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 (2nd Edition)
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.
If a debtor is unable to repay its debts as they become due, and its assets are insufficient for the settlement of all its debts or it is obviously insolvent, this provides a ground for the debtor to be bankrupted. Chinese law is silent on any obligation on the part of the management of a debtor to initiate a bankruptcy procedure, but the person/team who is responsible to handle liquidation of the debtor pursuant to law is obliged to apply to a court of competent jurisdiction for bankruptcy liquidation when there is a ground for the debtor to be bankrupted, or else the person/team will be held accountable for the loss incurred to the creditors.
In Australia, the definition of insolvency is set out 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 that 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 can be held personally liable for debts that are incurred thereafter in these circumstances.
The Insolvency Law Reform Act 2016 (Cth) (ILRA) and its related instruments (the provisions of which are either in their infancy or still being rolled out) introduced a new concept of a ‘safe harbour’ protection for directors who might otherwise be exposed to insolvent trading. The safe harbour protection could, in certain circumstances, enable a company to delay a formal insolvency process where it seeks to pursue a turnaround plan that has a ‘better outcome’ for the company. If such a plan is being developed, the company must ensure it meets the relevant criteria to enliven the protection, because as a matter of practice, if the turnaround plan is unsucessful and a formal insolvency follows, the safe harbour protection will only operate as a defence to an insolvent trading claim rather than a positive exception to liability.
The conditions for bankruptcy are (i) the debtor faces a durable cessation of payments and (ii) it is unable to obtain further credit (cumulative conditions). A durable cessation of payments exists when a debtor continuously is unable to repay its (some of its) debts as they fall due. If the debtor can still be redressed or still has access to sufficient credit, the debtor is not in a state of bankruptcy.
The directors of the debtor have a legal obligation to file for bankruptcy, within one month of the date on which the bankruptcy conditions are met. Failure to do so may lead to personal liability of the directors. In addition, criminal penalties may apply, if it was the director’s intention to postpone the bankruptcy.
A debtor who has ceased to pay may be declared bankrupt by a court order at his own application or at the request of one or more of his creditors. The basis for a bankruptcy adjudication is that the debtor has at least two creditors (one of them being the filing creditor, if the filing is involuntary) and that at least one of these two debts is currently due and payable. Dutch insolvency law does not have the concept of “balance sheet insolvency” as exists in other jurisdictions. The test instead is whether a debtor has ceased to pay.
Pursuant to the Dutch Bankruptcy Code a debtor who foresees that he will be unable to continue to pay his payable debts may apply for suspension of payments. Suspension of payments can also be requested by a debtor who foresees that he will not be able to pay off debts which will become payable in the future.
Dutch law does not contain a provision pursuant to which management of a debtor is obliged to file for insolvency. However, based on Dutch case law, management may be held liable if it continues the business and assumes new obligations on behalf of the debtor company knowing that the company will not be able to (timely) fulfil its obligations (and where there is insufficient recourse for creditors). More generally, a director may be held liable in case he continues the debtor company’s business while it is clear that such continuation serves no reasonable purpose anymore and only prejudices creditors’ possibilities to take recourse against the debtor company.
In the U.S., one of two insolvency tests is typically applied: (i) the equitable insolvency test, which is generally defined as the debtor’s inability to pay debts when due and (ii) the balance sheet insolvency test, which examines the balance sheet of the debtor to determine if the amount of the debtor’s liabilities exceeds the value of its assets. The United States, however, does not have an insolvency requirement; thus, a debtor need not be insolvent to commence proceedings.
The balance sheet test defines “insolvent” as a financial condition such that the sum of the debtor’s debts is greater than all of the debtor’s property at a fair valuation. Generally, the value of goods is assessed at “fair market value” and courts have adopted a rather flexible approach in analyzing a debtor’s insolvency. Courts tend to value companies that continue to operate day-to-day on a going concern basis. Under the equitable insolvency test (also referred to as the cash flow test), a debtor will be deemed insolvent if the company is unable to produce sufficient cash to pay debts as they become due. The cash may come from the disposition of assets, continuing operations, or other capital raises. Courts have not decidedly determined how far in the future the assessment should be made.
U.S. law does not impose an obligation on a company’s board to commence insolvency proceedings and provides the board with the latitude to pursue alternative strategies in good faith to maximize the value of the company. Generally, directors and officers of a company owe a fiduciary duty only to its shareholders, not to creditors. However, when a company is insolvent, some states’ laws expand the fiduciary duties of the directors and officers of a company to include creditors as well as shareholders. The State of Delaware, for example, has ruled that directors of a solvent debtor operating in the “zone of insolvency” must discharge their fiduciary duties to the corporation and its shareholders. Thus, only when the debtor actually becomes insolvent do such duties shift to creditors as well. Apart from having a fiduciary duty, so long as directors continue to operate the business in good faith, they cannot be held liable. Most courts adopt the view that creditors are sufficiently protected by virtue of the protections in their contractual arrangements and that additional protections are not necessary.
The French insolvency test is a pure cash flow test, defined as the debtor’s inability to pay its debts as they fall due with its immediately available assets (cessation des paiements), taking into account available credit lines and moratoria. Within 45 days from the insolvency date, the legal representative of the insolvent company is required to file for reorganization proceedings or liquidation proceedings.
In the event directors of the debtor knew of the insolvency and failed to file the appropriate proceeding within this required time period, they will be held personally liable in tort for an act of mismanagement (“faute de gestion”).
