In­sol­ven­cy – a pathway out of debt

In­sol­ven­cy is always a tough test for both business owners and their employees, as well as for investors and business partners who are stuck with out­stand­ing invoice oblig­a­tions. However, in­sol­ven­cy pro­ceed­ings don’t always have to mean the absolute worst. Unlike liq­ui­da­tion, which aims to com­plete­ly dissolve a company, in­sol­ven­cy pro­ceed­ings give business owners the chance to revamp their company. The main objective is to settle out­stand­ing payments during ongoing op­er­a­tions and ensure that the company continues operating (possibly with new owners).

The term in­sol­ven­cy is derived from the Latin word solvere and refers to the state of a company or in­di­vid­ual that is unable to settle out­stand­ing payments because its ex­pen­di­ture can no longer be covered by its revenue. This can happen because of a company making a mis­in­vest­ment, mis­judg­ing business risk, or making errors in price cal­cu­la­tion. However, general market changes or an economic crisis can also drive a company into in­sol­ven­cy.

The US Bank­rupt­cy Code dis­tin­guish­es between different cases of in­sol­ven­cy, each subject to certain con­di­tions:

• In­sol­ven­cy for cor­po­ra­tions, part­ner­ships, and sole traders.
• Consumer in­sol­ven­cy (including private in­sol­ven­cy) for natural persons (private in­di­vid­u­als) and the formerly self-employed who have low debt burdens and no existing claims from previous em­ploy­ment periods.

A company’s in­sol­ven­cy can be caused by internal and external factors. Internal factors include anything that is the re­spon­si­bil­i­ty of man­age­ment or planning errors, such as:

• Pro­duc­tion costs were estimated too low.
• In­suf­fi­cient funding was secured.
• The company has expanded too ex­ten­sive­ly.
• Important internal company processes were poorly organized or ma­nip­u­lat­ed.

When it comes to external factors, a company can go bankrupt through no fault of its own. This could happen, for example, as a result of an economic crisis, or if important customers or business partners become insolvent and out­stand­ing claims are not ad­e­quate­ly settled.

The latter often affects companies that are highly dependent on sub­con­trac­tors and/or imports of raw materials, like con­struc­tion and man­u­fac­tur­ing.

However, an industry-by-industry view of corporate in­sol­ven­cies in North America in 2018 shows that the top three sectors for in­sol­ven­cies are con­struc­tion, retail, and agrifood busi­ness­es. Man­u­fac­tur­ing in­dus­tries occupy the lower ranks in the in­sol­ven­cy list. Retail in­sol­ven­cies appear to be fairly common because a lot of start-ups and small busi­ness­es are in this sector, which increases com­pet­i­tive pressure. Ad­di­tion­al­ly, business owners’ lack of ex­pe­ri­ence can make new companies par­tic­u­lar­ly vul­ner­a­ble to poor planning.

There are several tell-tale signs that a company is heading for bank­rupt­cy. For example, if the company requires regular private con­tri­bu­tions from the business owner’s private funds, the credit limit is regularly increased, payments are delayed over a long period of time, and idler time in pro­duc­tion occurs, savings are quickly depleted on new ac­qui­si­tions and personnel costs. These are clear in­di­ca­tions of impending in­sol­ven­cy.

Of­fi­cial­ly, a company is not con­sid­ered insolvent until in­sol­ven­cy pro­ceed­ings have been initiated. To do this, at least one of the three following reasons must apply:

• The company is unable to meet its payment oblig­a­tions.
• The company is not expected to be able to meet payment oblig­a­tions when they become due.
• The amount of existing li­a­bil­i­ties exceeds the amount of an en­ter­prise’s total assets.

The looming pos­si­bil­i­ty of a company’s in­sol­ven­cy does not nec­es­sar­i­ly have to result in in­sol­ven­cy pro­ceed­ings. Be­fore­hand, ne­go­ti­a­tions with creditors will examine whether in­sol­ven­cy can be avoided.

Possible ways to avoid in­sol­ven­cy include:

• Canceling debts (either the total amount or through in­stall­ments)
• Extension of payment deadlines
• Agreement on in­stall­ment payments (this is par­tic­u­lar­ly useful if the company is only tem­porar­i­ly ex­pe­ri­enc­ing payment dif­fi­cul­ties and they expect their situation to improve shortly).
• Inclusion of a partner who can make a private con­tri­bu­tion to the company.

