Insolvency vs. bankruptcy - distinct notions or complementary instruments?

Publishing date: 4 May 2023

Serious imbalances in the relationship between a trader's assets and liabilities may result in the trader being unable to meet its obligations under contractual relationships to which it is a party. In such cases of imbalance, the institution of insolvency may intervene or, in some more severe cases, the spectre of bankruptcy may even arise.

It is precisely these two fundamental notions of the relationships governed by commercial law that will be the subject of this article, in which we will try to highlight the differences between insolvency and bankruptcy and offer some general guidelines and directions for action to avoid such situations.

Contents

1. The difference between insolvency and bankruptcy in general terms

2. Bankruptcy vs. insolvency - procedures, conditions, effects

3. Avoiding insolvency or bankruptcy: general advice and courses of action

1. The difference between insolvency and bankruptcy in general terms

Most of the time, there is confusion between the two notions of insolvency and bankruptcy. The two concepts, even though, as you will see from the content of this article, they are related and governed by practically the same legal rule, are essentially different.

Thus, it can be said from the outset, and without much ado, that the difference between insolvency and bankruptcy is the same as the difference between whole and part. Bankruptcy is thus subsumed under the institution of insolvency, being only one stage, the final stage, of a general procedure whose essential aim is the recovery and recovery of the economic entity in difficulty and its reintegration into the economic circuit. In a plastic way, insolvency could be likened to a process of "recovery" of an economic entity and bankruptcy to an unwanted, final but necessary phase of removing the entity from the economic circuit.

Therefore, defining insolvency, it can be stated that it is a procedure provided for by law which can be triggered at the request of parties in a commercial relationship (debtors and creditors alike) in certain cases where the debtor entity is deemed unable to pay its certain, liquid and enforceable debts to creditors on the basis of its current assets and available funds.

The concept of judicial reorganisation also appears in the context of insolvency proceedings, which represents the intervention of the State's judicial power to limit or, as far as possible, re-engage the insolvent company in the economic circuit with the clear aim of protecting the interests of the creditors of this entity in difficulty. Thus, judicial reorganisation as part of insolvency proceedings may impose a recovery programme on the debtor based on a plan for the reorganisation of its economic and legal activity, which may contain one or more of the following courses of action:

• Restructuring of the entity by changing the share capital structure;
• Restriction of activity by selling assets that were part of the entity's patrimony;
• Restructuring the operations and financials of the distressed entity.

On the other hand, bankruptcy can be defined as part of insolvency proceedings involving the liquidation of the available assets of the debtor entity in order to satisfy all or part of the creditors of that entity, followed by the removal of the entity from the commercial register.  Bankruptcy occurs, of course, when judicial reorganisation has failed with the aim of putting the entity back on a stable footing in terms of economic viability. Bankruptcy can therefore also be seen as a last resort, which is by no means compulsory when a company becomes insolvent.

2. Bankruptcy vs. insolvency - procedures, conditions, effects

Insolvency proceedings are regulated in Romania by Law No. 85 of 25 June 2014, which also lays down the rules for preventing the emergence of this economic and legal situation for debtors facing difficulties in their business.

As regards the insolvency procedure, it can be general or simplified depending on whether additional steps are taken before a bankruptcy is reached or even with the aim of avoiding bankruptcy.

Thus, general insolvency proceedings comprise three main stages:

• Observation period;
• Judicial reorganisation;
• Bankruptcy.

The observation period is a period of time between the date on which insolvency proceedings commenced and the date on which the judicial reorganisation plan was approved or the date on which the company goes bankrupt after the judicial reorganisation has not been completed.

The judicial reorganisation, as already noted in this article, is a legal procedure in which a company that has become insolvent is forced, through the intervention of a reorganisation plan adopted by the company's creditors and confirmed by a court-appointed judge, to pay its outstanding debts. It should be noted that a judicial reorganisation plan for a company cannot last for more than three years from the date of confirmation of the reorganisation plan.

The role of judicial reorganisation is, as already noted, to give the economic entity a chance to become viable again and to manage to pay its debts to creditors, thus returning to the economic circuit with new strength.

However, if the reorganisation plan fails to achieve this goal or if the plan has not been approved by the creditors' meeting or has not been confirmed by the insolvency judge appointed in the insolvency proceedings, the company will go straight into bankruptcy proceedings.