The substantive test for insolvency is where the commercial entity has both :
- ceased payments and is unable to meet its commitments (“cessation des paiements”), i.e., the company cannot, or does not, fully pay its due, certain and liquid debts as they fall due; and
- lost its creditworthiness (“ébranlement de credit”), i.e., the company is unable to obtain credit from any source.
If the court considers that these two criteria are met, it declares the company bankrupt and opens a bankruptcy procedure. Luxembourg law does not have the balance sheet or cash flow tests. The legal requirements of bankruptcy (i.e., the substantive test for insolvency) are assessed on the day of the declaratory judgement of bankruptcy.
The management of a company is required to file for bankruptcy (“faillite”) within one month from the date of cessation of payments. Otherwise, it could be held criminally and civilly liable.
The New Zealand Companies Act 1993 has two "solvency" tests concepts applied in different circumstances.
In the context of liquidation or voluntary administration the relevant question is whether the company "is able to pay its debts" when due. This is a cashflow solvency test having regard to a commercial assessment of overall liabilities measured against the resources available in order to meet those liabilities when due.
In the context of distributions to shareholders and amalgamations, there is a different "solvency test" which combines the same cashflow test as discussed above with a balance sheet test by reference to the value of assets being greater than the value of liabilities of the relevant entity.
Obligations and duties of directors
There are no circumstances in New Zealand which require a company or its directors to commence insolvency proceedings, nor is there any express prohibition on, or duty to avoid 'trading while insolvent'. However, there is a positive duty on directors in relation to reckless trading (as discussed further in Question 13 below), which can ‘force the hand’ of directors to place a company into voluntary administration or liquidation.
Directors owe their duties to the company to which they are appointed. Directors generally do not owe duties to creditors (or shareholders), and creditors and shareholders generally cannot take direct action against directors for a breach of duties. Remedy for a breach of duty by a director is to be sought by the company (or by a liquidator on behalf of the company under section 301 of the Companies Act 1993 as discussed below), or by a shareholder on behalf of the company (with the leave of the Court by a derivative action under section 165 of the Companies Act 1993.
Directors should, however, consider the interests of creditors when a company is or maybe operating in the ‘twilight zone’, namely, the time during which the company is or is nearing insolvency, as those interests are directly relevant to the interests of the company and are the subject of specific director's duties (as discussed in Question 13 below) regarding insolvent (reckless) trading and incurring obligations beyond a company's ability to perform. Not doing so does not, however, provide creditors with a directly enforceable right against directors for a breach of director’s duties or for the debt claimed by the creditor against the distressed company.
As discussed in the context of Question 13 below, post-liquidation of a New Zealand company, section 301 of the Companies Act 1993 can be invoked by a liquidator, a creditor or a shareholder of the company to bring actions against directors (and others) where, among other things, such directors (and/or others) have misapplied, retained, or become liable or accountable for money or property of the company, or been guilty of negligence, default, or breach of duty or trust in relation to the company. Many of the claims in New Zealand seeking redress for breaches of the relevant provisions relating to breach of director's duties in the twilight period prior to insolvency are brought by liquidators under section 301.
Any creditor having a certain, liquid and exigible receivable for more than 60 days and higher than Lei 40,000 may request the insolvency of a company. If these conditions are met, the law does not provide for other restrictions also in what regards the capacity of the creditor that may request the opening of a procedure of insolvency of a company. In the same situation the debtor also may request its own insolvency, and the directors must request the opening of an insolvency procedure in a term of maximum 6 months from the date when payments cease, and the sanction may be even a criminal one, the failure to declare the insolvency in the legal term being possible to be considered, in certain condition, the crime of simple bankruptcy. There is, of course, also the risk of a civil liability for the failure to fulfil this obligation.
Under Swiss law, the following terms must be distinguished:
- Illiquidity (Zahlungsunfähigkeit): A Swiss corporate debtor 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 debtor is over-indebted within the meaning of Art. 725 para. 2 of the Swiss Code of Obligations (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 debtor is generally obliged to file for bankruptcy proceedings in case of over-indebtedness within the meaning of Art. 725 CO. 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 debtor may further resolve to apply for the liquidation of the Swiss corporation 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 Art. 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 corporation in case of (looming) illiquidity. Such rules are not currently expected to enter into force before 2020. It is not proposed to make (looming) illiquidity an automatic trigger for insolvency proceedings.
Please refer to question 14 below for the consequences of a breach of obligations by the highest executive body of a Swiss corporation.
The Israeli case law recognizes two types of insolvency tests, and did not explicitly chose one over the other:
(a) The balance test – where the total obligations of a creditor exceeds the value of its assets.
(b) The cash flow test – examines the debtor ability to repay its obligation when becomes due and payable.
There is no explicit current legal provisions requiring directors and officers to open insolvency proceedings, however such obligations may be derived from case law and practice, under which in distressed circumstances the officers of the company are required to act in favor of the company creditors, and to take all precautionary measures for such purpose.
The new Insolvency Law adopts both tests for insolvency and set forth some factual presumptions of insolvency.
The new Insolvency Law imposes specific liability on directors and officer that knew or should have known that the company is insolvent and did not took reasonable measures to reduce its scope. A presumption of taking reasonable measures exists where such directors and officers acted in order get consultation from insolvency experts, negotiated a debt arrangement with the company creditors or commencing insolvency proceedings.