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Insolvency and bankruptcy



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Insolvency and bankruptcy

  2. 2. Insolvency and Bankruptcy What Is Insolvency? You can be insolvent without being bankrupt, but you can’t be bankrupt without being insolvent. Insolvency is a problem that bankruptcy is designed to solve. Insolvency is the inability to pay debts when they are due. Fortunately, there are solutions for resolving insolvency, including borrowing money or increasing income so that you can pay off debt. You also could negotiate a debt payment or settlement plan with creditors. Bankruptcy is usually a final alternative when other attempts to clear debt fail.
  3. 3. Reasons for Insolvency Individuals and businesses can become insolvent for a vast number of reasons, but some of the most common include: --Job loss or salary reduction --Divorce --Medical bills --Imprudent use of credit --Financial mismanagement
  4. 4. Two types of insolvency THERE ARE TWO TYPES OF INSOLVENCY CASH- FLOW INSOLVENCY: When an insolvent debtor can’t make a payment because he doesn’t have the money. BALANCE-SHEET INSOLVENCY: When debts exceed Assets.
  5. 5. This is the concept of “cash flow”.
  6. 6. Cash-flow insolvency and Balance sheets insolvency. In the first case, the debtor doesn’t have the money to make a payment when it is due; In the second, it might be possible to make a payment with cash on hand, but financial collapse might not be far off. Paying debts will deplete cash and that leads to cash-flow insolvency. Insolvency only becomes an issue when a creditor seeks to collect and the debtor can’t pay what’s due.
  7. 7. Debt collection and foreclosure Failing to pay debts usually leads to DEBT COLLECTION efforts (by the creditor) that force some kind of action. For example, if you own a house and don’t pay the mortgage, you will go into default that can soon lead to FORECLOSURE. If you cannot meet minimum monthly payments on your credit cards, and you do not try to work out a solution with the card company, you will almost certainly hear from debt collectors.
  8. 8. Financial hardship. Loans. Bankruptcy Insolvency is a trigger for financial hardship. If you cannot pay your rent or electric bill because you do not have the money, you could call a friend and ask for a loan. If you get one, the insolvency goes away, probably temporarily unless you are able to balance your income and expenses. The longer you are insolvent, the worse things will become. If you cannot resolve the insolvency, bankruptcy might be the only way to stop your financial hemorrhaging. Showing that you are insolvent is necessary for establishing a bankruptcy claim. Federal bankruptcy law defines insolvency for corporations and individuals as the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.”
  9. 9. Acts in the United States. --Bankruptcy Reform Act of 1978. --Codified in Title 11 of the United States Code --the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). --The creation and jurisdiction of bankruptcy courts are found in Title 28 of the United States Code (Judiciary and Judicial procedure). --Bankruptcy cases are filed in United States Bankruptcy Court and federal law governs procedure in bankruptcy cases. --However, state laws are often applied to determine how bankruptcy affects the property rights of debtors. For example, law governing the validity of liens or rules protecting certain property from creditors (known as exemptions), may derive from state law or federal law. Because state law plays a major role in many bankruptcy cases, it is often unwise to generalize some bankruptcy issues across state lines.
  10. 10. Cash-flow insolvency in particular Cash flow or equitable insolvency impacts both businesses and individuals. Usually it occurs when they have exhausted other ways of resolving debt. If you have a credit card payment due, you might be able to liquidate an asset like a lawnmower to pay a debt and avoid cash-flow insolvency, at least for the moment. When you run out of assets to sell and places to borrow money, and your income is not enough to cover your debts, you will probably be forced to negotiate a payment agreement with your creditors, either directly or through a debt management firm.
  11. 11. Balance Sheet Insolvency. The “test”. Businesses commonly use a balance sheet insolvency test to decide whether to take steps to stay afloat or file bankruptcy. To decide, the business will evaluate its inflows, outflows and assets. If inflows are less than outflows and the value of the business’ assets are worth less than what is owed – a condition called negative net assets — it might conclude that restructuring without the help of a bankruptcy filing might be pointless. But if it has assets that could be sold – a truck or store locations, for instance – that could be used to cover debts, it might attempt to sell the asset and shrink the business. INFLOATS OUTFLOWS ASSETS
  12. 12. Financial advisors will review business operations, suggest scenarios for reducing or eliminating debt and suggest a course of action. Staying in business might require that the company convince its creditors that it has made the correct assumptions about future cash flows, but many times businesses and their lenders don’t see eye to eye.
  13. 13. Cash –flow and Balance Sheet Insolvency A business can be cash flow insolvent, but balance sheet solvent, if it holds non-liquid (non-cash) assets worth more than its liabilities. The reverse is also possible: A business can be balance sheet insolvent (more debt than assets), but cash flow solvent if its revenues allow it to meet its immediate financial obligations. Many companies that hold long-term debt operate continually with no major problems.
  14. 14. Insolvency and Bankruptcy. Insolvency is not the same as bankruptcy. Insolvency is a state of economic distress, whereas bankruptcy is a court order that decides how an insolvent debtor will deal with unpaid obligations. That usually involves: -- selling assets to pay the creditors and --erasing debts that cannot be paid. --Bankruptcy can severely damage a debtor’s credit rating and ability to borrow for years. An individual or company can be insolvent without being bankrupt — especially if the insolvency is temporary and correctable — but not the opposite. Insolvency can lead to bankruptcy if the insolvent party is unable to successfully address its financial condition.
  15. 15. Measures to face insolvency Insolvent companies can reverse course by: --Cutting costs, --selling assets, --borrowing money, --renegotiating debt or --allowing themselves to be acquired by a larger corporation that agrees to take over the insolvent company’s debts in return for control of its products or services. --They should contact a non-profit debt counsellor or debt management company that can help review the balance sheet. --Even if you do not have enough income to pay your debts, a debt manager can try to negotiate a settlement that will partially repay what you owe and avoid a bankruptcy filing.
  16. 16. Insolvency, agreements and the I.R.S. If you reach an agreement that involves debt forgiveness, you might be liable to pay taxes on the amount the creditor writes off. However, the Internal Revenue Service allows insolvent and bankrupt taxpayers to reduce cancelled debt by their insolvency amount. For example, if a creditor agrees to settle a $20,000 debt with a $5,000 payment from you, you would have cancelled debt income of $15,000. But if you only had $3,000 in assets at the time you reached the agreement, you would insolvent in the amount of $12,000 ($15,000 cancelled debt income minus $3,000 assets). You would then report $3,000 in income on your taxes ($15,000 less the $12,000 insolvency amount).
  17. 17. Insolvency order WHO REQUESTS OR DECLARES INSOLVENCY? --A court can deem a company or individual insolvent by issuing an insolvency order. --A debtor can petition for an insolvency order as part of a request for personal bankruptcy protection. In most jurisdictions, an insolvency order temporarily prevents any attempts at debt collection. --Conversely, a creditor can, in some instances, request an insolvency order to be issued against a debtor, if there is reason to believe that the debtor can repay all or part of the debt. In that case, the court can issue an insolvency order, requiring the debtor to repay all or part of the debt.
  18. 18. Sources. --Fay, William. What is Insolvency? – Published on “Debt-Org”.