeable debts such as child support, alimony, taxes and student loans.) It is, however, NOT a "free ticket." The bankrupt's assets are seized by a court appointed trustee who will use the assets to pay the debts of the bankrupt, even if only pennies on each dollar owed. Some small amount is exempt so that the bankrupt is not left penniless.
It is a bit misleading to suggest (as the previous response does) that the availability of bankruptcy will encourage people to take business risks. Bankruptcy is a painful process with substantial loss of assets. Additionally, one's credit is destroyed for ten years. One hoping to avoid liability for business failure could more easily do so by forming a corporation which would then be solely responsible for its debts. No one considers bankruptcy as an escape hatch unless all other options have been exhausted.
The basic purpose of bankruptcy is to allow the person who has fallen into debt to get a fresh start in life. This is particularly important for our economy because it allows people to take more risks than they might otherwise be willing to take.
A major factor in creating economic growth is entrepreneurship. Our economy needs people who are willing to take risks to do things like starting companies. If these companies succeed, they can become important parts of our economy. But entrepreneurs would take many fewer risks if there were no such thing as bankruptcy protection. They would fear taking risks because it might lead to them losing all of their possessions. The system of bankruptcy we have in the US allows such people to have second chances to prosper after they fail.