Insolvency v Bankruptcy v Liquidation

This article studies the differences between insolvency, bankruptcy, and liquidation. In doing so it also studies the meaning, elements and types of insolvency, bankruptcy, and liquidation.
Estimated Reading Time: 11 minutes

Introduction

Insolvency and Bankruptcy Code, 2016 (IBC) applies to companies, partnerships, and individuals & provides them a time-bound process to resolve insolvency. When a default in repayment occurs, creditors gain control over the debtor’s assets and must make decisions to resolve insolvency. Under IBC debtor and creditor both can start ‘recovery’ proceedings against each other. The law of IBC was necessitated in 2016 due to the huge pile-up of non-performing loans of banks and delays in debt resolution. Insolvency resolution in India took 4.3 years on an average against other countries such as the United Kingdom (1 year) and the United States of America (1.5 years), which is sought to be reduced besides facilitating the resolution of big-ticket loan accounts.[1]

Insolvency

In legal terms, insolvency is a state where the liabilities of an individual or an organization exceed its asset and that entity is unable to raise enough cash to meet its obligations or debts as they become due for payment. Technically insolvency could be a financial state when the value of the total assets of an individual or a group exceeds its liabilities.

A person facing insolvency needs to take corrective actions to rectify its situation to avoid possible bankruptcy. This can be done in many ways like generating surplus cash or by minimizing the overhead cost. This can also be done by negotiating the repayment terms with your lenders.

Often an entity facing the state of insolvency can be declared bankrupt however the opposite is not true. Bankruptcy is a legal procedure that could be one of the ways to solve insolvency. Also, insolvency could be temporary and can be fixed with time. Often people may just ask for some legal protection from its creditors for said period to allow him to pay off its debts easily. In other words, all insolvent entities might not be declared bankrupt however all bankrupt’s entities are said to be insolvent.

Objective of insolvency laws

A primary objective of insolvency laws is to prevent disorderly and discriminatory individual grabs by protecting creditors’ equality and ensuring that the proceeds of the debtor’s assets are divided between the creditors according to the bankruptcy law’s hierarchy of payment. Well-functioning insolvency laws achieve this goal in a variety of ways, although a review of leading bankruptcy laws around the world yields many common elements:[2]

  • Establishing a single, clear hierarchy of payments. The order of various priorities should be precise, transparent, and easy to understand. This not only allows creditors to realize, with some degree of comfort, their relative priority also allows a presiding court to determine clearly which parties’ economic interests are truly at stake in an insolvency proceeding and, consequently, whose interests should be safeguarded.
  • Providing for the immediate transfer of a failed reorganization into liquidation. While it is an accepted principle of insolvency law that the law should provide for a balance between liquidation and reorganization, one of the primary incentives for a creditor to participate in a reorganization process is the understanding that should that process fail, no additional steps or processes will be required to ensure that the court or insolvency administrator remains in control of the insolvent estate and that the assets in question will remain under a continuing conservatorship for the benefit of the creditors.
  • Allowing creditors to play a large role in the insolvency, but not to manipulate the process. In both dominant paradigms of modern insolvency laws (administrator-led and debtor-in-possession), creditors play a large role in the insolvency through the use of creditor committees or de facto control of the administrator. While the presiding court must ensure that the interests of all stakeholders are protected, one of the key incentives for creditors to participate in the collective process of bankruptcy (rather than rush to individual enforcement) is the comfort that they, as a group, will exert some control over that process. This includes having clear voting requirements for the approval of any plan of reorganization that appropriately divides creditors into classes, for voting, based on shared economic interests.
  • Balancing certainty and flexibility. This may be the most difficult element to achieve, but it is a key feature of leading legislation. For the reasons noted above, creditors will require a level of certainty to incentivize their participation in a reorganization process that could otherwise be regarded as needlessly delaying the enforcement of their rights. This will include, wherever practicable, preserving prebankruptcy rights and priorities inside of bankruptcy. At the same time, without a measure of flexibility (such as the ability to authorize post-commencement priority financing, often at high margins), it will be difficult to craft a workable reorganization plan that serves the broad interests of all stakeholders. This flexibility-certainty balance usually requires both a well-designed law and a highly competent cadre of judges who can determine where the law’s flexibility can most appropriately be applied, without unduly compromising the rights of stakeholder

Bankruptcy

It is the next state of insolvency where an individual and partnership firm is declared by the relevant authority under a specified law for the purpose, as incapable of paying up his debt/bills at any time in the present as well as in the foreseeable future. Generally, the failure of the resolution process leads to bankruptcy.

Bankruptcy is a legal proceeding involving a person or business that is unable to repay their outstanding debts. The bankruptcy process begins with a petition filed by the debtor, which is most common, or on behalf of creditors, which is less common. All of the debtor’s assets are measured and evaluated, and the assets may be used to repay a portion of outstanding debt in other words Bankruptcy is a legal proceeding carried out to allow individuals or businesses freedom from their debts, while simultaneously providing creditors an opportunity for repayment.

