Insolvency

The term Insolvency describes a financial condition experienced by a person or business entity when his (or its) assets no longer exceed his liabilities (commonly referred to as balance-sheet insolvency) or when the person or entity can no longer meet its debt obligations when they come due (commonly referred to as cash-flow insolvency). It is often used interchangeably, and incorrectly, with the term bankrupt.

Insolvency

The term Insolvency describes a financial condition experienced by a person or business entity when his (or its) assets no longer exceed his liabilities (commonly referred to as balance-sheet insolvency) or when the person or entity can no longer meet its debt obligations when they come due (commonly referred to as cash-flow insolvency). It is often used interchangeably, and incorrectly, with the term bankrupt.

A state of insolvency generally leads to a legal finding of bankruptcy. However, because putting a person or entity into bankruptcy requires the payment of court fees, an insolvent person or entity may be insolvent and not legally bankrupt.

In most jurisdictions, it is an offence under the bankruptcy laws for a corporation to continue in business once it is insolvent. (A notable exception is the UK, where it isn't, in and of itself, even considered improper.) It is also usually 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. When 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 bankruptcy, will usually be the primary consideration (however in the UK, both are relevant).

For example, if a corporation pays a large bonus to its management several months before it actually files for bankruptcy protection, the court will not look at the date of the bankruptcy filing, but at the date where the corporation's debts exceeded its liabilities, and/or the date at which it was unable to pay its debt obligations when they became due, in determining whether the directors can be sued for the return of the bonuses.

In the 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 as against an insolvent party which are otherwise unavailable.

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.

Bibliography

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

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