Insolvency (Corporate)

by Felix Steffek

1. Principles

a) Topic, terminology and economic context

At the heart of corporate insolvency are the grounds for opening insolvency proceedings in relation to limited liability companies. In Europe, the insolvency grounds for companies, in which no natural person is liable for the debts of the company, are essentially cash flow insolvency, balance sheet insolvency and imminent cash flow insolvency. Cash flow and balance sheet insolvency were already known under classical Roman law. There, balance sheet insolvency was a ground for opening insolvency proceedings over separate estates with limited liability such as separate funds of a slave or a child (peculium) or an inherited estate (hereditas). Under classical Roman law, cash flow insolvency had a social component and was connected with a loss of honour (infamia).

A company is cash flow insolvent if it is unable to pay its debts as they fall due. Economically, cash flow insolvency is about illiquidity which is determined on the one hand by monetary claims against the company and on the other hand by the company’s ability to pay. On a time scale, one can differentiate whether a company is unable to pay at the relevant time of assessment or whether it will be unable to pay in the future. Accordingly, actual and imminent cash flow insolvency are distinguished.

A company is balance sheet insolvent if the value of the company’s assets is less than the amount of its liabilities. In principle, on the liabilities side all debts are taken into account irrespective of whether they are contingent or prospective. On the assets side all assets are added which may be utilized to satisfy creditors’ claims.

Balance sheet insolvency is determined rather statically while cash flow insolvency has more of a dynamic character due to the relevance of the due date over time. However, if one takes into account that a company’s cash flow is relevant both for its assets and for its liabilities, the indirect connection between balance sheet and cash flow insolvency becomes apparent. Certainly, both insolvency grounds can be determined separately. Not every company that is balance sheet insolvent is necessarily unable to pay its debts as they fall due and vice versa. Since a company that is not balance sheet insolvent will generally be able to lend against its free assets in an efficient credit market, on a time scale usually balance sheet insolvency will set in before cash flow insolvency.

b) Purpose and functions

Insolvency grounds as such only have a purpose or a function insofar as they define different financial conditions concerning liquidity and the potential to pay debts, respectively. For example, the insolvency grounds of imminent cash flow insolvency (drohende Zahlungsunfähigkeit, § 18 German Insolvenzordnung) and of likely inability to pay debts (para 11 sch B1 English Insolvency Act 1986) were introduced in order to define a financial status that is more favourable than balance sheet and cash flow insolvency and to allow companies an early initiation of insolvency proceedings in their own rescue interest.

Apart from that, purposes and functions of insolvency grounds only unfold in connection with the rules that refer to them. For instance, the purpose and function of insolvency grounds as an essential condition for the opening of insolvency proceedings is the triggering of a creditor-oriented corporate governance. As such, insolvency grounds determine the point in time at which the imbalance between liability and decision rights becomes intolerable because the entrepreneurial risk is shifted to the creditors (insolvency grounds as termination rules).

Besides, there are numerous other types of rules referring to the insolvency grounds with other purposes and functions than triggering insolvency proceedings. Among them are liability rules like the liability for wrongful trading (s 214 English Insolvency Act 1986), the responsabilité pour insuffisance d’actif (Art L 651-2 French Code de commerce) and the Insolvenzverschleppungshaftung (§ 69 Austrian Insolvenzordnung in connection with § 1311 Austrian Allgemeines Bürgerliches Gesetzbuch). On the one hand, these liability rules preventively—ie ex ante—aim to avoid wrongful trading to the detriment of creditors by threatening to hold directors liable. On the other hand, these rules compensatorily—ie ex post—force directors who are responsible for the delayed opening of insolvency proceedings to contribute funds in the interest of creditor payment. Further examples are rules allowing to challenge transactions prior to the opening of insolvency proceedings (in Poland according to Arts 127 ff Prawo Upadłościowe i Naprawcze) and rules dealing with the disqualification of directors (in England set out in the Company Directors Disqualification Act 1986).

