Michael Goldman & Associates, L.L.C. - Consulting
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Goldman's Critical Support - Winter 2002Solvent or Insolvent – That is the QuestionSolvency
is always a primary issue for the owner or chief financial officer of an
on-going business. But it is a concern that goes well beyond the bean counters.
It can also have a major impact on acquisitions, divestitures, payments to
shareholders, reorganizations, tax filings, and other financial transactions., A
company’s selling shareholders, lenders, managers, or directors can
potentially face liability for entering into a transaction that renders the
company insolvent or occurs during a condition of insolvency, whether or not it
enters bankruptcy. Transactions made while a company is insolvent can be voided
in court. On
a more positive note, companies that are insolvent are generally permitted to
have debts cancelled without incurring taxes on cancellation of debt income. While
articles in this newsletter generally deal with methods of keeping businesses
solvent, this article will focus more on determining whether a business is or is
not solvent, and some of the implications of insolvency. Definitions
of solvency It
is possible for a debtor to be legally solvent from a balance sheet perspective,
but unable to pay its bills – most assets are in the form of machinery,
equipment, real estate, or other illiquid forms. Intangible property such as
trade names, patents, and property rights can be included in the fair value of
assets used for a solvency test, even though these are not easily converted to
cash for use in paying bills. It is also possible for a debtor to be legally
insolvent (liabilities exceed the fair value of the assets), but currently
paying its debts as they mature. Note that as long as debts are being paid,
there is little likelihood of creditor action against the insolvent debtor, and
creditors are probably not even aware of the insolvency. Some
definitions of solvency are clear-cut, while others depend on valuation
concepts. An example of the former is the Uniform Commercial Code, which defines
an insolvent debtor as one who either has ceased to pay his debts as they become
due or is insolvent within the meaning of the Federal Bankruptcy Code.
An example of the latter is the Bankruptcy Code, which states,
“Insolvent means … financial conditions such that the sum of … [the]
entity’s debts is greater than all of such entity’s property, at a fair
valuation…”. Similarly, the Uniform Fraudulent Conveyance and Transfer
Act defines insolvency as occurring when the present fair salable value of
the debtor’s property is less than the amount required to pay its debts. As
you can see, the latter two definitions hinge on issues of value and valuation. The
fair value of an asset is usually determined based on a market approach and/or
an income approach. The income approach involves discounting the future cash
flows from the assets at a risk-appropriate discount rate. If
using a market approach, the valuator must determine what the assets could be
sold for to a ready and willing buyer. That is a different standard from either
(a) a forced liquidation sale, which assumes transaction costs, substantial
discounting for third-party risk and a profit margin for the buyer; or (b) what
could be obtained in the ordinary course of business if the debtor were allowed
to take what ever time was necessary to sell the assets at their customary
prices and profit margins. As
in all valuation matters, selection of the basis of valuation depends on the
circumstances and assumed financial condition of the company. Other
issues that the valuator of a troubled company needs to be prepared for include:
Fraudulent
conveyance Solvency
analysis is usually done in fraudulent conveyance actions. According to the
Bankruptcy Code, a transfer may be considered a fraudulent conveyance and voided
if the debtor
For
a company to be deemed to have unreasonably small capital, it is not necessary
to show that it is or will be unable to pay debts as they mature. The concept of
unreasonably small capital tests whether a company is likely to become insolvent
at some future time based on likely business conditions. There
are three tests for solvency: the
balance sheet test, the adequate capital test, and the cash flow test. A debtor
must pass all three tests to be considered solvent. The three tests provide a
legal standard that if not met could lead to the reversal of a transaction that,
due to the company’s insolvency, is considered a fraudulent conveyance.
Courts have significant power in these matters -- a successful fraudulent
conveyance challenge can void a new lender’s rights to enforce obligations on
loans incurred by the debtor, or the rights of selling stockholders of the
company to retain the proceeds received by them in a leveraged sales
transaction. Balance
Sheet Test Cash
Flow Test The
cash flow test determines whether a company incurred debts that were beyond its
ability to pay as the debts matured. To do this, you must analyze the business
based on a series of projections of future financial performance that are
created by varying some key assumptions about operating characteristics of the
business. Consider past
performance, current economic conditions, and future prospects. Prepare likely
cash flow schedules and determine if obligations can be met from operations.
Good cash projections should consider cash on hand, borrowing ability, and a
sensitivity analysis of operating results that models various scenarios such as
management’s expectations, a no-growth and no-change scenario, lower than
expected sales growth, and continuation of most recent trends. Adequate
Capital Test The
adequate capital test is intended to determine whether a company is likely to
survive after the transaction in question, assuming reasonable business
fluctuations in the future. Even if the value at which the assets were
transferred was adequate and the company was not insolvent at the time of the
transaction, bankruptcy could result from the transaction. The issue is whether
there was sufficient capital on a post-transaction basis to reasonably expect
that the company could survive in the normal course of business. This analysis
must consider cash flows, asset values and volatility, expected growth in
assets, timing of debt repayments, amount of debt, loan covenants, the
company’s borrowing base, and the sensitivity to various assumptions. Probability
of bankruptcy Therefore,
the probability of bankruptcy could depend in large part on creditors’
tolerance and their perceptions of management, and the willingness and ability
of customers to help out. These in
turn are often determined by the company’s position in the marketplace, the
goodwill that it has earned, and general perceptions about the company’s
prospects. It
is important to distinguish perceptions about the value of the business (used
for the balance sheet test) from perceptions about the probability of bankruptcy
(reasonable capital test). However, in order to estimate the probability of
bankruptcy, it is necessary to have opinions regarding the company’s value. Be
aware that perceptions of both value and probabilities of bankruptcy are subject
to rapid and drastic changes, especially in “new age” companies such as
Enron, CMGI, and Exodus, where billions of dollars of “value” were wiped out
almost overnight. Proper
analysis of solvency issues requires one to:
It
is incumbent on potential lenders, sellers, and creditors, as well as a
company’s managers and directors, to be aware of solvency issues and to act
accordingly.
© Michael Goldman 2002 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.
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