insolvency

insolvency

[in-sol-vuhn-see]

Condition in which liabilities exceed assets so that creditors cannot be paid. It is a financial condition that often precedes bankruptcy. In the context of equity, insolvency is the inability to pay debts as they become due; insolvency under the balance-sheet approach means that total liabilities exceed total assets.

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Insolvency means the inability to pay one's debts.

This is defined in two different ways:Cash flow insolvency: unable to pay debts as they fall due;Balance sheet insolvency: having negative net assets: liabilities exceed assets.

A business may be cash flow insolvent but balance sheet solvent if it holds illiquid assets, particularly against short term debt. Conversely, a business can have negative net assets showing on their balance sheet but still be cash flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid default – for instance, if it holds long term debt.

Insolvency is not a synonym for bankruptcy, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency.

Definition

Insolvency is defined both in terms of cash flow and in terms of balance sheet in the UK Insolvency Act 1986, Section 123, which reads in part:

123. Definition of inability to pay debts

(1) A company is deemed unable to pay its debts - ...

(e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.

(2) A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

Consequences of insolvency

The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the liquidation and 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. In some jurisdictions, it is an offence under the insolvency laws for a corporation to continue in business while insolvent. In others, the business may continue under a declared protective arrangement while alternative options to achieve recovery are worked out. Increasingly, legislatures have favoured alternatives to winding up companies for good.

It can be grounds for a civil action, or even an offence, to continue to pay some creditors in preference to other creditors once a state of insolvency is reached.

Debt restructuring

Out-of court debt restructurings, also known as workouts, are increasingly becoming a global reality. Debt restructurings are typically handled by professional insolvency and restructruing practitioners, and are usually less expensive and a preferrable alternative to bankruptcy.

Debt restructuring is a process that allows a private or public company - or a sovereign entity - facing cash flow problems and financial distress, to reduce and renegotiate its deliquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations.

Government debt

Although the terms bankrupt and insolvent are often used in reference to governments or government obligations, a government cannot be insolvent in the normal sense of the word. Generally, a government's debt is not secured by the assets of the government, but by its ability to levy taxes. By the standard definition, all governments would be in a state of insolvency unless they had assets equal to the debt they owed. If, for any reason, a government cannot meet its interest obligation, it is technically not insolvent but is "in default". As governments are sovereign entities, persons who hold debt of the government cannot seize the assets of the government to re-pay the debt. However, in most cases, debt in default is refinanced by further borrowing or monetized by issuing more currency (which typically results in inflation and may result in hyperinflation).

Insolvency law in individual countries

Insolvency regimes around the world have evolved in very different ways, with laws focusing on different strategies for dealing with the insolvent corporate. The outcome of an insolvent restructuring can be very different depending on the laws of the state in which the insolvency proceeding is run, and in many cases different stakeholders in a company may hold the advantage in different jurisdictions.

South Africa

In South Africa, owners of businesses that had at any stage traded insolvently (i.e. that had a balance-sheet insolvency) become personally liable for the business' debts. Trading insolvently is often regarded as normal business practice in South Africa, as long as the business is able to fulfil its debt obligations when they fall due.

United Kingdom

In the United Kingdom, it is a criminal offence to trade whilst insolvent. However, there are insolvency practices ("Administrators") which aim to protect the creditors of the insolvent individual or company and balance their respective interests. Alternatives such as Company Voluntary Arrangements and Administration in the UK reflect this shift towards a rescue culture.

When determining whether a gift or a payment to a creditor is an unlawful preference, both the date of the insolvency and the date of the bankruptcy – the liquidator or administrator will be able to recover money paid to a creditor as a preference if paid within six months (or two years if the creditor is a person connected to the company) preceding the date of liquidation and the company was insolvent at the time. In addition to unlawful preferences, liquidators and administrators in the UK may also challenge transactions at an undervalue, extortionate credit transactions, some floating charges and transactions defrauding creditors.

In the UK, the term bankruptcy is reserved for individuals; a company which is insolvent may be put into liquidation (sometimes referred to as winding-up).

United States

Under the Uniform Commercial Code, a person is considered "insolvent" when the party has ceased to pay its debts in the ordinary course of business, or cannot pay its debts as they become due, or is insolvent within the meaning of the Bankruptcy Code. This is important because certain rights under the code may be invoked against an insolvent party which are otherwise unavailable.

The United States has established insolvency regimes which aim to protect the creditors of the insolvent individual or company and balance their respective interests. For example, see Chapter 11, Title 11, United States Code.

In determining whether a gift or a payment to a creditor is an unlawful preference, the date of the insolvency, rather than the date of the legally-declared bankruptcy, will usually be the primary consideration.

Switzerland

Under Swiss law, insolvency or foreclosure may lead to the seizure and auctioning off of assets (generally in the case of private individuals) or to bankruptcy proceedings (generally in the case of registered commercial entities).

Bibliography

  • Born Losers: A History of Failure in America, by Scott A. Sandage (Harvard University Press, 2005).

References

See also

External links

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