Generally speaking, insolvency refers to situations where a debtor cannot pay the debts they owe. For instance, a troubled company may become insolvent when it is unable to repay its creditors money owed on time, often leading to a bankruptcy filing. Nonetheless, the legal definition of insolvency is complicated and situational. “The meaning of ‘insolvency,’” as one Texas Court noted in Parkway/Lamar Partners, L.P. v. Tom Thumb Stores, Inc., “is not definitely fixed and it is not always used in the same sense, but its definition depends rather on the business or fact situation to which the term applies.” The solvency diagnosis often varies depending on the solvency test that is applied; solvency under the one test does not imply solvency under another, and vice versa, because they measure different things. It is important to employ the appropriate definition of insolvency depending on the context because solvent firms may do things that insolvent firms cannot, such as pay dividends. Testing solvency is thus a critical dividing line in corporate and bankruptcy law.
The definition of insolvency is notoriously difficult to define and often leads to litigation. Delaware’s Court of Chancery remarked in Prod. Res. Group, L.L.C. v. NCT Group, Inc., that “it is not always easy to determine whether a company even meets the test for solvency.” In practice, lawyers may spend more time litigating how to determine insolvency than litigating whether a given firm is solvent. A prominent bankruptcy treatise notes that litigation on the meaning of insolvency “generates a formidable and, on the surface, not always consistent stream of adjudications.”
There are two principal definitions of insolvency in the United States: the first, balance sheet insolvency, occurs when the debtor’s liabilities exceed its assets. The second, cash flow insolvency, occurs when the debtor cannot pay its debts as they mature due to the debtor’s lack of financial liquidity–but not for her lack of assets.
Balance Sheet Insolvency
The balance sheet test asks whether a firm’s assets are greater than its liabilities. The Bankruptcy Code defines “insolvent” as “financial condition such that the sum of such entity’s debts is greater than all such entity’s property, at a fair valuation.” Hence, under the Bankruptcy Code, insolvency is “essentially a balance sheet test.” A debtor is insolvent when the debtor’s liabilities exceed the debtor’s assets, excluding the value of preferences, fraudulent conveyances, and exemptions; in this situation, a debtor has negative net assets. As the Fifth Circuit accurately stated in Langham, Langston & Burnett v. Blanchard, “[o]ne is insolvent under the [bankruptcy] statute when his assets, if converted into cash, at a fair not forced sale will not pay [his debts].”
The definition of “insolvent” depends on whether the debtor is a corporation, partnership, or municipality. Even so, the standard insolvency test by which an entity’s “fair value” is measured is the sum of its assets and liabilities. A common method to calculate the fair value of assets and liabilities is to determine what price, in cash, a hypothetical willing buyer would pay, and a hypothetical willing seller would accept in a sale of the property in a reasonable amount of time. This method is termed the fair market value valuation. The Second Circuit noted in In re Roblin Indus. Inc., “[f]air value, in the context of a going concern [i.e., assuming the firm will continue in operation and generate cash flow from its business], is determined by the fair market price of the debtor’s assets that could be obtained if sold in a prudent manner within a reasonable period of time to pay the debtor’s debts.” When a firm is valued as a going concern, the market value typically includes “intangibles such as relationships with customers and suppliers, and the name, profile, and reputation of the business.”
By contrast, in the case of a liquidation, as in Matter of Lamar Haddox, the Fifth Circuit accurately noted that the fair value of the liquidated property is determined by “‘estimating what the debtor’s assets would realize if sold in a prudent manner in current market conditions,’” and not by arbitrary book values of assets. Here, “fair value” is equivalent to fair market value at the time of the transfer. Asset valuation in liquidation is another litigious matter. Since the speed of a sale affects the purchase price of the assets, the firm’s liquidated assets' fair market value depends on the timing of the sale, among other factors. In general, courts eschew the assumption that assets are liquidated in fire-sale auctions since such auctions are not value-maximizing.
The Seventh Circuit in In re Taxman Clothing Co., Inc. provides a useful example of this thinking. The principal issue was the proper valuation of a clothing company’s inventory. At an auction, the inventory was liquidated for $110,000, but there was strong evidence that the inventory would net $215,000 if sold as a going concern. The court chose the latter value for solvency purposes because the court concluded that the firm’s inventory's proper value was the profit that it could have obtained through a sale in the usual course of business, rather than the value resulting from a quick and harsh liquidation. In any case, courts must balance competing concerns when determining a “reasonable time” for liquidating assets. There is, as the Third Circuit noted, “the desire to maximize the dollar figure from the assets to be sold,” on the one hand, and “the desire to have the assets sold off quickly to satisfy creditors’ claims sooner rather than later,” on the other.
The choice between valuing a firm in liquidation or as a going concern is difficult because most firms are, at the test date, “midway between a prosperous going concern and a dead enterprise.” Nonetheless, courts tend to elect the going concern standard when a firm is operating at the valuation date and paying its debts. In In re DAK Indus. Inc., the bankruptcy court determined that DAK, the debtor firm, was a going concern at the valuation date because DAK continued to conduct business under Chapter 11 protection for more than two years.