When an individual is unable to pay off his liabilities and debts then he generally files for bankruptcy. Here is ask for help from the government to pay off his debts to his creditors.

Types of Bankruptcy

Bankruptcy could of two types,

  • Reorganization bankruptcy
  • Liquidation bankruptcy

Usually, people tend to restructure the repayment plans to pay them easily under reorganization bankruptcy. And under liquidation bankruptcy, the debtor tends to sell off certain of their assets to pay off their debts for their creditors.

Legal procedure to declare bankruptcy

One must follow a legal procedure to declare themselves bankrupt and get aid from the government to deal with their creditors. To do this debtor must apply for bankruptcy in a relevant court. Or else one of his creditors applies in a relevant court to declare that entity or person as bankrupt. This can also be a result of a special resolution passed by Register of Companies for the entity to be declared bankrupt.

The bankruptcy of an individual can be initiated only after the failure of the resolution process. The bankruptcy trustee (insolvency professional) is responsible for the administration of the estate of the bankrupt and distribution of the proceeds based on the priority of payments (waterfall) as determined under a law/agreement. Indigent individuals with income and assets lesser than specified thresholds (Gross income <Rs.60,000 p.a. and Total Assets < Rs.20,000) would be eligible to apply for discharge only from their “qualifying debts” (up to Rs.35,000) under “fresh start process”.

Principles that underlie the design of a good bankruptcy regime

In addition to bankruptcy laws, speedier court resolutions can also reduce uncertainty for entrepreneurs, creditors, and management, and improve assets value and transparency. Actions that expedite court procedures include minimizing dependence on the courts (through the appointment of a receiver for distressed companies, for example in Georgia), establishing special courts (for example in India, Thailand, Indonesia, and Uganda), and limiting appeals and introducing time limits (for example in Tajikistan and Lithuania). Several important principles that underlie the design of a good bankruptcy regime:[3]

  • Ensure equitable treatment of similarly situated creditors, recognize existing creditors’ rights, and establish clear rules for ranking priority claims (UNCITRAL 2005).
  • Maximize the value of assets and preserve the insolvency estate to allow equitable distribution to creditors. For instance, the recovery rate varies among economies from 4.4 cents on the dollar claimants in the Philippines to 92.5 cents in Japan (World Bank 2010).
  • Preserve some portion of firm value for shareholders, even in bankruptcy. Otherwise, shareholders may do anything to prevent bankruptcy, including undertaking high-risk projects when the corporation is under distress (Hart 2000).
  • Provide for timely resolution of insolvency. For instance, Ireland provides the fastest bankruptcy procedure—less than four months—whereas in many developing countries the process takes many years, for example, eight in Mauritania and seven in India (World Bank 2010).

Liquidation

It is the winding up of a corporation or incorporated entity i.e., selling its assets, investigating its affairs, recovering any legal claims, and distributing the funds received to creditors and/or shareholders, under the supervision of a person or “liquidator”, empowered under the law for such operation and distribution of proceeds to the various creditors as per an agreed formula. Only firms can be liquidated. Defaulting individuals cannot be liquidated.

Liquidator

Liquidation will be led by a regulated insolvency professional, the liquidator. In this process, the assets of the company are held in trust. The rights of secured creditors are respected: they have the choice of taking their security interests and realize it on their own. The recoveries that are obtained are paid out to the various claimants through a well-defined waterfall (means who gets paid first). The rights of the Central and State Government in the distribution waterfall in liquidation is given a priority below that of the unsecured financial creditors (in addition to all kinds of secured creditors) for promoting the availability of credit and developing a market for unsecured financing (including the development of bond markets).[4]

Types of liquidation

Liquidation of a company can get complicated as there are different types of liquidation i.e.

  • Court-ordered liquidation
    • Creditors voluntary liquidation
    • Members voluntary liquidations

Court-ordered liquidation is a Compulsory liquidation while voluntary liquidation occurs when members of the company resolve to close the business and dissolve.

The procedure of insolvency has in the minimalist hope for the Company as the Company Administration aims to help the company to repay the debts to escape insolvency. Whereas Liquidation is one step ahead followed by winding up of the company which includes the process of selling all assets before dissolving the company completely

Under IBC, if the resolution plan is not approved by 75% of the creditors or if they vote affirmatively to put the debtor into liquidation, the NCLT is required to pass a liquidation order. The liquidator shall be the insolvency professional who managed the IRP, or a new insolvency professional would then be appointed to manage the distribution of assets to creditors and winding-up process of the company.[5]

Insolvency vs. Bankruptcy

  • Insolvency refers to a situation, whereas bankruptcy refers to a legal state.
  • If you are insolvent, you are simply not in the state to pay off your debts.
  • Whereas, if you are declared bankrupt, then you have to pay off your debts by either selling off your assets or by restructuring payment processes with governments’ help.
  • Insolvency is a state of being. Bankruptcy is the conclusion.
  • A bankrupt can become insolvent but not all insolvencies lead to the declaration of bankruptcy.

