February 01, 2017

What Is Insolvency?

David J. Cook

From David J. Cook, Insolvency Explained, Introduction (2017), at 1-6. © 2017 American Bar Association. Reprinted with permission.

 

Insolvency is a general term for any legal proceeding or business arrangement that enables a failed or troubled business to seek to liquidate its assets, pay its creditors, and terminate or reorganize its business operation. A legal proceeding establishes a court appointed trustee, or even a debtor in possession, who has a brand new set of legal rights and powers that can vacate or nullify state court judgments; void key contract provisions; stay enforcement of valid liens, levies, and judgments; and claw back valid liens and payments. A “legal proceeding” means a statutory (or common law) legal process established by the Congress (i.e., the bankruptcy code) or the state legislatures (probates; receiverships; and, in some states, assignments). A business arrangement is an agreement to sell or dispose of assets and pay creditors (bulk sales; workouts; arrangements; and, in some states, assignments). A business arrangement is called an insolvency process, as opposed to an insolvency proceeding, which is established by law.

The new entrants, which are established by law, are the lien creditors, and they include the bankruptcy trustee, assignee for the benefit of creditors, and equity receivers, who take priority over unsecured creditors, unperfected secured creditors, and tardily filed secured creditors. For example, a bankruptcy trustee enjoys vast statutory rights, including the “strong arm statutes” that dispossess lawful titles to assets held by others [Bankruptcy Code Section 544].

The term insolvency can be defined in several ways:

  • Insolvency means that the business is unable to pay its liabilities as they accrue. This is called the equitable definition of insolvency, and it creates a presumption of insolvency. The debtor might well agree to pay the liabilities through a long term payment program.
  • Insolvency means that the liabilities exceed the asset of the business. This is called the legal definition of insolvency. This is also called a “balance sheet test,” but in practice the assets are valued at their fair market value and not at their “book value.”
  • Insolvency means that the debtor stopped functioning as an ongoing business; shut the doors; sent the employees home; and faces lawsuits, liens, and levies. This is a commonly understood definition of insolvency. Under these conditions, the debtor’s assets might exceed its liabilities; nonetheless, the debtor is sinking into a financial sinkhole. This also includes a debtor facing a large judgment that might require the debtor to liquidate its assets to pay off the judgment.
  • Insolvency means that the debtor liquidates its assets, which makes a pool of funds available for creditors. In some, or many, cases, the liabilities clearly exceed the assets. This could be a pot plan. Expect far more debt than money. Expect pennies on the dollar. Expect a default.
  • Insolvency also might mean that the debtor is cash poor but land rich. The debtor lacks the ability to pay its obligations in some lump sum, but could pay the liability when and if an asset is sold. Some cases might hold that a debtor whose assets exceed liabilities is not insolvent, but if the debtor is unable (or unwilling) to pay its current and past liabilities, the debtor is insolvent under the equitable definition. Insolvency means a lack of liquidity, not necessarily an excess of liabilities over debts.

The shortest summary is that the debtor is now dead broke. The debtor cannot pay its creditors. Insolvency instills legal rights and claims in favor of trustee, assignee, receiver, or estate representative, a proceeding that obligates the creditors to timely claims.

The label of insolvency invokes some very serious consequences, as follows:

A. Any transfer by an insolvent of its property for less than fair and equivalent consideration is a fraudulent conveyance, which entitles the creditors of the debtor to recover the assets. The insolvency status of a debtor, in the face of any transfer, is a badge of fraud.

B. Under any commercial loan agreement, being declared insolvent, or insolvent based on a financial statement, constitutes ground to declare the loan due and accelerate all remaining installments. Most major loan agreements compel the debtor to notify the creditor of any change in its financial condition, or grant digital access to its financial records under its noneconomic loan covenants. Many loan agreements pre-define solvency, including inventory receivable and cash ratios, retention of key employees, sales minimums, cash minimums, and payable of ordinary trade debt.

C. Many vendor, supply, government and other major contracts (leases, etc.) require that a party remain in good financial condition (i.e., “solvent”). The fact that the debtor is insolvent might enable the other party to terminate the contract or at least suspend performance.

D. The insolvent nature of the debtor raises concerns about whether the debtor can or will pay payroll, employee taxes due the IRS and the state, franchise taxes (state income taxes), sales tax, and property taxes. Insolvency frightens away key employees, vendors, and management. In a digital world, word of insolvency might go viral.

E. Insolvency is a touchstone in Article 2 of the Uniform Commercial Code (UCC). A vendor might reclaim products sold to an insolvent, assuming timely notice; this can perhaps go back 90 days under UCC Code Section 2702. This is called a claw-back. If a debtor is insolvent, the vendor might demand assurance of payment before proceeding with continuing assets. This is called a demand for adequate assurance under UCC Code Section 2609(1). The fact that a debtor is insolvent might enable the creditor to halt further credit sales (or any sale) based on a reasonable insecurity clause. (See Commercial Code Section 2609(2): “Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.”)

