Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a
businessA business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
, insolvency refers to the inability of a
companyA company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
to pay off its debts.
Business insolvency is defined in two different ways:
Cash flow insolvency: Unable to pay debts as they fall due.
Balance sheet insolvency: Having negative
net assetsNet assets, sometimes referred to as net worth, is the shareholders' equity = assets minus liabilities. The term net assets is commonly used with charities or not for profit entities -- a measurement of their ability to reinvest profits toward their mission....
– in other words, liabilities exceed assets.
A business may be 'cash flow insolvent' but 'balance sheet solvent' if it holds
illiquid assetsIn business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
, particularly against short term debt that it cannot immediately realize if called upon to do so. Conversely, a business can have negative net assets showing on its balance sheet but still be cash flow solvent if ongoing revenue is able to meet debt obligations, and thus avoid
defaultIn finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
: for instance, if it holds long term debt. Many large companies operate permanently in this state.
Insolvency is not a
synonymSynonyms are different words with almost identical or similar meanings. Words that are synonyms are said to be synonymous, and the state of being a synonym is called synonymy. The word comes from Ancient Greek syn and onoma . The words car and automobile are synonyms...
for
bankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, which is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency.
Insolvency is defined both in terms of cash flow and in terms of balance sheet in the UK
Insolvency Act 1986The Insolvency Act 1986 is an Act of the Parliament of the United Kingdom that provides the legal platform for all matters relating to personal and corporate insolvency in the UK.-History:...
, 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. This is known as cash flow insolvency.
-
- (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. This is known as balance sheet insolvency.
Consequences of insolvency
The principal focus of modern insolvency
legislationLegislation is law which has been promulgated by a legislature or other governing body, or the process of making it...
and business
debt restructuringDebt 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 delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its...
practices no longer rests on the
liquidationIn law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
and elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing
financial distressFinancial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy...
so as to permit the rehabilitation and continuation of their business. This is known as
Business Turnaround or
Business Recovery. In some jurisdictions, it is an offence under the insolvency laws for a
corporationA corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
to continue in business while insolvent. In others (like the United States with its Chapter 11 provisions), the business may continue under a declared protective arrangement while alternative options to achieve recovery are worked out. Increasingly, legislatures have favored alternatives to winding up companies for good.
It can be grounds for a civil action, or even an offence, to continue to pay some
creditorA creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...
s in preference to other creditors once a state of insolvency is reached.
Debt restructuring
Out-of court
debt restructuringDebt 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 delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its...
s, also known as workouts, are increasingly becoming a global reality. Debt restructurings are typically handled by professional insolvency and restructuring practitioners, and are usually less expensive and a preferable alternative to bankruptcy.
Debt restructuringDebt 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 delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its...
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 delinquent 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
governmentGovernment refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
obligations, a government cannot be insolvent in the normal sense of the word. Generally, a
government's debtGovernment debt is money owed by a central government. In the US, "government debt" may also refer to the debt of a municipal or local government...
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
interestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
obligation, it is technically not insolvent but is "in
defaultIn finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
". As governments are
sovereignSovereignty is the quality of having supreme, independent authority over a geographic area, such as a territory. It can be found in a power to rule and make law that rests on a political fact for which no purely legal explanation can be provided...
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
refinancedRefinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...
by further borrowing or
monetizedMonetization is the process of converting or establishing something into legal tender. It usually refers to the coining of currency or the printing of banknotes by central banks...
by issuing more
currencyIn economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
(which typically results in
inflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and may result in
hyperinflationIn economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...
).
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.
Canada
In
CanadaCanada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...
, bankruptcy and insolvency are generally regulated by the Bankruptcy and Insolvency Act. An alternative regime is available to larger companies (or affiliated groups) under the Companies' Creditors Arrangements Act, where total debts exceed $5 million.
South Africa
In
South AfricaThe Republic of South Africa is a country in southern Africa. Located at the southern tip of Africa, it is divided into nine provinces, with of coastline on the Atlantic and Indian oceans...
, 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 fulfill its debt obligations when they fall due.
United Kingdom
In the United Kingdom, the term
bankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
is reserved for individuals.
A company which is insolvent may be put into
liquidationIn law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
(sometimes referred to as winding-up). The directors and shareholders can instigate the liquidation process without court involvement by a shareholder resolution and the appointment of a licensed
Insolvency PractitionerIn the United Kingdom, only an authorised or licensed Insolvency Practitioner may be appointed in relation to formal insolvency procedures.Quite often IPs have an accountancy background...
as liquidator. However, the liquidation will not be effective legally without the convening of a meeting of creditors who have the opportunity to appoint a liquidator of their own choice. This process is known as creditors voluntary liquidation (CVL), as opposed to members voluntary liquidation (MVL) which is for solvent companies. Alternatively, a creditor can petition the court for a winding-up order which, if granted, will place the company into what is called compulsory liquidation or winding up by the court. The liquidator realises the assets of the company and distributes funds realised to creditors according to their priorities, after the deduction of costs. In the case of
Sole Trader InsolvencyAccording to the Office for National Statistics, sole proprietors represented 23.8% of all UK enterprise in 2010. Of that number, more than half a million sole traders were operating via the PAYE or VAT system alone. Sole traders are a distinct legal entity, operating as one type of UK business...
