E. The Concept of Insolvency

Author:Roderick J. Wood
Profession:Faculty of Law. University of Alberta

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1) The Legal Significance of Insolvency

It is important from the outset to distinguish between the insolvency of a debtor and the initiation of an insolvency regime. Insolvency is a fact. It occurs when a debtor is unable to pay his or her creditors. The insolvency regimes provide a legal definition of insolvency in order to determine precisely when this state of affairs is considered to exist. The various insolvency regimes provide different legal responses to the fact of the debtor’s insolvency. These insolvency regimes do not come into operation simply by the occurrence of insolvency. They must be initiated by some action or proceeding taken by the creditors or the debtor. Often the initiating party must make a choice between two or more insolvency regimes in order to pick the one that provides the most appropriate solution to the problem.

The concept of insolvency serves a number of different purposes. First, it has a gatekeeping role. The various insolvency regimes typically require that the debtor be insolvent before insolvency proceedings can be initiated.33 The federal insolvency regimes that use insolvency as a precondition are enumerated below:

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· voluntary assignments in bankruptcy;34· restructuring proceedings under the CCAA;35· commercial proposals;36· receiverships;37· consumer proposals;38· orderly payment of debts;39· liquidation or restructuring under the WURA;40· farm debt mediation;41 and

· railway insolvencies.42Second, the concept of insolvency is used in a number of provisions that give the trustee the right to impugn pre-bankruptcy transactions. In order to attack a pre-bankruptcy transaction as a fraudulent preference, the trustee must prove that the debtor was insolvent at the time of the transaction.43 An insolvency requirement is also imposed where the trustee seeks to recover against the directors or shareholder of a corporation in respect of a dividend, redemption, or share purchase.44

Third, provincial law uses the concept of insolvency in fraudulent preference statutes as well as statutes that impose liability on directors for distributions to shareholders that were made at a time when the corporation was insolvent. These provincial statutes do not create insolvency regimes. However, a trustee in bankruptcy is able to use these provisions and therefore their operation is of great significance. Although the federal and provincial insolvency tests are roughly comparable, they are not identical.

Fourth, a court cannot grant an absolute discharge in bankruptcy if the debtor has continued to trade after becoming aware of being insolvent.45

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2) The Definition of Insolvent Person

The legal definition of insolvency in the BIA is contained in the definition of "insolvent person."46 The definition contains the following tests of insolvency:

(a) [The debtor] is for any reason unable to meet obligations as they generally become due.

(b) [The debtor] has ceased paying his current obligations in the ordinary course of business as they generally become due.

(c) The aggregate of [the debtor’s] property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all obligations, due and accruing due.

The three tests set out in the definition are alternatives. It is sufficient to show that any one of them is satisfied.47The Canadian approach48 differs slightly from that in two other common law countries, the United States and the United Kingdom, which provide two tests for insolvency rather than three. The first test, known as the cash flow test, examines if the debtor is able to pay debts as they fall due. The second test, known as the balance sheet test, determines if the debtor’s liabilities exceed the debtor’s assets. The first two tests in the Canadian formulation are essentially cash flow tests, while the third is a balance sheet test. However, there is an important difference between the two cash flow tests in that the first is forward-looking while the second is backward-looking.

3) The Cash Flow Tests

The first insolvency test requires proof of the debtor’s inability to meet current obligations as they generally become due. This is a cash flow test that contains an element of futurity. It is not directly concerned with whether the debtor has not paid his or her current obligations in the past. The question is whether the debtor is able to pay. A debtor who is able but unwilling to pay does not satisfy this test of insolvency.49 A

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debtor is insolvent under this test even though there are no payments currently due if it is shown that the payments will become due in the immediate future and the debtor does not have the means to satisfy these obligations.50 In order to determine the debtor’s ability to pay, it is necessary to assess the assets available to the debtor to meet these obligations. A lack of liquid funds is not determinative. A debtor who has a line of credit or other credit facility that can be drawn on to satisfy the obligations is not insolvent under this test.51 However, the assets that are to be considered do not include assets that are not normally liquidated in the ordinary course of business.52The second cash flow test requires proof that the debtor has ceased paying current obligations in the ordinary course of business as they generally become due. This test looks to the past. It is not concerned with the debtor’s inability to pay obligations in the immediate future. The question is whether the debtor has ceased to pay them. The second test is more limited than the first in that it applies only to a debtor who carries on a business.

Under either of these cash flow tests, it may be necessary to determine if a particular obligation qualifies as a current obligation. Long-term liabilities that are payable at some future date should not be considered.53 Unliquidated claims or debts that are subject to a bona fide dispute should also be excluded. A debt may be presently due and payable, but the creditors may have agreed to defer payment to a later date. If this is the case, the debtor will not be insolvent under the cash flow tests.54 The mere failure by a creditor to seek recovery by commencing a legal action or taking some other step is not enough to qualify as an agreement to defer payment.55 In principle, the date specified in the contract should be used to determine the date that the debt is due and payable unless there is some express or implied agreement between the parties, or a course of conduct sufficient to ground an estoppel.56

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4) The Balance Sheet Test

Under the balance sheet test, a debtor is insolvent if the assets of the debtor are insufficient to satisfy all liabilities of...

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