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Insolvency:
What It Means To Be Insolvent

Insolvency is a financial condition experienced by a person or business entity when their assets no longer exceed their 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.

Overview

The term insolvency is often incorrectly used as a synonym for bankruptcy, which is a distinct concept, except in Germany. In some jurisdictions, a state of insolvency may lead to a legal finding of bankruptcy. In the United Kingdom, the term bankruptcy is reserved for individuals; a company which is insolvent may be put into liquidation (sometimes referred to as winding-up).

In some jurisdictions, it is an offence under the bankruptcy laws for a corporation to continue in business while insolvent, though in the United States even bankruptcy typically sees the corporation continue operations.

Both the United States and United Kingdom have established insolvency regimes which aim to protect the creditors of the insolvent individual or company and balance their respective interests. Increasingly, legislatures have favored alternatives to winding up companies for good. Alternatives such as Company Voluntary Arrangements and Administration in the UK reflect this shift towards a rescue culture.

It is also usually grounds for a civil action, or even an offense, to continue to pay some creditors in preference to other creditors once a state of insolvency is reached. In the United States, 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 — 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 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.

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 against an insolvent party which are otherwise unavailable.

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 hyperinflation).

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