In any case, it is important for business owners to deal with any financial dif­fi­cul­ties in their company as quickly as possible, and explore all possible solutions. If the managing director of a company ignores payment dif­fi­cul­ties for too long or de­lib­er­ate­ly conceals them, you could be held liable for pro­cras­ti­nat­ing your in­sol­ven­cy pro­ceed­ings. If in­sol­ven­cy pro­ceed­ings are filed too late, the company can be punished with fines or even im­pris­on­ment.

In­sol­ven­cy pro­ceed­ings include the following steps and are strictly regulated at the federal and state level. Please consult a financial con­sul­tant to ensure that you are within the remit of the law when un­der­tak­ing in­sol­ven­cy pro­ceed­ings.

As soon as the creditor or debtor considers the re­quire­ments for in­sol­ven­cy fulfilled, they can request that in­sol­ven­cy pro­ceed­ings begin. This ap­pli­ca­tion is then examined by a judge or an expert appointed by the court.

The court examines whether a company has enough remaining funds to finance the set­tle­ment of debts required in the in­sol­ven­cy pro­ceed­ings. If this ex­am­i­na­tion ends pos­i­tive­ly, in­sol­ven­cy pro­ceed­ings are launched. If the necessary con­di­tions for in­sol­ven­cy are not met, an opening decision is issued publicly.

As soon as in­sol­ven­cy pro­ceed­ings are opened with a public an­nounce­ment from the court, an in­sol­ven­cy ad­min­is­tra­tor is appointed. The ad­min­is­tra­tor directs and su­per­vis­es all the necessary steps and co­or­di­nates with the business owner on the course of action so that all parties involved can benefit. In par­tic­u­lar, the in­sol­ven­cy ad­min­is­tra­tor tries to secure and preserve the company’s assets. The in­sol­ven­cy ad­min­is­tra­tor de­ter­mines the company’s exact debt burden and its in­sol­ven­cy assets, i.e. the assets available to settle the debts in the context of in­sol­ven­cy pro­ceed­ings.

All creditors are invited to report within a pre­de­ter­mined period and to disclose their claims. On the basis of the situation just de­ter­mined, a decision is made as to how all debts can be settled as fairly as possible and whether a re­struc­tur­ing of the company is possible. The decision will be taken at a creditor’s meeting, after the in­sol­ven­cy ad­min­is­tra­tor has disclosed the company’s economic situation.

The next step is to conduct the company’s open business. This means that all existing contracts will be reviewed, and the resulting oblig­a­tions examined. Here, the in­sol­ven­cy ad­min­is­tra­tor decides in co­op­er­a­tion with the con­tract­ing parties, whether remaining con­trac­tu­al services can be provided or the contracts (possibly with severance payments from the in­sol­ven­cy estate) are dissolved.

The in­sol­ven­cy ad­min­is­tra­tor liq­ui­dates the in­sol­ven­cy assets into money, which can then be dis­trib­uted to the creditors. Ex­ploita­tion may be carried out by selling or auc­tion­ing off assets or equipment such as pro­duc­tion machinery.

If the company is sold to a new owner, the proceeds from the sale will also be included in the in­sol­ven­cy estate.

If there are positive in­di­ca­tions that the company might survive, the law offers the option of in­sol­ven­cy plan pro­ceed­ings that result in the company staying afloat. The advantage is that in­di­vid­ual reg­u­la­tions can be defined in an in­sol­ven­cy plan that deviates from the legal re­quire­ments for a regular in­sol­ven­cy situation.

To fa­cil­i­tate this, all parties involved in the in­sol­ven­cy pro­ceed­ings jointly draw up an in­sol­ven­cy plan, which is then subject to legal review. Sub­se­quent­ly, the creditor’s meeting will vote on the plan, and in the event of a positive outcome, the court will confirm the official in­sol­ven­cy plan. Once completed, the plan becomes final and the rules set out therein are binding to all parties.

This type of in­sol­ven­cy pro­ceed­ing usually aims to fa­cil­i­tate the main­te­nance and suc­cess­ful con­tin­u­a­tion of a company.

Click here for important legal dis­claimers