What is the test for insolvency? Is there any obligation on directors or officers of the debtor to open insolvency procedures upon the debtor becoming distressed or insolvent? Are there any consequences for failure to do so?
Restructuring & Insolvency
The existence of a non-reversible state of insolvency (i.e. a debtor’s inability to regularly fulfill its obligations as they fall due) is a requirement for insolvency proceedings.
When a company is in the vicinity of insolvency with no reasonable chances to continue as a going concern, its directors are under the obligations to: (i) take appropriate actions to monitor the financial situation and minimize potential losses to creditors, (ii) file for insolvency proceedings if no other solution is viable, or (iii) attempt a good faith effort to rescue the business or achieve an out-of-court composition with the creditors (or with some of them) using, as much as possible, the new instruments recently introduced by the Italian Bankruptcy Law (IBL) (see answer to Question 7). Should these obligations fail to be timely fulfilled and the distressed company be declared bankrupt, the directors of the companies subsequently found to be or to have become insolvent are liable for such losses as may be suffered by creditors as a result of the unnecessary delay in the commencement of insolvency proceedings, without the possibility of relying on the honest business judgment defense.
Additionally, should the debtor delay the filing of a petition for bankruptcy, its directors may incur criminal liability where such delay has worsened the debtor’s distress. The criminal consequences for directors are more severe if the debtor has undertaken seriously incautious transactions with the purpose of delaying the declaration of bankruptcy or made preferential payments and/or created securities in favour of a particular creditor to the detriment of the others.
Insolvency can be defined as the situation in which a company or a natural person cannot meet its payable obligations consistently and on time. At that moment, the two-month period to file for voluntary insolvency begins.
As provided under article 5 of the Spanish Insolvency Act 22/2003 (the “Spanish Insolvency Act”), directors should file for insolvency with the competent commercial court within two months of when they became aware, or should have become aware, of the company’s state of insolvency. There is an exception to this rule, which consists of filing, within the two-month period, a so-called “5 bis notice” with the same competent commercial court, claiming that the directors are negotiating with the creditors to reach an out-of-court refinancing agreement or obtain their support to file a pre-pack or advanced composition agreement. The filing of the 5 bis notice extends by four months the deadline for filing for insolvency.
If the petition is filed once the two-month period has elapsed and it is proved that the delay in filing for insolvency has exacerbated the debtor’s situation, the directors (and even other affected persons) could be penalized under the Spanish Insolvency Act and be obliged to compensate for damages.
A petition for commencement of bankruptcy proceedings may be filed by a debtor, a director of a debtor company or a creditor in the following circumstances:
- where the debtor is characterised as being ‘unable to pay its debts’ – that is, where a debtor is generally and continuously unable to pay its debts as they become due; or
- in cases where the debtor is a company, where the debtor is characterised as ‘insolvent’ – that is, where the debtor’s debts exceed its assets.
The court must order commencement of the proceedings if it is satisfied that one of the above circumstances (as applicable) exists.
There is no specific statute providing obligations on directors or officers of the debtor to open insolvency procedures. Directors and officers, however, owe general duties of care and loyalty to the company. It is theoretically possible that failure to open insolvency procedures may be a violation of such duties. In such situations, directors and officers are liable for damages of the company, creditors and shareholders.
Under Danish law, the test for insolvency for the debtor’s insolvency is whether the debtor is able to fulfill its obligation as they fall due. If the debtor cannot do this, it is assumed that the debtor is insolvent, unless the inability to pay is temporary.
Individuals are not obliged to file their own petition.
Under Danish law, the management of a distressed company (the debtor) is not obliged to file a petition in bankruptcy. Under the Danish Companies Act the management of a company must ensure that the debtor’s capital reserves are sufficient at any time so that the debtor is able to fulfill its present and future obligations as they fall due.
As a starting point, the management of a company does not incur liability if insolvency proceedings are commenced against the debtor. However, the trustee or a third party may raise a claim for civil management liability or criminal management liability against the management if it is discovered that the management has carried out transactions in a manner that has contributed decisively to the debtor’s insolvency or if the operation has continued after the time at which the management could establish that further operation was to no avail.
The trustee may also institute disqualification proceedings against the management. If the management is disqualified, the management must not participate in the management of a limited liability company without being personally liable for the company’s obligations.
