Is It Insolvent? How Do We Tell?

Assessing Insolvency

Following most large insolvency filings, there are questions about when insolvency first struck and what stakeholders (lenders, employees, pension plans, and others) can do to maximize recoveries.  Establishing solvency or insolvency, and determining the moment when it first occurred, is important for a number of reasons.  For instance:

  • Contracts commonly embody “insolvency clauses”, whereby certain powers are available to counterparties should another party become insolvent. Common examples include the right to demand certain security be posted to guard against losses that might be caused by later non-performance by the insolvent party, or the right to terminate the contract entirely.
  • With few exceptions, the Bankruptcy and Insolvency Act (“BIA”) and the Companies’ Creditors Arrangement Act (“CCAA”), the primary tools to restructure or liquidate debtors in default of financial obligations, can only be applied to insolvent entities.
  • A number of provisions, such as reviews for “preferences” or “transfers undervalue”, only come into play once the BIA or CCAA apply. The ability of creditors or other aggrieved parties to make recoveries is enhanced if a preference or transfer undervalue occurred, provided that the debtor was insolvent, not just when the company was declared bankrupt or the CCAA order was granted, but at earlier points in time (such as when the preference or transfer undervalue occurred).
  • Corporations are to only pay dividends if they pass some stress tests before the dividend is declared, and if the dividend itself does not cause a failure of those tests. Those tests, while not specifically referring to “insolvency”, mimic the wording of some of the BIA’s solvency tests.

What is “Insolvent”?

The BIA states that:

“insolvent person” means a person[1]

(a) who is for any reason unable to meet his obligations as they generally become due (“the cash flow test”);

(b) who has ceased paying his current obligations in the ordinary course of business as they generally become due (“the general payment default test”); or

(c) the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due (“the balance sheet test”).

(The italics above indicate terms I use for each of the tested conditions.)

Note that the tests are disjunctive, not conjunctive.  If one of the three tests is failed, then the person is insolvent.  Being “way in the black” on one test does not make up for being “in the red” on another.

The above definition appears in the BIA.  It is the definition of insolvency most frequently used in other matters (such as contract interpretation), but parties should be cautioned that other definitions may be applicable in some circumstances.  There is nothing in the BIA (or elsewhere) forcing the definition to be applied anywhere other than in the BIA.

The Canada Business Corporations Act (“CBCA”) imposes something similar to the insolvency tests, on the ability to pay dividends:

“A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that:

(a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or

(b) the realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.”

Thus, it embodies tests that are very close to the BIA’s cash flow test and balance sheet test (but avoids a test analogous to the BIA’s general payment default test).  The CBCA governs only corporations formed under the CBCA, but most corporations statutes (most notably, each of the provincial corporations acts) contain a test similar to that in the CBCA.

A Closer Look at the Insolvency “Cash Flow Test”

The cash flow test for insolvency asks whether a debtor is able to meet obligations as they generally come due.

The wording of the test suggests it cannot be applied prospectively.  That is, the test is only failed once a debt is due and the debtor is unable to pay it.  The week before it is due, even if it seems entirely unlikely that the entity will be able to generate the cash to pay the debt before its due date, the entity would not be regarded as insolvent.  While there have been exceptions to this position—where courts have applied the test prospectively, saying essentially “if you will be unable to pay debts, then you are insolvent already”, those exceptions are rare.

The test looks, not to any one debt, but to debts “generally” being not met.  This typically means several creditors must be affected.  Being unable to pay one creditor, while being able to pay others as they come due would likely not result in an entity being declared insolvent.  (Exceptions do exist, where debtors have only one creditor.)

For instance, consider a debtor with three assets (Assets 1, 2 and 3), each pledged as security for a different lender (Creditors 1, 2 and 3).  Some of Creditor 2’s debt is due on Tuesday, and Asset 2 will generate sufficient cash that very day, just before the debt is due.  Assume that Asset 3 and Creditor 3 will meet a similar fate on Wednesday.  But assume Creditor 1’s debt was due on Monday, and Asset 1 will not generate sufficient cash to extinguish the debt until next month.

It seems unlikely that the failure to pay Creditor 1 when its debt was due will be regarded as having triggered a failure under the Cash Flow Test.  The debtor is generally able to pay the debts as they are due.  The debtor will certainly be in default of its loan from Creditor 1, and that could trigger certain rights for Creditor 1, but it is unlikely that the debtor could be said to be insolvent.

