What is bankruptcy (insolvency)?

If you hear someone is 'bankrupt', most people understand that to mean that the person is broke or doesn’t have enough money to pay their debts.

While bankruptcy is an essential part of our economy, it's not very well understood by the general public. It's a very complex subject and there's a huge amount of jargon involved.

So, to begin our explanation of bankruptcy let's define some key terms.

‘Bankrupt’ and ‘insolvent' – what's the difference?

While most people have heard of the word 'bankrupt', not everyone is familiar with the term 'insolvent'.

When a person or company is unable to pay their debts when they are due for payment, they are insolvent.

In Australia the words 'bankrupt' and 'insolvent' are often used interchangeably and taken to mean the same thing.

But the correct term to describe someone (or a company) who can't pay their debts is 'insolvent'.

'Bankruptcy' is in fact a legal procedure for people who are insolvent.

So, from now on we'll use the word 'insolvent' instead of the more commonly used term 'bankrupt' to describe people and companies who can't pay their debts.

Debtors & creditors

That are two other important terms that are important to understand when we're talking about insolvency:

A creditor is owed money by a person or company.

A debtor owes money to a person or company.

Insolvency: The big picture

To understand insolvency, we have to think about credit.

Credit is a normal part of our everyday lives. For example, most adult Australians have a credit card which they may use to pay for everything from a coffee to an overseas holiday. We use home loans to buy houses and pay for renovations, and we use personal loans to buy cars and boats.

In business, companies buy goods from their suppliers on credit and often extend credit to their customers. Employees who are paid at the end of the working week extend a form of credit to their employers.

The vast majority of debts are repaid in accordance with the agreement between the creditor and the debtor. But there will always be situations when a debtor can't repay their debts in full.

This is where insolvency comes in.

Insolvency provides a fair and orderly process for sorting out the financial affairs of people and companies that are unable to pay their debts.

Insolvency is a legal framework that:

• allows both the insolvent debtor and their creditors to participate with minimum delay and expense
• provides for the repayment of debts to creditors in whole or in part from the insolvent debtor's property
• ensures that the proceeds from property recovered from the insolvent debtor are shared fairly among the creditors
• allows for an examination of the insolvent debtor's financial affairs to find out the cause of the insolvency and if any laws were broken
• enables insolvent debtors who break insolvency laws to be prosecuted
• provides a way for viable but financially distressed businesses to continue trading so jobs are saved, and the business can continue making a contribution to the economy
• releases insolvent debtors from debt and allows them a fresh start
• is impartial and efficient.

Who’s who in insolvency?

The people who you encounter in an insolvency all have different roles to play.

Debtors

Debtors owe money to people or companies. An ‘insolvent debtor’ is unable to repay the debts they owe.

Creditors

Creditors are the people and companies who are owed money by the insolvent debtor. Usually, a creditor is owed money because they have provided goods or services, or made loans to the insolvent debtor.

In an insolvency, an insolvency practitioner (see below) works with creditors to establish how much money is owed.

In a corporate insolvency, creditors are often asked to get involved in the insolvency procedure, for example approving the appointment of the insolvency practitioner or agreeing on the insolvency practitioner's payment.

Insolvency practitioners

Insolvency practitioners are the professionals who are licensed by government authorities to manage insolvency procedures.

They are highly regulated and bound by legal duties and professional rules when carrying out their jobs.

In an insolvency procedure – such as a bankruptcy or liquidation – an insolvency practitioner is appointed to deal with the insolvent debtor's assets and their creditors.

They have a legal duty to act in the best interests of all the creditors. So, their responsibility is to creditors as a whole, not the insolvent debtor or any particular creditor.

Because of their experience, insolvency practitioners are also asked to give advice to people and companies about how to resolve their financial difficulties.

In a nutshell, insolvency practitioners help restore heavily indebted people to financial health, rescue businesses, ensure creditors are treated fairly, and help bring misbehaving company directors and fraudsters to justice.

Lawyers & courts

Some insolvencies – particularly corporate ones – are very complex. In some instances, a judge in a court of law may need to make a ruling on a difficult issue in the insolvency.

Different types of insolvency

There are many different types of insolvency which apply in different circumstances.

One of the most important things to know is the difference between personal insolvency and corporate insolvency.

Personal insolvency relates to a person – as opposed to a company. Different types of personal insolvency:

• bankruptcy
• debt agreement
• personal insolvency agreement.

Find out more about personal insolvency and bankruptcy

Corporate insolvency relates to a company – as opposed to a person. Different types of corporate insolvency:

• liquidation
• voluntary administration.

Find out more about corporate insolvency