, the insolvency options include Individual Voluntary Arrangements and
BankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
.
It can be a civil and even a criminal offence for directors to allow a company to continue to trade whilst insolvent. However, two new insolvency procedures were introduced by the
Insolvency Act 1986The Insolvency Act 1986 is an Act of the Parliament of the United Kingdom that provides the legal platform for all matters relating to personal and corporate insolvency in the UK.-History:...
which aim to provide time for the rescue of a company or, at least, its business. These are Administration and Company Voluntary Arrangement:
- Administration is a procedure to protect a company from its creditors in order for it to be able to make significant operational changes or restructuring so that it could continue as a going concern, or at least in order to achieve a better outcome for creditors than via liquidation. In contrast to Chapter 11 in the US where the directors remain in control throughout that restructuring process, in the UK an Administrator is appointed who must be a licensed Insolvency Practitioner
In the United Kingdom, only an authorised or licensed Insolvency Practitioner may be appointed in relation to formal insolvency procedures.Quite often IPs have an accountancy background...
to manage the company's affairs to protect the creditors of the insolvent company and balance their respective interests. Unless the company itself is saved by this process, the company is subsequently put into liquidation to distribute the remaining funds.
- A Company Voluntary Arrangement (CVA) is a legal agreement between the company and its creditors, based on paying a fixed amount lower than the outstanding actual debt. These are normally based on a monthly payment, and at the end of the agreed term the remaining debt is written-off. The CVA is managed by a Supervisor who must be a licensed Insolvency Practitioner
In the United Kingdom, only an authorised or licensed Insolvency Practitioner may be appointed in relation to formal insolvency procedures.Quite often IPs have an accountancy background...
. If the CVA fails, the company is usually put into liquidation.
One particular type of
Administration that is becoming more common is called
pre pack administration (more information under administration (law)). In this process, immediately after appointment the administrator completes a pre-arranged sale of the company's business, often to its directors or owners. The process can be seen as controversial because the creditors do not have the opportunity to vote against the sale. The rationale behind the device is that the swift sale of the business may be necessary or of benefit to enable a best price to be achieved. If the sale was delayed, creditors would ultimately lose out because the price obtainable for the assets would be reduced.
In addition to the above-mentioned corporate insolvency procedures, a creditor holding security over an asset of the company may have the power to appoint an insolvency practitioner as administrative receiver or, in Scotland, receiver. The process, latterly known as administrative receivership or, in Scotland, receivership, has existed for many years and has often resulted in a successful rescue of a company's business via a sale, but not of the company itself. Since the introduction of the collective insolvency procedure of
Administration in 1986, the legislators have decided to set a shelf life on the administrative receivership or, in Scotland, receivership procedure and it is no longer possible to appoint an administrative receiver or, in Scotland, receiver under security created after 15 September 2003.
In individual cases the bankruptcy estate is dealt by an official receiver, appointed by the court. In some cases the file is transferred to RTLU (OR Regional Trustee Liquidator Unit) that will assess your assets and income to see if you can contribute towards paying costs of bankruptcy or even discharge part of your debts.
United States
Under the
Uniform Commercial CodeThe Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...
, a person is considered to be insolvent when the party has ceased to pay its debts in the
ordinary course of businessIn law, the ordinary course of business covers the usual transactions, customs and practices of a certain business and of a certain firm. This term is used particularly to judge the validity of certain transactions...
, or cannot pay its debts as they become due, or is insolvent within the meaning of the
Bankruptcy CodeBankruptcy in the United States is governed under the United States Constitution which authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States." Congress has exercised this authority several times since 1801, most recently by adopting the Bankruptcy...
. This is important because certain rights under the code may be invoked against an insolvent party which are otherwise unavailable.
The
United StatesThe United States of America is a federal constitutional republic comprising fifty states and a federal district...
has established insolvency regimes which aim to protect the insolvent individual or company from the creditors, and balance their respective interests. For example, see
Chapter 11, Title 11, United States CodeChapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to every business, whether organized as a corporation or sole proprietorship, and to individuals, although it is most...
. However, some state courts have begun to find individual corporate officers and directors liable for driving a company deeper into bankruptcy, under the legal theory of "deepening insolvency."
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
SwissSwitzerland name of one of the Swiss cantons. ; ; ; or ), in its full name the Swiss Confederation , is a federal republic consisting of 26 cantons, with Bern as the seat of the federal authorities. The country is situated in Western Europe,Or Central Europe depending on the definition....
law, insolvency or
foreclosureForeclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
may lead to the seizure and auctioning off of assets (generally in the case of private individuals) or to
bankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
proceedings (generally in the case of registered commercial entities).
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