More on the Insolvency “General Payment Default Test”

The General Payment Default Test looks, not to an ability to pay, but to whether payments are, in fact, being made (regardless of ability).  Like the Cash Flow Test, its wording suggests the failure to pay must have occurred.  For instance, where a debtor has debts that will be due, has the resources with which to pay them, but states that it has no intention of paying them, then it is unlikely that insolvency could be said to exist by virtue of this test.

Like the Cash Flow Test, the General Payment Default Test requires a cessation of payment to creditors generally, not to just one of them (although, as in the case of the Cash Flow Test, exceptions are made when the business has only one creditor).

The Insolvency “Balance Sheet Test”

The Balance Sheet Test, in contrast to the other two tests, is more prospective in nature.  It refers to the “value” of assets, which, in most cases, calls for at least some consideration of what it will likely deliver in future (because that is how rational buyers most frequently determine value, or price—by the value that will be delivered over to them in the future, after they own the assets).

The Balance Sheet Test is, in my experience, frequently misread as if it called for assessment of liquidation values.  While this may be true in cases where the business has unequivocally failed, I suggest it is not necessarily so.  Consider a business that is viable, and valuable, but is simply saddled with excessive debt.  A reasonable vendor of that business’s assets would maximize value by selling them as an intact business, and I suggest that that value is what is referred to in the Balance Sheet Test.  This also, very broadly, correlates to what most valuators would regard as “fair value”, a term which is alluded to in the Balance Sheet Test.  On a going-concern basis, there are assets of value that might not be considered in a liquidation, and in fact, do not readily come to mind as they often do not appear on an entity’s balance sheet, such as:

  • Customer and supplier relationships: These relationships, particularly if cemented by contracts, can be of value.   The ability to acquire raw materials, for instance, at prices below current market prices, is valuable;
  • An assembled workforce: Most businesses have workforces that are not easily replaced, at least not without a decrease in productivity for a number of months, as the new workforce must be trained and advance along a learning curve;
  • Leasehold interests: The ability to occupy space at a rate that is below current market rates may be an asset of value;
  • Goodwill: It is often wrongly believed that an insolvent business has no goodwill (after all, it is likely unprofitable).  However, I return to the example of a business that is simply overburdened by debt, but is profitable at an operating level.  Or, a particular business segment of the entity might be profitable (which profitability is obscured by the results of unprofitable segments).

Liquidation more commonly results in assets being sold piecemeal, to different buyers, and with some urgency.  There is typically a loss of some of the value components listed above, as the interests might have delivered value for the present owner on a going-concern basis, but may not be transferrable in a liquidation (for instance, lease contracts, supplier contracts and customer contracts, may not be transferrable, and workforces are not a saleable item at all).  There is also a loss of goodwill, as goodwill “evaporates” when the component pieces of a business are disseminated.  Liquidation values applied within the Balance Sheet Test are, I would suggest, only relevant if liquidation of the entity represents the highest and best use of its assets.

Consideration must also be given to the measure of liabilities applied in the Balance Sheet Test.  Here, too, are a number of complexities:

  • While a starting point in measuring liabilities is certainly the entity’s financial statements, it should be borne in mind that not all liabilities appear on a financial statement. Financial statements are generally prepared assuming a going-concern.  Many liabilities that exist and will be satisfied through future earnings of a going-concern business do not appear on the balance sheet.  For instance, employee severance and termination pay liabilities are rarely reflected.  That is because a going-concern entity rarely sees itself terminating a material number of its employees, and the terminations that may occur in the normal course of business can usually be satisfied by providing the employee notice in lieu of cash.  This same reasoning may make it most reasonable to not consider these liabilities in performing the Balance Sheet Test, if the business unit is otherwise viable. The same may be said of some pension obligations.
  • Similarly, if circumstances dictate that the Balance Sheet Test should be prepared on a liquidation basis, consistent with that scenario, a number of contracts will likely be terminated, giving rise to claims (such as claims for damages) which should likely be considered. For instance, terminating agreements for long term supply of goods to customers may give rise to claims from those customers, if they cannot replace supply with alternate suppliers at the same price.  Agreements for forward purchases of supplies can give rise to damages claims from suppliers who cannot find alternate buyers for goods on hand that had been destined for the terminated business.  Another example is franchisors, whose franchisees will be unserviced once the franchisor terminates business.

All of these are reasons why claims in bankruptcy often surpass the stated balance of liabilities on a business’s balance sheet.

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This article has focussed on how to establish whether a business is insolvent or not.  Next, I will turn attention to what the repercussions are, particularly for creditors of those insolvent entities, including avenues to enhance recoveries.

[1] The BIA defines “person” to include corporations, with a few exceptions—banks, for instance, are specifically excluded.