Insolvency and bankruptcy
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Negotiation Anatomy™
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Insolvency
ɪnˈsɒlvᵊnsi (n.)
A credit officer’s blackest fear.
- (Cashflow ~): That one cannot pay one’s bills when due.
- (Balancesheet ~): That one owes more than one has.
The statutory definition of insolvency for UK persons appears in Section 123 of the Insolvency Act 1986. It includes cashflow insolvency (Section 123(1)(e)) and balance sheet insolvency (Section 123(2)).
Insolvency generally
Broadly, being insolvent means you are no longer a viable business. Your creditors are entitled to apply to the court for the appointment of an administrator whereupon you move from the nebulous financial state of insolvency to the hard-edged legal state of bankruptcy. The administrator will liquidate your assets, determine your liabilities, and distribute the proceeds of that liquidation to your creditors pro rata. After that, the game is up and you no longer exist.
There are all sorts of special regimes and intermediate statuses in different jurisdictions (such as America’s famous Chapter 11 which are designed to help a struggling company reorganise itself and get out of insolvency without going to the wall - and banks and financial institutions generally will be subject to bank resolution and recovery regimes which make the winding-up process a little bit more complicated.
Termination upon insolvency
Credit officers will hotly deny this, but when it comes to closing out a master trading agreement there are two main triggers: failure to pay and bankruptcy/insolvency. They also tend to be the most lightly negotiated — it’s hard to argue that your counterparty shouldn’t be allowed to pull its trigger if you are insolvent.
Still, there are some nuances to what counts as insolvency. It may differ for different entity types: banks and insurers, in particular, having special local administrative regimes or recovery and resolution frameworks which ameliorate the hard lines between solvency and oblivion. So expect a little jiggery-pokery around the edges in defining what counts as an “insolvency event”. But it is not contentious stuff; just detail.
Where these suspension rights stop you quickly closing out and netting your exposures they might mean your netting analysis fails altogether. This gives you real-world, present time problems, since you must hold capital against the gross exposure under the contract.
Difference between insolvency and bankruptcy
The question oft arises what is the difference — even, is there one? — between insolvency and bankruptcy. “Insolvency” is an oddly nebulous financial state: essentially, that one cannot meet one’s debts as they fall due (cashflow insolvency), or that one’s liabilities exceed one’s assets (balance-sheet insolvency); while “bankruptcy” is a more determinate legal state: definitive formal steps have been taken to put a legal entity into administration, or to wind it up, usually on account of its insolvency.
An insolvent entity may file for bankruptcy or its creditors may petition for it. But it need not. Technically, insolvent entities can limp around indefinitely without ever entering formal bankruptcy. GameStop was arguably insolvent for much of 2019, and look at that sweet unicorn now.
Insolvency is usually, but not necessarily,[3] a precondition for bankruptcy.
The water is further muddied because many finance contracts, and notably the ISDA Master Agreement, conflate the concepts of insolvency and bankruptcy. ISDA’s crack drafting squad™ defines “Bankruptcy” to include measures of formal legal bankruptcy,[4] and measures of financial insolvency[5] and some that are a bit of both.[6]
But, bottom line: insolvency is an accounting concept; bankruptcy a legal one.
Cashflow insolvency
Note well: the test is not that you have simply failed to make a debt payment, but that you couldn’t. Therefore a straightforward Failure to Pay or Deliver is not, of itself, evidence of cashflow insolvency: if you are as absent-minded about paying your bills as JC, you will miss due payments as a matter of habit.[7]
Being forgetful does not tip you over the edge — but remember your creditors have no insight into the reason you neglected to make your payment: they cannot see that you are flush, and do not, unless you tell them, know that the banking system was down; or that your accounts payable guy was sick. So you throw your fortune to the lap of the Gods if you do not sort out any late payments pronto. As ever, over-, rather than under-communication is the key.
Balance-sheet insolvency
Also known as “technical insolvency” or “accounting insolvency”, “Balance sheet insolvency”, like cashflow insolvency, is a variety of being “unable to pay one’s debts”, an expression which in turn features in many definitions of “insolvency”.
Compared with the carefully crafted prose of other limbs, this seems a dangerously vague expression. But it has a pretty technical meaning — conferred by statute, no less — Section 123(2) of the Insolvency Act 1986, which says a company will be deemed unable to pay its debts “if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities”. This is what we mean by balance sheet insolvency.
English courts have recently had an opportunity consider what this means, and have resourcefully concluded: “what it says”.
In BNY Corporate Trustees v Eurosail the Supreme Court noted that while this test this is often called “balance sheet insolvency” it can’t be satisfied purely by reference to the company's statutory balance sheet, because that may omit important information like contingent liabilities. Nor does it mean that the company has “reached the point of no return because of an incurable deficiency of assets”, which was what the Court of Appeal in this case had hypothesised.
The court decided that for “the value of the company’s assets to be less than the amount of its liabilities, taking into account its contingent and prospective liabilities” the court must be satisfied, on the balance of probabilities, that the company has insufficient assets to be able to meet all its liabilities including prospective and contingent liabilities (I know what you’re thinking by the way — the highest court in the land isn’t adding a whole lot of value at this point is it?) discounted for contingencies and deferment.
Whether that is satisfied depends on the particular circumstances, and the burden of proof will be on the party asserting insolvency.
See also
References
- ↑ This is cashflow insolvency
- ↑ This is “balance sheet insolvency”.
- ↑ Nothing’s easy, is it? It is not unheard of for a solvent entity to file for a “strategic bankruptcy”. But let us not get distracted.
- ↑ You really want to do this? Okay: True bankruptcy events: Section 5(a)(vii) limbs (1) (Dissolution), (4) (Institution of bankruptcy proceedings), (5) (Winding-up resolution), (6) (Appointment of administrator) and parts of (8) (Analogous events)
- ↑ Practical insolvency events: Section 5(a)(vii) limbs (2)(Cashflow insolvency and arguably balance sheet insolvency too) (3) (Composition with creditors)
- ↑ Hybrid events: Section 5(a)(vii)(7) (Enforcement of security)
- ↑ A shout out to the very patient and understanding people at A.E. Stanton, fine coffee merchants of North London, by the way.