This is the second post in my “popular law” series. In a previous job, a few years ago, I was a Senior Solicitor in the Insolvency department of a substantial regional law firm. The trainee solicitor seat in the Department was with me, in my office. Trainee solicitors would spend six months with me, before moving on to another seat in another department.
On the first day in my office, I would ask each new trainee to give some thought and to come back to me with a clear and simple answer to the question:
what is insolvency?
As often as not, I would be given a learned explanation citing cash flow and balance sheet tests. In such a case, I would ask the trainee to come back with a simpler answer.
Because the answer is simple …
insolvency is when there is not enough money to go round
That’s right. A person/business/company (which I will refer to as “the debtor”) is insolvent when he/she/it owes more money than he/she/it can pay.
In such an event, the very simple legal position is that the debtor goes into bankruptcy liquidation. The debtor’s assets are sold, and any cash due to the debtor is collected. The total cash realised is then divided up between the creditors, pro-rata according to what they are owed. They each get the same percentage of the cash available as the debt owed to them bears to the total of the debtor’s overall debts. Of course it is not as simple as this, not least as it is not often possible to sell assets/collect debts at full book value than the fees charged by liquidators/trustees in bankruptcy will often take a large chunk out of the money available to pay creditors.
This principle of equal payment pro-rata is called the pari-passu principle. Understanding this is essential to understanding insolvency law. Everything flows from this.
I would then take the conversation into some aspects of insolvency law that relate to efforts to bypass the pari-passu principle.
The first of these is taking security. A typical example is the bank or other lender which requires a charge for mortgage over property as security for a loan. The lender does not want to be an ordinary unsecured creditor sharing equally in the value of the debtor’s realised assets. So it takes security. This puts the lender in the position of having (subject to priorities of any other security) the first bite at the value of the charged property.
On the other side of things, debtors often recognise that they are heading into insolvency. Sometimes they arrange to transfer valuable assets into “safe” hands to put them out of reach of a liquidator/trustee in bankruptcy. Or sometimes they arrange to pay particular debts, for example to family members or close associates or people with whom they will want to do business when they set up a new venture. These are amongst the ways in which debtors try to “protect” assets and to avoid the pari-passu principle. Insolvency law has long recognised this type of situation, and has developed procedures which allow “antecedent transactions” to be set aside. If a debtor, within a specified period of time before bankruptcy liquidation has disposed of an asset at less than market value (including for no value) or has paid a creditor so that the creditor is in a better position than he would have been in a bankruptcy/liquidation, then the Court can undo that transaction.
PLEASE NOTE : this is a very simple introductory level post. Insolvency law becomes a massively complicated subject at times. There is a lot more detail to the simple principles that I have outlined. However, it all flows from the simple fact that there is not enough money to go round.
Do you have any suggestions for a future popular law topic? Please leave acomment.
This blog post necessarily contains a brief summary of the legal principles and should not be treated as legal advice in any specific case. Please contact me if you wish to discuss any specific situation.