While both situations refer to the state of being unable to pay off debts, they are two contrasting scenarios. If untreated, insolvencies can lead to bankruptcies.[6]

Bankruptcy vs. Liquidation

  • Liquidation is for companies and bankruptcy is for individuals.
  • Bankruptcy is a legal state where an individual is declared insolvent, with certain legal consequences, while liquidation is a means or tool to shut down a company in an orderly way.
  • While bankruptcy status remains on a public record forever, it is not a permanent state of affairs as it lasts only three years. In contrast, liquidation leads to a permanent outcome, i.e., it is the “end of the road” for a company as assets are sold off and the company structure dismantled with no possibility of returning to operations.
  • Bankruptcy concerns an individual and his or her creditors whilst liquidation can impact more parties. Directors, shareholders, creditors, and employees could be impacted by a company going into liquidation, whether it is through termination of employment, recovering debt, or not successfully recovering the debt.
  • Bankruptcy usually happens due to insolvency, but companies that enter liquidation could do so because of insolvency or some other reason. A solvent company can choose to liquidate because its members choose to stop operating, or for some other reason.

Bankruptcy and liquidation are sometimes confused with each other, but they are distinct concepts. The key difference to note is bankruptcy is available only to individuals, whilst a liquidation is an option only available to companies. Both are likely to arise because of insolvency or inability to meet debt obligations, but solvent companies sometimes choose to liquidate for other reasons. Hence, bankruptcy is an interim, not permanent state, but liquidation leads to a permanent winding down of a company.[7]

Insolvency vs. Liquidation

  • Insolvency can be considered a financial “state of being”, when a company is unable to pay its debts or when it has more liabilities than assets on its balance sheet, this being legally referred to as “technical insolvency”. Whereas liquidation is the legal ending of a limited company. It will stop a company from doing business or employ staff.
  • It is also possible to be technically solvent and unable to repay debt. This occurs when a company is “cash insolvent” and with assets that exceed its liabilities, but unable to source additional funds. A liquidator is appointed to administer the liquidation of the company’s assets and to distribute the proceeds to creditors according to the provisions of the Code
  • A True solvent business may also go into liquidation when its shareholders wish to realize the value of large, accumulated reserves in a tax-efficient way.

These companies are placed into Members’ Voluntary Liquidation (MVL) and a firm of insolvency is appointed as Official Liquidator.

The above differences between insolvency and liquidation show that simply being insolvent does not necessarily provide enough grounds for a firm’s creditors to petition for a compulsory liquidation of a business, legally known as Court Liquidation, as in some cases the indebted may even be paid back.

Conclusion

Insolvency is the trigger that causes a bankruptcy or liquidation. For some, the right answer after default is to take the firm straight into liquidation. But there may be many situations in which a viable mechanism can be found through which the firm can be protected as a going concern. To the extent that this can be done, the costs imposed upon society go down, as liquidation involves the destruction of the organizational capital of the firm. The ideal insolvency and bankruptcy regime may provide for early determination of economic viability or otherwise of an entity, management of the conflicts between the interests of creditors and debtors and provide for predictable, equitable and fair loss allocation to all concerned in economic difficulties and reduce the time taken in resolution, then recoveries would be faster, and the capital would be preserved for better allocation.


[1] Chatterjee, Sreyan, et al. “An Empirical Analysis of The Early Days of The Insolvency and Bankruptcy Code, 2016.” National Law School of India Review, vol. 30, no. 2, 2018, pp. 89–110. JSTOR, www.jstor.org/stable/26743938. Accessed 16 July 2020.

[2] Cirmizi, Elena, et al. “The Challenges of Bankruptcy Reform.” The World Bank Research Observer, vol. 27, no. 2, 2012, pp. 185–203., www.jstor.org/stable/23262829. Accessed 16 July 2020.

[3] Cirmizi, Elena, et al. “The Challenges of Bankruptcy Reform.” The World Bank Research Observer, vol. 27, no. 2, 2012, pp. 185–203., www.jstor.org/stable/23262829. Accessed 16 July 2020.

[4] https://trezzalaw.com/understanding-bankruptcy-basic-concepts/ (last visited: 16-07-2020)

[5] https://blog.ipleaders.in/sica-to-ibc-historical-analysis/ (last visited: 16-07-2020).

[6] Acharya, Viral V., and Krishnamurthy V. Subramanian. “Bankruptcy Codes and Innovation.” The Review of Financial Studies, vol. 22, no. 12, 2009, pp. 4949–4988. JSTOR, www.jstor.org/stable/40468335. Accessed 16 July 2020.

[7] https://gamechangerlaw.com (last visited on 16-07-2020)

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