What Is Insolvency?

AuthorDavid J. Cook
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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