F.  Any public entity must report material changes in its financial condition to the SEC, which includes any material adverse change in its financial conditions. Classically, these statements are reflected in an announcement that invokes “substantial doubts about the [debtor’s] ability to continue as a going concern” (Public Accounting Oversight Board, AU 341.12). This language—of the “substantial doubts” variety—has entered the American lexicon of public discourse euphemisms next to “retired suddenly to spend more time with family,” “suspending operations pending a strategic revamping,” or “taking steps to reinvent itself in a new market.”

 

Which Type of Insolvency?

Insolvency cases fall into three easy categories.

Judicially Supervised Proceedings

These include:

  • bankruptcies (all Chapters)
  • receiverships
  • probates and conservatorships (includes trust administration)
  • judicially supervised ordered liquidations (depending upon the state assignments, but not all states)
  • judicially supervised corporate, LLC, or partnership dissolutions
  • restitution claims arising from criminal proceedings or civil forfeiture proceedings
  • excess proceeds arising from personal or real property foreclosures deposited into court (real and personal property)
  • disputed bulk sales of business that land in court in a dispute over the claim, proceeds, or management of the sale
  • some class action cases that offer creditors “pennies on the dollar” for their claims.

These also include mass tort and bankruptcy hybrid funds for asbestos, Dalkon Shield, silicone breast implant, and other large scale tort cases bearing a close similarity to insolvency cases. These cases might offer a fixed pool of money (funds at hand and funds generated over time) to a large group of claimants. While these proceedings are outside the normal parameters of an insolvency (i.e., a failing business), these proceedings bear some of the earmarks of one, which consist of a large group of creditors, a multi-million (or even billion-) dollar creditor class, and a limited distribution. This paradigm describes tobacco and other mass tort trust funds, which the debtor (i.e., the tortfeasor) funds with insurance policies, stock of the revested debtor, or future revenues.

Non-Judicially Supervised Proceedings

These typically include:

  • bulk sales and sales of liquor licenses.
  • excess proceedings from the foreclosure of personal or real property when the secured creditor has been paid in full, but the foreclosure process generates cash above the secured debt, which enables junior secured claimants to seek payment of their claims. The agent for the foreclosing party cannot sort out the competing claim; the agent (i.e., a stakeholder) will file an interpleader action and deposit funds in court.
  • assignments for the benefit of creditors, extensions, compromises, pot plans, or earn-out plans administered by third party creditor associations, such as the National Association of Credit Managers, Credit Managers Associations, trustees, assignees or other creditor bodies, or attorneys for the debtor.
  • funds held by insurance companies or third parties to compensate for a mass tort or loss (9-11 Fund, the BP Gulf Settlement, other Kenneth Feinberg funds and similar arrangements). These third party funds are established by the government or private parties, and they offer limited compensation to victims of mass torts or disaster.

Administrative Insolvencies

These include:

  • an insurance, bank, credit union, or other regulated entity whose dissolution is overseen by a regulatory entity, such as the FDIC or a state insurance commissioner. (This could cover just about any regulated entity.)
  • bond and deposits mandated by federal or state law and made available to claimants. (The most common are bonds for contractors.)
  • client security funds for payment of claims asserted by clients who claim embezzlement at the hands of an attorney, crime funds, department of real estate funds, department of industrial relations funds that provide compensation to employees whose employers declined to offer worker’s compensation insurance, and similar funds that compensate victims when the third parties lack insurance.

State and federal law offer these funds, whether financed by industry, the state or federal treasury, liquidation of assets, or other sources. The most common is the FDIC. The government oversees these funds, might receive and adjudicate the claims, and distributes a limited recovery to the claimants. The state government department of real estate offers a “real estate recovery fund” to compensate the parties who have been swindled by a real estate broker (or agent). All states have a state bar client security fund that compensates clients who have suffered financial losses arising from attorneys misappropriating or embezzling funds.

Regulated entities (i.e., banks, thrifts, credit unions, insurance companies, stock brokers, among many others) when insolvent come under the jurisdiction of the regulatory entity who might liquidate the regulated entity and pay creditors—or move for the appointment of a receiver who would undertake the same function.

The absolute imperative is that the claimants must timely file and document their claims with the claims administrator and moreover be very watchful for correspondence, including a claim objection, originating from the claim administrator.

These proceedings might be judicial, non-judicial, or administrative, but all bear earmarks of insolvency. These proceedings—no matter their origin or title—marshal, recover, and liquidate the assets of a failed business. The administrative, secured, and priority claimants are paid first, and the balance is paid pro rata to the claimants. Depending upon the fund, the state, and the proceedings, the funds might offer a maximum amount per claimant, no matter the amount of the loss.

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David J. Cook

David J. Cook of Cook Collection Attorneys PLC has been practicing in the area of enforcement of judgments and collection of debts for nearly 40 years. He is the author of The Debt Collector’s Handbook, published by the Division.