In Australia, the definition of insolvency is contained in section 95A of the Corporations Act which states,
- A company is solvent if, and only if, the company is able to pay all the company’s debts, as and when they become due and payable.
- A company which is not solvent is insolvent.
Case law in Australia has indicated that the focus of the insolvency test for companies approaching financial distress is the ‘cash flow’ position of the business rather than its balance sheet.
Company directors are burdened by a positive duty to prevent insolvent trading. This duty prevents directors from incurring any debt on behalf of the company if the company is insolvent or the director has reasonable grounds for suspecting that it is likely to become insolvent. Directors will be personally liable for any debts that are incurred thereafter in these circumstances.
To guard against the risk of an insolvent trading claim, directors are required to consider the solvency of the company regularly and to place the company into voluntary administration if, in their opinion, the company is, or is likely to become, insolvent.
A company may be wound up on the ground of insolvency if it is unable to pay its debts as they fall due (i.e. the cash flow insolvency test). A company will be deemed to be unable to pay its debts if:
- It fails to satisfy a statutory demand (provided that the debt claimed in the demand is not disputed by the debtor company in good faith and on substantial grounds);
- Execution of a judgment is returned wholly or partly unsatisfied; or
- It is proved to the satisfaction of the Court that the company is unable to pay its debts.
There is no statutory obligation on a company's directors to commence liquidation proceedings. However, in circumstances in which the company is insolvent or of doubtful solvency, the directors' duty to act in the best interests of the company requires them to have regard to the interests of its creditors. Directors may incur personal liability to the company for any losses which they cause to the company if they act in breach of that duty, for example, by causing the company to incur further obligations when they knew or should have known that there was no reasonable prospect of the company avoiding an insolvent liquidation.
Under Swiss law, the following terms must be distinguished:
- Illiquidity (Zahlungsunfähigkeit): A Swiss corporate is illiquid pursuant to Art. 191 of the Swiss Federal Act on Debt Enforcement and Bankruptcy (DEBA) if it is no longer in a position to pay its debts as and when they fall due. Hence, this test focuses on the solvency of the corporation.
- Over-indebtedness (Überschuldung): A Swiss corporate is over-indebted within the meaning of Art. 725 par. 2 (CO) if its assets are no longer sufficient to cover its liabilities. This test is balance sheet based. That said, over-indebtedness may result from illiquidity where, as a result, the going concern assumption is no longer sustainable and, thus, accounting will have to be made at liquidation values.
The highest executive body of a Swiss corporate is generally obliged to file for bankruptcy proceedings in case of over-indebtedness within the meaning of Art. 725 DEBA. Certain exceptions apply where a deep subordination exists (cf. section 5 below) or where a restructuring can be implemented without delay. The general assembly of a Swiss corporate may further resolve to apply for the liquidation of the Swiss corporate through a bankruptcy proceeding if the company is illiquid pursuant to Art. 191 DEBA but no general obligation to initiate such proceedings in case of illiquidity currently exists under Swiss corporate law. Furthermore, a creditor may directly apply for the opening of bankruptcy proceedings if the corporation has ceased to make payments pursuant to article 190 DEBA.
There is no specific trigger event for a debtor to request the opening of composition proceedings although (looming) illiquidity and/or over-indebtedness will often exist. In addition, both creditors entitled to request the opening of bankruptcy proceedings and the bankruptcy court may request the opening of composition instead of bankruptcy proceedings.
It is currently being proposed within the context of a general revision of Swiss corporate law to extend the duties of the highest executive bodies of a Swiss corporate in case of (looming) illiquidity. Such rules are not currently expected to enter into force before 2019. It is not proposed to make (looming) illiquidity an automatic trigger for insolvency proceedings.
Please refer to section 11 below for the consequences of a breach of obligations by the highest executive body of a Swiss corporate.
There are three independent tests for insolvency:
- Illiquidity (Zahlungsunfähigkeit) is the debtor's inability to meet its payment obligations as and when due. A debtor is generally assumed to be illiquid if he has ceased to make payments. Illiquidity cannot be presumed if there is only a temporary delay in payments. Only debt that is being seriously pursued by the creditor (ernstliches Einfordern) must be considered for the purposes of determining illiquidity.