2. Legal structures

a) Cash flow insolvency

Cash flow insolvency is a ground for the opening of insolvency proceedings in relation to companies that is recognized throughout Europe: Zahlungsunfähigkeit (Austria: § 66 Insolvenzordnung; Germany: § 17 Insolvenzordnung), cessation des paiements (Belgium: Art 2(1) Loi sur les faillites; France: Art L 631-1(1) Code de commerce), platební neschopnost (Czech Republic: § 3(1) Insolvenční Zákon), inability to pay debts as they fall due (England: s 123(1)(e) Insolvency Act 1986; also referred to as cash flow insolvency), fizetésképtelenség (Hungary: § 27(2) törvény a csődeljárásról és), insolvenza (Italy: Art 5 Legge Fallimentare), toestand van hebben opgehouden te betalen (Netherlands: Art 1(1) Faillissementswet), niewypłacalność (Poland: Art 11(1) Prawo Upadłościowe i Naprawcze), platobne neschopný (Slovakia: § 3(2) Zákon o Konkurze a Reštrukturalizácii), insolvencia (Spain: Art 2(2) Ley Concursal), insolvens or obestånd (Sweden: Chapter 1 § 2(2) Konkurslagen).

The legal definitions of cash flow insolvency mentioned above are largely similar to the definition set out in s 123(1)(e) English Insolvency Act 1986. Cash flow insolvency means that the company is unable to pay its debts as they fall due. The majority of legal systems limit themselves to such a short statutory definition and leave further interpretation to the courts. Since in practice cash flow insolvency can routinely be easily detected at the time of the filing for insolvency, the relevant judgments largely deal with cases of directors’ liability and vulnerable transactions in insolvency.

A few European countries deviate from the model of a short, liquidity-based definition and instead link cash flow insolvency to the suspension of payments. This approach is employed in Belgium (cessé ses paiements), France (cessation des paiements) and the Netherlands (opgehouden te betalen). In those countries, the suspension of payments, which according to § 17(2) German Insolvenzordnung is only a rebuttable presumption for cash flow insolvency, has been promoted to being the main legal definition. From a functional perspective, there is, however, a convergence towards the definitions based on illiquidity as Art L 631-1 French Code de commerce requires in addition that the debtor is unable to pay the debts due with the disposable assets (l'impossibilité de faire face au passif exigible avec son actif disponible) and Art 2 Belgian Loi sur les faillites cumulatively requires a lack of creditworthiness. Against this background, the following text refers to definitions based on illiquidity.

Two mitigations of cash flow insolvency are generally accepted. They refer to the degree and the duration of illiquidity. Both mitigations are supposed to avoid the liquidation of enterprises which are worth rescuing and whose insolvency is not serious or permanent. It must be pointed out, though, that the aspects of substantiality and duration of cash flow insolvency cannot always be strictly distinguished from a functional perspective.

In some European legal systems cash flow insolvency requires much more than just minor liquidity gaps. The German Federal Supreme Court (Bundesgerichtshof) has decided in a leading case of 2005 (BGH 24 May 2005, BGHZ 163, 134) that generally solvency is to be assumed if liquidity gaps which cannot be remedied within three weeks affect less than 10 per cent of all debts due, unless it is already foreseeable that the liquidity shortfall will surmount 10 per cent shortly. A judgment of the Austrian Oberlandesgericht Graz (20 June 2002, 3 R 102/02y) points in the same direction. According to this decision minor liquidity gaps do not constitute cash flow insolvency if one may conclude from the insignificance that the liquidity distress will be remedied soon. According to Art 15(9) Italian Legge Fallimentare, a declaration of insolvency requires the unpaid debts due to amount to at least €30,000.