Cash Flow Insolvency
“Cash flow” insolvency is also known as equitable insolvency or the “ability to pay” test. An Ohio court stated in Cellar Lumber Co. v. Holley that cash flow insolvency is “the inability to pay debts as they become due in the ordinary course of business.” It is a “broader concept [than balance sheet solvency], originating with merchants or traders.” Under the Uniform Fraudulent Conveyance Act (§ 6), cash flow insolvency is determined by asking whether the debtor “intends or believes that he will incur debts beyond his ability to pay as they mature.” While the UCC includes in its definition of “insolvent” “being unable to pay debts as they become due.” By its nature, cash flow insolvency is a forward-looking test. A firm must prove that it is capable of paying both current and prospective debt obligations. A test that considers only the firm’s historical ability to pay its debts would be wholly ineffective in deterring activities that destroy credit. Moreover, firms may be balance-sheet insolvent but liquid enough to pay creditors. In Angelo, Gordon & Co. L.P. v. Allied Riser Commc’ns Corp., for example, the debtor corporation, while balance-sheet insolvent, had liquidated all its assets and had enough cash to pay its currently maturing obligations.
Furthermore, a firm’s ability to pay is not equivalent to a firm’s expected cash flow, or the total of its possible cash flows measured by their probabilities. To the contrary. A firm may have large expected cash flow but a very small likelihood of repaying its bills. Here’s an example. Suppose Firm A has a prospective debt payment of $1,000 but no current ability to pay the debt. However, Firm A has a 25% chance of receiving $10,000 before the maturity date but a 75% chance of receiving $0. Accordingly, there is a 75% chance that Firm A will not pay its debt when it matures because there is a 75% chance that Firm A will have $0 when the debt is due. But there is a 25% chance that Firm A will pay its $1,000 debt. Should this occur, and Firm A pays its $1000 debt with its $10,000 expected payment, the expected cash flow is $2,500 because 25% of 10,000 plus 75% of $0 equals $2,500. This example shows that a firm’s expected cash flow can be higher than its debt despite a very high probability that it will be unable to pay its debt when it comes due.
Insolvency According to the Uniform Commercial Code
The Uniform Commercial Code also defines insolvency. § 1-201(23) of the UCC incorporates not only the Bankruptcy Code’s test but also two “equity tests” of insolvency. A “person”––which “includes an individual or organization,” under § 1-201(30)––can be insolvent when: one “has either 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 federal bankruptcy law.” The UCC’s Official Comment 23 to § 1-201 observes that these three definitions of insolvency “are expressly set up as alternative tests and must be approached from a commercial standpoint.”
Consequences of Insolvency
The consequences of insolvency are significant for firms, their creditors, and shareholders. As an overarching goal, insolvency law aims to protect creditors' interests by preventing many gratuitous asset transfers or potentially creditor-harming activities of the debtor firm. An over-inclusive test for insolvency would be detrimental to firm value by decreasing entrepreneurial investments and constraining other forms of capital raising. Likewise, an underinclusive test would be detrimental to creditors, who would be left with little in terms of repayment; a borrower could plunder the firm of its assets by gratuitous transfers, excessively leveraged buyouts, massive salaries and bonuses, and the like.
In this way, insolvency plays out in a practical way in various proceedings. To begin with, the payments an insolvent firm makes to creditors before a bankruptcy filing may be voidable under Title 11, Section 547. Under state and federal fraudulent transfer law, solvency similarly determines what transactions are voidable when they lack “fair consideration” or “reasonably equivalent value.” And in bankruptcy law (Section 1102(a)(1)), solvency determines whether shareholders are entitled to form an equity-holders’ committee in the bankruptcy proceeding.
“Bankruptcy versus Insolvency”
The distinction between the terms “bankruptcy” and “insolvency” is an important one. Insolvency is not equivalent to bankruptcy. Bankruptcy is a legal finding that imposes court supervision over the financial affairs of the debtor. In modern legislation, insolvency is often a necessary but not sufficient condition for bankruptcy. As a “factual determination” in bankruptcy court, the plaintiff bears “the ultimate burden of persuasion” of establishing a debtor’s insolvency status. The First Circuit, in Consove v. Cohen, held that in circumstances when unaudited financial statements are the best available evidence of a debtor’s insolvency, they are admissible, and it was up to the trier of fact to assess the accuracy of such debtor financial statements. Similarly, the Fifth Circuit has held in In re Erstmark Capital Corp., that “while the balance sheets alone may not be sufficient evidence to support an insolvency finding, they can provide, in some circumstances, competent evidence from which inferences about a debtor’s insolvency may be drawn.”
Like companies and individuals, countries may suffer from financial distress and fail to repay their debts. When a country is a debtor, insolvency occurs when the country defaults on its sovereign debt or fails to pay interest on its treasury obligations, regardless of the country’s ability to pay. Countries like Argentina, Greece, and Lebanon have recently defaulted on their debt payments and faced an insolvency crisis.
However, when a sovereign becomes insolvent, the legal recourse for debtors and creditors alike is significantly different. Because of sovereign immunity, there is no legally and politically recognized process for restructuring the debt of bankrupt sovereigns. Alexander Hamilton's statement in Federalist 81 remains true today–“[t]he contracts between a nation and individuals are only binding on the conscience of the sovereign, and have no pretensions to a compulsive force. They confer no right of action, independent of the sovereign will.” As sovereigns, governments control their own affairs and thus cannot be obligated to pay back their debt. In turn, creditors lack a well-defined claim on the sovereign’s assets. Insolvent governments, nonetheless, are heavily incentivized to repay their debt obligations. For a country that fails to pay its debts will likewise struggle to borrow money in the future; it’s access to credit markets will be severely limited by wary investors.
[Last updated in June of 2020 by the Wex Definitions Team]