- A company is overindebted (überschuldet) if its assets (on market value basis) no longer cover its liabilities, unless the continuation of the company’s business is predominantly likely, which requires sufficient funds to carry on its business within the present and the following business year. If this prognosis is negative, overindebtedness is determined solely on the basis of a special balance sheet (Überschuldungsstatus).
- Impending illiquidity (drohende Zahlungsunfähigkeit) which is defined as the debtor not being able to meet its payment obligations as and when they will become due in the future.
In case of illiquidity or overindebtedness, managing directors of limited liability companies, corporations and partnerships ultimately having limited liability must file for insolvency at the latest within three weeks. This three-week period, may only be fully used, if there is a well-founded expectation that within it illiquidity and overindebtedness can be cured. Managing directors who intentionally or negligently breach this duty face civil liability to the company and its creditors for any losses which these have incurred due to the delayed petition and criminal liability. These severe consequences are a serious threat for managing directors in distressed situations.
In case of impending illiquidity, management has a right, but not a duty, to file for insolvency.
As a general rule (the “Insolvency Standard”), a company may be declared insolvent (in “Concurso Mercantil”) when it has defaulted in its payment obligations to two or more creditors, and on the date of filing of the insolvency petition:
- its due obligations that have been delinquent for more than 30 days represent 35% or more of its total outstanding obligations; and/or
- it does not have sufficient liquid assets to pay for at least 80% of its obligations that are due and payable on such date (the “General Default”).
Once the company has defaulted in its payment obligations to two or more creditors, it may file a voluntary insolvency petition when only one of the conditions described in items (a) and (b) above has been satisfied. In contrast, creditors of the company or the attorney general’s office may also file an insolvency claim against the company, but only if it satisfies both such conditions.
There is no obligation on directors or officers of the debtor to open insolvency procedures upon the debtor becoming distressed or insolvent.
British Virgin Islands
A company is insolvent if—
- it fails to comply with the requirements of a statutory demand that has not been set aside,
- execution or other process issued on a judgment, decree, or order of a BVI court in favour of a creditor of the company is returned wholly or partly unsatisfied, or
(i) the value of the company’s liabilities exceed its assets, or
(ii) the company is unable to pay its debts as they fall due: see section 8(1) IA.
In the BVI, there is no express duty on the directors of a company to commence insolvency proceedings at any particular time; however, there is a substantial body of case law from a variety of common-law jurisdictions that suggests that in certain circumstances the directors’ duty to act in the best interests of the company as a whole (and not to any individual person or class of persons) will require them to take account of the interests of the company’s creditors rather than those of the company’s members. In such circumstances, the directors must take those interests into account when deciding how to act until such time as solvency is restored, the company’s debts are restructured, or the company goes into liquidation. In some cases, therefore, acting in the best interests of the company will mean recommending that the members put the company into liquidation or causing the company to apply for the appointment of a liquidator (if the power exists).
In addition, if a company goes into insolvent liquidation and the court is satisfied that a director ‘at any time before the commencement of the liquidation of the company, knew or ought to have concluded that there was no reasonable prospect that the company could avoid going into liquidation’, then it can order any director to make such contribution to the assets of the company as it considers proper: section 256 IA.
The court cannot make an order against a director if it is satisfied that the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, but that the director ‘took every step reasonably open to him to minimise the loss to the company’s creditors’.
Any contribution that the court orders will be compensatory rather than penal, and the money recovered will be pooled with the general assets of the company for distribution by the liquidator. The court has broad powers to order such person to repay, restore or account for the money or assets, or pay compensation for such misfeasance.
A company will be insolvent if it is “unable to pay its debts” (section 161(e) Companies Act 1981). There are two tests for insolvency: the cash flow test and the balance sheet test (section 162(c) Companies Act 1981; In the matter of LAEP Investment Ltd  Bda LR 35). In making a determination of insolvency, the concept of liabilities is extended and will include contingent liabilities.
In the event that there may be some doubt as to whether or not a company is insolvent, or if proving insolvency may be difficult or costly, a creditor may issue a statutory demand for payment. If the demand has not been satisfied or set aside within 21 days, the company will be deemed to be insolvent.
Directors are not required to file liquidation proceedings where a company becomes insolvent. However, if they do not, they risk personal liability for breach of fiduciary duties, fraudulent trading and/or misfeasance.