If we refer now to the simplified insolvency procedure, in this situation the debtor company in difficulty enters directly into bankruptcy proceedings in which liquidation takes place with total or partial coverage of debts and write-off.

From the point of view of the opening of insolvency proceedings, which may or may not lead to bankruptcy, it is worth noting that the opening of insolvency proceedings may be initiated either by the creditors of an economic entity that has entered into financial difficulty and is accumulating claims, or by state institutions expressly provided for by law, or even by the legal representatives of the debtor company. The first condition for the initiation of insolvency proceedings is the existence of outstanding debts totalling at least RON 50 000. It should be noted that in the case of natural persons, insolvency proceedings may be requested from a minimum threshold of 6 gross average wages per economy, representing unpaid debts.

Once the application for the opening of insolvency proceedings has been granted, the official receiver will appoint a liquidator or administrator, as the case may be. This administrator will be provisional until the creditors' meeting, which may confirm the person appointed by the official receiver or replace him with another person who is an insolvency practitioner and registered with the National Union of Insolvency Practitioners of Romania. The first task of the administrator or liquidator will be to draw up the provisional list of claims. The list shall be drawn up on the basis of the applications for registration of the various creditors of the company in difficulty, as well as by automatically listing the salary claims for which no application for registration on the creditors' list is required.

The debtor company will continue its economic activity under the supervision of the insolvency administrator either under the direction of a special administrator or under the direct direction of the insolvency administrator if the debtor's right of administration has been withdrawn.

If the preventive role of the insolvency proceedings is successful, and all payment obligations assumed in the confirmed plan have been met along with the payment of all current claims, the economic entity can exit the insolvency proceedings and resume normal business activity. Otherwise, as has already been noted, bankruptcy and liquidation proceedings followed by striking off are initiated.

3. Avoiding insolvency or bankruptcy: general advice and courses of action

Although insolvency provides, in a somewhat plastic way, a 'lifeline' for an economic entity facing difficulties in paying its debts, this procedure should not be seen as an insurance and a green light for unbalanced corporate behaviour.

Thus, in order to avoid reaching the brink of insolvency, the management of economic entities should continuously adopt a proactive and prudent attitude in order to take the best decisions for the development of the companies in their overall business relations. Here are some prudential guidelines for action that could form the basis of a philosophy that every manager should adopt:

•  Keeping expenses under control and business development

Of course, expenditure within a company is absolutely necessary for the economic development of its business. But often expenses can get out of control, in which case calling in a financial audit that can provide an accurate picture of cash flows or using administrative services to optimise day-to-day operations can be healthy decisions. Also, business management services, whereby professionals with a wealth of business experience can offer advice and optimal courses of action can be a beneficial addition to a firm's business, especially when important decisions need to be made. In this context, such services are offered by Mazars in Romania.

• Avoiding or successfully resolving disputes

Litigation can be a source of significant financial loss to an economic entity. This is why companies must act prudently in assuming contractual obligations and be able to defend their legal rights arising either from primary legislation or those gained through commercial relationships themselves. It is therefore advisable to seek legal advice specialised in the field and cases encountered by entities whenever there is a potential danger of litigation which could have negative financial consequences.

• Tax compliance

One factor that can raise the spectre of insolvency is negligence in tax compliance and keeping proper accounting records. Fines and litigation that can arise with the state tax authorities over-reporting errors or late compliance can result in significant losses of money and time and can contribute to the "derailment" of a business entity from a sustainable line of business. Thus, using financial advice to clarify issues in these areas and using good quality accounting and financial and tax reporting services can be a strong defence against any oversights or inadequacies, especially in the context of changing tax legislation.

In conclusion, insolvency and bankruptcy can be considered in a dichotomous sense, bankruptcy being a part of the legal institution of insolvency, distinct and without the obligation to produce, but existing as a danger for economic entities that do not approach the economic game prudently enough. On the one hand, insolvency can be seen as a salutary element of intervention and recovery of a company in difficulty, and on the other hand, together with bankruptcy, as an instrument for cleaning up the economic environment by eliminating entities that fail to adapt to the rigours of capitalism.

*This material has been prepared for information purposes only and is not intended to provide tax, legal or accounting advice. We recommend that you consult your team of tax, legal and accounting advisers before making any decisions on the topics mentioned in this article.