Finally, in Europe there is a tendency to negate cash flow insolvency if the payment delay is only temporary. The German Bundesgerichtshof has decided in the aforementioned judgment of 2005 (BGHZ 163, 134) that a debtor suffers (only) a temporary delay in payment if the delay only takes as long as it would require a creditworthy person to obtain the necessary funds. The court considers up to three weeks both as necessary and sufficient. Roughly the same criteria apply to cash flow insolvency according to s 123(1)(e) English Insolvency Act 1986, since similar descriptions are used in the English (near future) and in the German literature (absehbare Zukunft, ie foreseeable future). However, the misguided decision Re Cheyne Finance Plc [2008] BCC 182 (Ch) has introduced a certain degree of uncertainty here. An only temporary delay in payment is not sufficient for cash flow insolvency in Italy, Luxembourg, Sweden, Spain and the Czech Republic either.

b) Balance sheet insolvency

Unlike cash flow insolvency, balance sheet insolvency is not accepted as a statutory insolvency ground throughout Europe. Inter alia, the following balance sheet insolvency grounds are to be found in the European Union: Überschuldung (Austria: § 67 Insolvenzordnung; Germany: § 19(2) Insolvenzordnung), předlužení (Czech Republic: § 3(3) Insolvenční Zákon), inability to pay debts if the value of the company's assets is less than the amount of its liabilities (England: s 123(2) Insolvency Act 1986), maksejõuetu, kui võlgniku vara ei kata tema kohustusi ja selline seisund (Estonia: § 1(3) Pankrotiseadus), ylivelkaisuus (Finland: Chapter 2 § 5 Konkurssilaki) and predĺženosť (Slovakia: § 3(3) Zákon o Konkurze a Reštrukturalizácii). In Poland, cash flow insolvency is presumed according to Art 11(2) Prawo Upadłościowe i Naprawcze if balance sheet insolvency is detected.

Other European countries lack an equivalent legal concept. Among them are Belgium, Denmark, France, Greece, Hungary, Italy, Latvia, Luxembourg, the Netherlands, Spain and Sweden. However, the absence of a balance sheet test does not necessarily mean that these legal systems refrain from comparing assets and liabilities in the assessment of insolvency grounds. In Italy and Spain, balance sheet insolvency may indicate cash flow insolvency of a company. In Luxembourg, the criterion of loss of creditworthiness (ébranlement du crédit), which must be given in addition to an inability to pay in order to satisfy the cash flow insolvency test, leads to a functional convergence towards the balance sheet insolvency test.

c) Imminent cash flow insolvency

More than two-thirds (exactly 19) of the 27 Member States have introduced imminent cash flow insolvency as a supplementary insolvency ground. That is the case, for example, in Austria (§ 167(2) Insolvenzordnung), Belgium (Art 9(1) Loi relative au concordat judiciaire), England (para 11(a) sch B1 Insolvency Act 1986), Germany (§ 18(2) Insolvenzordnung), Greece (Art 3 § 2 Πτωχευτικός Κώδικας), the Netherlands (Art 214(1) Faillissementswet), Portugal (§ 3(4) Código da Insolvência e da Recuperação de Empresas) and Spain (Art 2(3) Ley Concursal).

Imminent cash flow insolvency aims to capture a situation in which, while the company is currently still able to pay its debts, it is already foreseeable that it will not be able to continue to do so at a certain future point in time. Due to the interrelation between future liquidity and the enterprise value relevant for the asset side of the balance sheet test, there is a certain functional parallel between imminent cash flow insolvency and balance sheet insolvency. This also results from the fact that both insolvency tests may be applied by preparing a financial plan largely following identical rules.

A frequent motive for introducing imminent cash flow insolvency into the statutes was to provide debtor companies with an insolvency ground which would allow them to voluntarily trigger a rescue procedure. Accordingly, imminent cash flow insolvency generally does not force company directors to file for insolvency and does not grant third party creditors a ground to apply for insolvency proceedings. Thus, in France, Germany, Greece, the Netherlands and Spain, imminent cash flow insolvency only grants a right to the company to file for rescue and insolvency proceedings, respectively. The room for rescue manoeuvre is smaller in those countries that force directors to file for insolvency upon balance sheet insolvency due to the partial parallel between imminent cash flow and balance sheet insolvency.

d) Further insolvency grounds

Occasionally, some jurisdictions have developed further insolvency grounds. According to s 123 (1)(a) and (b) English Insolvency Act 1986, a company is also considered to be insolvent if a statutory demand is neglected or an execution is returned unsatisfied. A statutory demand is a written demand left at the company’s registered office requiring the company to pay a sum then due exceeding £750 (s 123(1)(a) Insolvency Act 1986).

