When individuals or businesses cannot afford to pay their bills, typically, creditors will take some action to collect debts owed. Depending on the severity of the debtor’s financial situation, it may become insolvent, which has implications for both the debtor and creditor.
What Is Insolvency?
Insolvency is a legal term describing a debtor who is unable to pay its debts as they fall due. Both individuals and businesses can be insolvent. Many people think insolvency and bankruptcy are the same. However, a debtor can be insolvent without being bankrupt. Bankruptcy is one of many solutions to insolvency as discussed further below.
Cash Flow vs Balance Sheet Insolvency
There are two primary types of insolvency. In cash flow insolvency, a debtor cannot pay debts as they fall due because they lack the cash to do so. Individuals typically experience cash flow insolvency. Businesses may experience cash flow insolvency or balance sheet insolvency. In balance sheet insolvency, the debtor has more debts than assets (i.e., negative net assets). A debtor may be cash-flow insolvent but balance sheet solvent if it cannot pay its bills but has non-cash assets that are worth more than its debts. Alternatively, a debtor may be balance sheet insolvent but cash flow solvent, if it can pay its immediate debts, but has long-term debt that exceeds its revenues and financial problems are likely to affect its cash flow eventually.
Insolvency Under New York and Federal Law
The New York Uniform Voidable Transactions Act, under the Debtor & Creditor Law provides that a debtor is insolvent if, at a fair valuation, the sum of the debtor’s debts is greater than the sum of the debtor’s assets. A debtor that is generally not paying the debtor’s debts as they become due other than as a result of a bona fide dispute is presumed to be insolvent. The presumption means that a creditor has the burden of proving that the debtor is not insolvent.
Federal bankruptcy law defines insolvency in essentially the same way. It is the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.”
What Is the Effect of Insolvency?
An insolvent individual or business will need to address its failure to pay debts with creditors. In addition, there are other consequences. Insolvent debtors may face long-term issues such as damage to their credit rating and ability to borrow. If a debt is forgiven, a debtor may be liable to pay taxes on the amount the creditor writes off because debt forgiveness may be classified as income for tax purposes. However, the IRS allows insolvent and bankrupt debtors to reduce cancelled debt by their insolvency amount. If the debtor cannot resolve its debts, bankruptcy is the last resort. In that instance, a trustee is given control over the debtor’s assets and payment of creditors.
Consequences for Creditors
Creditors have various rights and protections under insolvency laws. For example, both New York and federal laws prohibit fraudulent transfers by a debtor. These are transfers made within a certain period before the bankruptcy filing in order to delay or defraud a creditor. A creditor with a judgment against the debtor can get a court order to obtain the property or proceeds from the sale of property fraudulently transferred.
Rights of Debtors
Under the Fair Debt Collection Practices Act (FDCPA), debtors are protected from harassment and misleading and unfair collection practices and have the right to dispute and obtain validation of debt information. Once a debtor files for bankruptcy, typically, creditor actions are stayed or suspended while the bankruptcy is pending.
How Can Debtors Address Insolvency Through Bankruptcy?
Individuals typically seek Chapter 7 bankruptcy, which allows them to discharge unsecured debts (e.g., credit card bills, personal loans, etc.). However, secured debts like mortgages, child support, alimony, student loans, and car loans, are generally not dischargeable. A debtor must meet the bankruptcy means test to be eligible for Chapter 7. The means test provides that the debtor’s household income must be lower than the average monthly household income in the debtor’s state, or if income is higher, the debtor’s allowable expenses are higher such that the debtor does not have sufficient disposable income to pay debts.
Chapter 13 bankruptcy is for those debtors who cannot meet the bankruptcy means test because they have some “disposable income” to put toward debts. It is still beneficial because it allows the debtor to better spread out payments until they recover financially.
Businesses may file for bankruptcy under Chapter 7 to liquidate or Chapter 11 to reorganize. Chapter 11 allows the business to continue to operate. The Chapter 11 debtor proposes a reorganization plan for how each class of creditors will be treated and paid. A trustee is appointed to monitor the plan. Creditors may participate in formulating the plan or file a competing plan to the debtor. If the plan is accepted and complied with, the remaining debts will be discharged.
How Can Debtors Address Insolvency Outside of Bankruptcy?
Outside of bankruptcy, debtors may seek to resolve debts through financial restructuring and asset protection. They may also seek to negotiate with creditors to seek debt consolidation or more favorable payment terms. Lenders may be open to loan modification or additional financing options. While creditors and lenders are not obligated to negotiate, it may be in their best interests especially if the debtor is likely to default in the absence of new terms.
How Has COVID-19 Affected Insolvency Rules?
COVID-19 has created a public health emergency that may cause the suspension or invalidation of some contract obligations due to “force majeure,” also known as “act of God” provisions. Because of city and state wide government orders and shutdowns, some contract obligations may become impossible or unfeasible to perform. A commercial contracts attorney can advise insolvent debtors of the potential effects of COVID-19 on their contractual obligations.
Various federal laws passed in response to the COVID-19 crisis provide financial assistance to businesses. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Payroll Protection Program, and Main Street Lending Program help eligible businesses affected by COVID-19 to receive loans on very favorable terms, including low interest rates, deferral of payments, loan forgiveness, and other provisions. Any business facing financial problems due to COVID-19 should contact an attorney or financial professional to discuss how these programs could benefit them.
In addition, CARES Act amendments to the Small Business Reorganization Act include revisions to certain provisions of the U.S. Bankruptcy Code to provide bankruptcy relief to small businesses and individuals. Small businesses can take advantage of protections similar to Chapter 11 but utilize a more streamlined and less expensive bankruptcy process.
Individuals also benefit from changes to Chapters 7 and 13. Those who already have a Chapter 13 plan but have suffered a “material financial hardship” due to COVID-19 can seek plan modifications, including extending their payments for up to seven years after their first plan payment was due, thereby reducing their monthly payment obligation.
In addition, CARES Act and other COVID-19 related stimulus payments are not included in the definition of “income” for bankruptcy eligibility purposes or included in the calculation of “disposable income” for plan confirmation purposes.
Individuals and businesses experiencing financial difficulties should seek assistance from reputable sources regarding credit counseling and negotiating with creditors. Business owners should discuss their circumstances with experienced business advisors so they can present the strongest case to creditors and lenders. In these difficult times, parties may be more open to negotiation to avoid default and bankruptcy.
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