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Understanding Insolvency

Updated on November 7, 2009

Insolvency denotes a state or condition of an individual who has failed to pay his debts. Generally, insolvency means that one's property at a fair value is insufficient in amount to pay what he owes. However, the term may mean a person's inability to pay his debts as they become due in the ordinary course of business.

These two concepts of insolvency often are included together in statutes, as in the Uniform Commercial Code (1952) in the United States, which deals only with commercial transactions concerning personal property: "A person is 'insolvent' who either has ceased to pay his debts in the ordinary course of business or cannot pay his debts as they become due or is insolvent within the meaning of the federal bankruptcy law". Under the federal Bankruptcy Act a person is insolvent whenever his property, exclusive of any that is fraudulently disposed of or concealed, has a fair value insufficient to pay his debts.

Federal and State Controls

The U.S. Constitution gives Congress power to establish uniform laws on the subject of bankruptcy throughout the United States. For a person to become an involuntary bankrupt he must commit an act of bankruptcy.

Under the federal Bankruptcy Act a bankrupt may, with certain exceptions, be discharged from his provable debts.

The federal constitutional provision does not prevent states from having their own insolvency laws if they do not conflict with the Bankruptcy Act. Under such statutes an insolvent debtor may be discharged from his debts that occur in the state after the enactment of state laws to that effect.

Basic Purposes

The two main purposes of the Bankruptcy Act and of state insolvency laws are basically the same, namely, (1) to make available to creditors a fair distribution of all the debtor's nonexempt assets (except for secured creditors and creditors with priority claims) and (2) to make it possible for honest debtors to begin anew, unencumbered by many debts.

The procedure employed by the federal Bankruptcy Act and state insolvency laws are very much alike, whether the debtor voluntarily initiates proceedings or his creditors subject him involuntarily to such proceedings. Some of the debtor's property is exempt from his creditors, and he is discharged only from those debts specified in the statute.

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