Such insolvency grounds have been introduced to satisfy the creditors’ need for insolvency grounds that are easy to prove, ie empirically and externally detectable. Functionally, they are close to cash flow insolvency according to s 123(1)(e) Insolvency Act 1986, since a solvent company will—in its own interest—always make sure that a creditor does not file for a value destroying insolvency proceeding on the grounds of a statutory demand or an unsatisfied execution. Hence, it would have made sense to formulate the statutory demand and the unsatisfied execution as mere presumptions of cash flow insolvency.

3. Regulatory challenges

Materially, there is no unified European law on insolvency grounds. A discussion whether this would be desirable remains to be held. Hence, here only regulatory issues can be identified taking into account unification initiatives.

The liquidity-based cash flow insolvency test is not only a constant in the comparison of laws, it is also considered indispensable in the context of international unification projects (UNCITRAL, World Bank, International Working Group on European Insolvency Law). This assessment is based on the advantage of illiquidity being perceivable for company outsiders in the form of default. A further rationale is that a company that is unable to raise equity or debt capital in times of crisis is not pursuing a valid business model and should therefore exit the market. However, cash flow insolvency—as it is at times assumed without further explanation—is not sufficient as the one and only insolvency ground. This would mean to neglect the fact that creditors as a whole are already threatened when the sum of third party claims against the company exceeds the sum of its assets valued at market prices.

One possibility for the legislature to allow for an earlier triggering of the insolvency regime, protecting both the debtor and the creditors, is to introduce an insolvency ground in addition to cash flow insolvency. UNCITRAL and the World Bank are considering the supplementary introduction of balance sheet insolvency. In order to avoid prematurely exposing value-generating enterprises to the risks of an insolvency proceeding there is a clear tendency to use fair value instead of book value accounting principles in the application of the balance sheet insolvency test. However, there is no consensus whether a positive going concern prognosis rules out balance sheet insolvency even if balance sheet insolvency is established using fair value accounting principles. For a limited time period, the German legislature settled for this approach in reaction to the financial crisis in order to avoid companies having a valid business model needing to be wound up due to an impaired credit market (Arts 5 and 6 Finanzmarktstabilisierungsgesetz of 17 October 2008, BGBl 2008, 1982).

A further possibility is the introduction of imminent or future cash flow insolvency as an additional insolvency ground (as proposed by the International Working Group on European Insolvency Law). As set out above, the difference between imminent cash flow insolvency and balance sheet insolvency is more of a theoretical (liquidity vs balance sheet approach) than of a functional nature.

In both cases legislatures have to decide whether only the company can invoke the insolvency ground(s) in addition to cash flow insolvency for restructuring purposes or whether creditors can also rely on them to trigger a creditor-oriented corporate governance. If one allows creditors (or governmental agencies) to initiate insolvency proceedings, the problem remains to be solved how imminent cash flow or balance sheet insolvency can be proven by company outsiders. Neither imminent cash flow insolvency nor balance sheet insolvency are empirically perceivable outside the company and, therefore, it is very difficult for outsiders to prove those insolvency grounds—be it during the filing for insolvency proceedings or ex post in a liability lawsuit. One possible solution is to shift the burden of proof for the going concern basis (Fortführungsprognose) in liability litigation to the director, who has better access to accountancy information (see BGH 27 April 2009, DStR 2009, 1384).

However, it is not only up to the legislature to move forward the point in time at which an insolvency proceeding may be initiated and directors (or even shareholders) are liable. In fact, by means of contractual rules creditors have the possibility to establish a liability order and a creditor-oriented corporate governance applicable before the statutory rules apply (caveat creditor). English law allows creditors and companies to stipulate insolvency grounds by way of autonomous self-regulation that allow creditors to initiate insolvency proceedings (paras 14 ff sch B1 Insolvency Act 1986). Collateral provided by directors and shareholders—especially personal guarantees—for company debts ensure that the individually liable person takes into account creditor interests as soon as it becomes likely that collateral assurances will be claimed.

