Establishing Corporate Insolvency: The Balance Sheet Insolvency Test

By Dr. Kubi Udofia

Cash flow and balance sheet insolvency tests are the two predominant means of determining insolvency. A company is cash flow or commercially insolvent if it is unable to pay its debts as they fall due. Balance sheet or technical insolvency occurs where the value of a company’s assets is less than the amount of its liabilities, taking into account both contingent and prospective liabilities. The term liabilities is broader than debts as it encompasses liquidated and unliquidated liabilities arising from contracts, tort, restitution etc. This article compares the two insolvency tests and introduces the English approach to the balance sheet insolvency test.

Commercial insolvency is the more prominent of the tests. It is also comparatively easier to establish. In restructuring, a creditor’s immediate concern is often the debtor’s ability to make payments as they mature as opposed to whether its assets are sufficient to meet its present and future liabilities. Despite its seeming obscurity, balance sheet insolvency test is commonly employed in commercial transactions as an event of default. This provides counterparties with early warning signs in long-term contracts where there are no avenues of making demands capable of triggering commercial insolvency.

In BNY Corporate Trustees Services Ltd v Eurosail-UK 2007-3BL Plc [2013] UKSC 28, the English Supreme Court stated that balance sheet insolvency test required a court to be satisfied that, on the balance of probabilities, a company has insufficient assets to meet its liabilities, taking into account prospective and contingent liabilities. This is easier said than done. It has been rightly observed that valuation of assets and liabilities is not an exact science but a matter of judgment as to the amount a willing buyer would pay in the market when dealing with a willing seller. The valuation process may understandably be laborious, detailed and complex. Courts may not be capable of effectively dealing with such intricacies.

The full article is available here.

Simple Insolvency Detection for Publicly Traded Firms

By J.B. Heaton (J.B. Heaton, P.C.)

Solvency plays important substantial roles in both bankruptcy and corporate law. In practice, however, balance-sheet solvency testing is fraught with difficulties. Mechanically, the balance-sheet solvency test asks if the market value of assets exceeds the face value of debt.  As for assets, direct market values of assets are rarely if ever available (closed-end funds may be an exception, but these are hardly run-of-the-mill businesses). Analytical valuation tools—including discounted cash flow analysis, comparable company multiples, and comparable transaction analysis—require considerable subjective judgment and can lead to large valuation errors. As for debt, much debt that is on the balance sheet does not trade in the market, and it is often impossible even to identify all the contingent liabilities like pensions, guarantees, insurance liabilities, and obligations to involuntary creditors like tort claimants, all of which should be valued appropriately and included in determining the total face value of debt.

In a new paper forthcoming in Business Lawyer, I develop a simple balance-sheet solvency test for publicly traded firms. I derive the test from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation: The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The test requires that at least one class of the firm’s debt is traded, and that the equity is traded as well. The result is a generated upper bound on the total amount of debt the firm can have and still be solvent.

The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. This may assist in a wide variety of situations where it is necessary to analyze solvency.

The full article is available here.