Some terms that mean the same thing in colloquial speech may not mean the same thing in a legal sense. Bankruptcy and insolvency are two such concepts. While related and similar on the surface, they are not the same thing in the strictest sense of the word.
Insolvency is a situation where a debtor is unable to pay their creditors. Bankruptcy, on the other hand, is a court-mandated process that defines how a debtor (usually also insolvent) will meet their obligations.
In the United States, an individual can undergo a Chapter 7 bankruptcy wherein their assets are sold off for cash that is disbursed to the creditors, or through a Chapter 13, where they are allowed to keep most of their assets but will have to pay off their debt over a period of 3-5 years.
An individual or institution can be insolvent, but not be bankrupt. Instead, they may turn to alternative methods such as debt negotiation, counseling and so on. This is normally the case if the insolvency is not serious and expected to be temporary. An extended period of insolvency, however, can lead to bankruptcy.
Insolvent individuals and institutions can get out of insolvency by borrowing more money to pay off other debts, selling assets, renegotiating debts, reducing costs, or turning to a strategy, such as a job change, that allows them to acquire more income. An insolvent business may also cut a deal with another company that can take on their insolvency in exchange for rights or other assets they may hold.
Cash flow insolvency vs. Balance-sheet insolvency
To muddle matters a bit further, insolvency usually takes two forms – Cash flow and Balance-sheet insolvency. Cash-flow insolvency is when a person or institution has assets with enough value to pay the debt but lacks an acceptable form of payment. One common example is having a car but not enough cash to pay off a debt. Chances are the debtor and the creditor can negotiate the debt so the creditor may get the car in exchange, or the creditor can agree to wait so the debtor can sell the car to pay off the debt.
Asset insolvency is far more serious and means the person or institution’s assets and income are not enough to pay the debt. These cases can be resolved by filing for bankruptcy, or by debt negotiation.
Declaring bankruptcy vs. declaring insolvency
Depending on where you are, declaring either bankruptcy or insolvency can be a legal recourse to get creditors to stop calling you. However, a bankruptcy can stay on a credit report for up to 10 years and will be a matter of public record virtually forever. A bankruptcy will also create restrictions on the types of credit that will be available to the debtor for many years to come. An individual can also suffer through a traumatic experience as a result of a bankruptcy, while a business can suffer a loss of confidence. Together, these can give someone in debt the motivation to avoid filing for bankruptcy except as a last resort. When the option is available, filing insolvency can buy the debtor a little more time and generally has less of an effect on one’s long-term credit rating.
Bankruptcy and insolvency are particularly complex fields of study. Before you take the plunge and file insolvency or bankruptcy, be sure to get in touch with a bankruptcy attorney to help you make a better-informed decision.