4. Conflict of laws

According to Art 4 European Insolvency Regulation (Reg 1346/2000; insolvency (cross-border)) the insolvency grounds are determined by the lex fori concursus. According to Arts 4(2) and 9(1) of Dir 2001/17 on the Reorganization and Winding-up of Insurance Undertakings, reorganization measures and the decision to open winding-up proceedings with regard to an insurance undertaking, the winding-up proceedings and their effects shall be governed by the law and regulations applicable in the home Member State. According to Arts 3(2) and 10(1) Dir 2001/ 24 on the Reorganization and Winding-up of Credit Institutions, reorganization and liquidation shall be governed by the laws, regulations and procedures applicable in the home Member State. There is much to be said in all these cases for an application of the insolvency grounds to companies rather than to individual branches.

5. Unification projects

Important unification projects that are relevant for the insolvency grounds both in the areas of substantive law and conflict of laws are: UNCITRAL Legislative Guide on Insolvency Law (balance sheet insolvency at the most as a supplementary insolvency ground next to cash flow insolvency); European Insolvency Regulation (according to Art 4 the law applicable to insolvency proceedings—and, hence, also to the insolvency grounds—shall be that of the Member State within the territory of which such proceedings are opened); a similar approach is taken in Arts 11 and 13 UNCITRAL Model Law on Cross-border Insolvency; Dir 2002/74 amending Dir 80/987 relating to the protection of employees in the event of the insolvency of their employer (definition of cash flow insolvency according to Art 2(1): where a request has been made for the opening of collective proceedings based on insolvency of the employer and involving the partial or total divestment of the employer’s assets and the appointment of a liquidator, and the competent authority has (a) decided to open the proceedings, or (b) established that the employer’s undertaking or business has been definitively closed down and that the available assets are insufficient to warrant the opening of the proceedings); similarly Convention No 173 (Employer’s Insolvency) of the International Labour Organization (Art 1(2) suggests balance sheet insolvency as a further statutory insolvency ground); International Monetary Fund, Orderly and Effective Insolvency Procedures (cash flow insolvency as insolvency ground for liquidation procedures, future cash flow insolvency or no insolvency ground for debtor petitions to commence rescue procedures); World Bank, Principles for Effective Insolvency and Creditor Rights Systems (cash flow insolvency as preferred insolvency ground, balance sheet insolvency only supplementary); International Working Group on European Insolvency Law (insolvency ground according to § 1.2: cash flow insolvency or imminent cash flow insolvency).

Literature

Inge Kroppenberg, Die Insolvenz im klassischen römischen Recht (2001); WW McBryde, Axel Flessner and Sebastian Kortmann (eds), International Working Group on European Insolvency Law, Principles of European Insolvency Law (2003); Karsten Schmidt, ‘Grounds for Insolvency and Liability for Delays in Filing for Insolvency Proceedings’ in Marcus Lutter (ed), Legal Capital in Europe, [2006] ECFR, special vol 1, 144; Bob Wessels, Cross-Border Insolvency Law (2007); Philip R Wood, Principles of International Insolvency (2nd edn, 2007); Hans-Peter Kirchhof, Hans-Jürgen Lwowski and Rolf Stürner (eds), Münchener Kommentar zur Insolvenzordnung, vol 1 (§§ 1–102, InsVV) and vol 3 (§§ 270–359, Internationales Insolvenzrecht und Insolvenzsteuerrecht) (2nd edn, 2007 and 2008 respectively); Gabriel Moss, Ian F Fletcher and Stuart Isaacs, The EC Regulation on Insolvency Proceedings (2nd edn, 2009); Felix Steffek, Insolvenzgründe in Europa (2009) 70 Zeitschrift für Insolvenzrecht (KTS) 317; Richard A Brealey, Stewart C Myers and Franklin Allen, Principles of Corporate Finance (10th edn, 2010); Felix Steffek, Gläubigerschutz in der Kapitalgesellschaft (2011).