Insolvency refers to being in a state in which a company or person cannot fulfill their financial duties. Although insolvency can lead to bankruptcy proceedings, insolvency is not necessarily the same as bankruptcy. Bankruptcy is a legal proceeding utilized to determine the extent of the party’s insolvency, as well as to determine potential remedies for the debt situation.

Being insolvent can lead to many legal repercussions, such as insolvency proceedings. Over the course of these proceedings, legal action is taken against the insolvent party and their assets are liquidated in order to pay off debts

When a person or company is declared legally insolvent, there may also be other, unexpected implications. An example of this would be how another party may be able to claim certain rights against a party that is insolvent. And, in some jurisdictions, a business cannot continue operations while it is legally insolvent.

Insolvency law can refer to the federal laws that are in place to protect those who are insolvent, whether they are businesses or individuals. It may also refer to the Uniform Commercial Code, as well as the bankruptcy code. The Uniform Commercial Code (“UCC”) states that a person is considered to be insolvent when they have stopped making payments on their debts, or cannot pay their debts as they come due. Other examples of insolvency law include the Fair Debt Collection Practices Act (“FDCPA”), and Chapter Fifteen of the US Bankruptcy Code.

Are There Different Types of Insolvency?

There are various types of insolvency, such as the aforementioned definition of insolvency which is also known as technical insolvency. Generally speaking, there are two main categories of insolvency. These are balance sheet insolvency, and cash flow insolvency.

Balance sheet insolvency refers to when liabilities exceed assets. A simple example of this would be having negative net assets. Cash flow insolvency can be defined as lack of “liquidity” in order to pay off debts. Cash flow insolvency can result in balance sheet insolvency.

To further differentiate between these two main categories of insolvency, a company experiencing balance sheet insolvency may still be able to pay its liabilities when they come due. They could have a large tax bill coming up that they could not pay, if the bill was due immediately. Whereas in a cash flow insolvency situation, the company is not able to meet the demands for payment as and when they are due. They could have sufficient assets to pay what is owed, but they do not have an appropriate form of payment with which to settle that debt. Additionally, it is unlikely that they would be able to sell their assets or accumulate liquidated cash quickly enough to pay their debts.

Another type of insolvency would be accounting insolvency. This refers to a situation in which total liabilities exceed total assets, such as a negative net worth. The value of the company’s liabilities exceed the value of the company’s assets.

Is Insolvency the Same as Bankruptcy?

As previously mentioned, no, insolvency is not the same as bankruptcy. However, insolvency can sometimes result in bankruptcy. Although the two terms are often used interchangeably, they are different concepts and legal processes.

Bankruptcy is a legal process in which a court determines whether a company or person is insolvent, and if there are any means available to assist is resolving that insolvency. Bankruptcy is just one way that a person or business can address their problem of being insolvent. For many entities such as small businesses, bankruptcy filings may prove to be more costly than they are worth. One alternative to bankruptcy may be debt restructuring, which will be further discussed below.

What Types of Legal Issues Are Associated with Insolvency?

Insolvency is generally not considered to be a legal issue in and of itself. However, it is often a central factor in many different legal disputes and lawsuits. Additionally, being in a state of insolvency frequently leads to legal disputes or issues. Some examples of common legal issues associated with insolvency are:

  • Bankruptcy;
  • Disputes over whether a debt is eligible to be discharged or not;
  • Long term effects on credit and credit score;
  • Difficulty obtaining a fair mortgage rate;
  • Effects on other financial aspects, such as alimony, child support, and garnishment of wages; and
  • Other legal effects, such as effects on certain tax issues and gift-giving statutes.

Specifically, one of the main issues commonly associated with insolvency is that of debt collection. A creditor may attempt to collect debts from a borrower who is insolvent. Depending on the specific circumstances of the situation, such as whether they have filed for bankruptcy, the person’s insolvency status can affect a legal claim in different ways.

It is also important to note that when an individual or business is insolvent, there are rules associated with the collection of debt. As mentioned above, individuals and businesses have the legal right to the fair collection of debt under the Fair Debt Collection Practices Act (“FDCPA”). One of the most common violations of the FDCPA is the failure to send the debtor written notice of the debt. 

In order to qualify for insolvency, a person or business must prove that all of their debts can be calculated as more than the Fair Market Value of all of their assets, immediately before the debt is cancelled. Additionally, those looking to file for insolvency must file Form 928. The IRS website would be the best place to start for those who think they may be insolvent.

What Is Debt Restructuring?

Generally speaking, for a business, insolvency will not trigger bankruptcy. Instead, the company may look at alternative measures. One such measure would be what is known as debt restructuring. Debt restructuring refers to a process in which the company reorganizes their financial plan with the goal of business recovery. Alternatively, their goal may be business turnaround which is essentially getting out of debt and meeting their financial responsibilities.

Debt restructuring often involves various efforts such as cutting costs, working with financial experts, and beginning new marketing campaigns. Restructuring can also involve negotiating with creditors, in order to reduce debt payments or obtain debt cancellation. Debt cancellation refers to the complete forgiving or releasing of a debt.

Debt restructuring may help the insolvent party renegotiate certain loans, or obtain a discharge of debt directly from lenders. Alternatively, refinancing can occur before the entity experiences too much debt. Refinancing is primarily used as a means of avoiding insolvency in the first place. 

Do I Need a Lawyer for Help with Insolvency Issues?

If you suspect you may be insolvent, or are needing help with insolvency issues, you should consult with a skilled and knowledgeable bankruptcy lawyer as soon as possible. An experienced and local bankruptcy attorney will help you understand your rights, obligations, and legal options. A local and licensed bankruptcy attorney can also inform you of any state bankruptcy laws that could affect your case. 

Additionally, an attorney can also provide guidance in terms of how best to deal with your financial situation. A bankruptcy attorney can also assist in filing all necessary paperwork, such as filling out and filing Form 928. Further, the attorney can attend any necessary bankruptcy meetings that are required, such as a Chapter 7 meeting of the creditors, which is also referred to as a 341 meeting. Finally, an experienced bankruptcy attorney can also represent your interests in court, as necessary.