What Is Insolvency?

• Author: David J. Cook
• Pages: 1-6

What Is Insolvency?

Insolvency is a general term for any legal proceeding or business arrange-

ment that enables a failed or troubled business to seek to liquidate its assets,

pay its creditors, and terminate or reorganize its business operation. A legal

proceeding establishes a court appointed trustee, or even a debtor in pos-

session, who has a brand new set of legal rights and powers that can vacate

or nullify state court judgments; void key contract provisions; stay enforce-

ment of valid liens, levies, and judgments; and claw back valid liens and

payments. A “legal proceeding” means a statutory (or common law) legal

process established by the Congress (i.e., the bankruptcy code) or the state

legislatures (probates; receiverships; and, in some states, assignments). A

business arrangement is an agreement to sell or dispose of assets and pay

creditors (bulk sales; workouts; arrangements; and, in some states, assign-

ments). A business arrangement is called an insolvency process, as opposed

to an insolvency proceeding, which is established by law.

The new entrants, which are established by law, are the lien credi-

tors, and they include the bankruptcy trustee, assignee for the benefit of

creditors, and equity receivers, who take priority over unsecured credi-

tors, unperfected secured creditors, and tardily filed secured creditors. For

example, a bankruptcy trustee enjoys vast statutory rights, including the

“strong arm statutes” that dispossess lawful titles to assets held by others

[Bankruptcy Code Section 544].

The term insolvency can be defined in several ways:

• Insolvency means that the business is unable to pay its liabilities as

they accrue. This is called the equitable definition of insolvency, and

it creates a presumption of insolvency. The debtor might well agree

to pay the liabilities through a long term payment program.

• Insolvency means that the liabilities exceed the asset of the busi-

ness. This is called the legal definition of insolvency. This is also

called a “balance sheet test,” but in practice the assets are valued at

their fair market value and not at their “book value.”

• Insolvency means that the debtor stopped functioning as an ongo-

ing business; shut the doors; sent the employees home; and faces

lawsuits, liens, and levies. This is a commonly understood definition

of insolvency. Under these conditions, the debtor’s assets might

exceed its liabilities; nonetheless, the debtor is sinking into a finan-

cial sinkhole. This also includes a debtor facing a large judgment

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