Cash flow and balance sheet tests for determining corporate insolvency

¶ … Insolvency Law

Cash flow and balance sheet tests

The cash flow test very simply put is the ability of a company to pay off their debts as they are liable to pay them; i.e. As soon as they are indebted they already have generated the money to pay it off immediately. A company will prove to be insolvent if and when the futuristic calculations prove it to be incapable of paying their debts. In case, a company is able to pay off their debts or bills for the first two months and after those, it is still considered insolvent. Hence, the cash flow insolvency test will be a futuristic calculation of debts and cash inflows based on the current trends of both e.g. If a company is earning $100,000 and has debts of $50,000 going out every month, the debts will increase to $60,000 in a month's time making the company insolvent (Arner et al., 2006).

The balance sheet test is somewhat similar to the cash flow test but instead of calculating futuristic cash inflows, it focuses on probabilities of increase or decrease in liabilities and cash flows. Hence, the entire balance sheet test is based on the perspective inflows and outflows of a company. If and when the difference between the cash inflows and cash outflows is negative, then the company is considered to be insolvent. It is important to note here that only a handful of companies will measure up to being solvent after the balance sheet insolvency tests are complete (Arner et al., 2006).

Between the cash flow and balance sheet test, the cash flow test is a lot more accurate to measure a company's insolvency as it considers the tangible inflows and outflows to determine a company's financial standing i.e. The cash flows that the company is already recording and will continue to record in the future as well. The balance sheet test on the other hand considers the perspective cash flows, i.e. those cash flows that might possibly occur in the future, which leaves a sense of unpredictability to the company's financial strength. Hence, the cash flow test is better and much more accurate.

Question #2: Hong Kong and Corporate Insolvency

The three ways in which the Hong Kong Insolvency Approach differs from the formal corporate insolvency procedures include: first, the liquidation of a company is referred to as 'winding up'. Furthermore, this winding up may be a result of voluntary actions i.e. without the court order and/or a compulsory winding up where the court decision comes into play. The Hong Kong approach also does not have an efficient system where the insolvent companies can be restructured through negotiations with the changing times. Another major difference between the Hong Kong approach and the formal corporate insolvency procedures is that it does not provide much opportunity or incentive to the creditors and/or debtors when insolvency or bankruptcy takes place.

Question #4: Secured transaction laws

I agree to the statement that "Secured transactions law is completely distinct from insolvency law; secured creditors' collateral should not be considered part of an insolvent company's estate." Firstly, the important thing to note is that the secured transaction laws are primarily the laws in place to prevent and insolvency case to occur for the creditors. They are formed to ensure that the creditors attain the maximum opportunities to get back their debts before a company becomes insolvent. Hence, the law clearly offers security to the creditors so that they don't have to worry about their finances going down the drain. Similarly, it provides a security for the creditor against any and all collateral investment in case the company does become insolvent. This protection is part of the creditor's rights to prevent any collateral damage to the creditor in case the company does turn insolvent. In case of liquidation, all the property set forth as collateral will have to be given back to the secured creditor and it will now be included as part of the liquidation assets available to the company to pay off the debts. This is the case within the United States as well as the United Kingdom. Also, since a majority of the laws adopted by the Asian laws include the UK stratagems and principles, we can see a similar stance being taken across Indonesia, Malaysia and Hong Kong as well. In fact, the U.S. also does not allow the company to liquidate any of the creditor's collateral without the secured creditor's consent and knowledge.

In case of the formal restructuring of a company, the collateral is not part of the company's assets and must be returned to the original lender or creditor for re-use. Also, it is only with the consent of the creditors that the company can use the collateral material offered by the creditors as part of the restructuring process. If the creditors are not willing to further contribute their collateral material in the restructuring process, they have every right to take back what they lent and the company cannot legally force them not to.

Moreover, in the out-of-court or voluntary restructuring regimes, if and when the voluntary restructuring is called by the creditors and they are informed of the company's performance by the directors in a formal meeting. This is where the decision to move forward with the restructuring is done and the creditors decide whether or not they want to continue on in the restricting process. At times, the creditors will pull out some of their collateral and invest other which is merely done to see how the restricting shapes up. The out of court restructuring is usually the preferred mode of negotiating out of a financial glitch across the United States (commercial cases) and Switzerland where the courts are only asked to step in if and when no negotiation between the debtors and creditors can be made.

Question #5: Unsecured creditors

Unsecured creditors are basically those creditors that have not signed a security or legal agreement with the borrower or debtor at the time of lending finance or collateral. This means that usually, in the times of a financial crisis, they become the lowest priority for the company in terms of returning the debts. This usually happens because there is no document that makes the company legally binding or liable to pay their debt which does not leave any pressure on them to pay off the unsecured creditors' debts. Also, the financial crises usually leave companies paying off the legal binding security loans first as non-payment of those can result in the liquidation of the company.

I intend to take a balanced stance on the statement that 'all unsecured creditors should be treated the same in corporate insolvencies'. I agree to the current action of giving them a low priority on the list in case of a financial crisis. This is so because mostly the impression is that the lender did not feel like his investment was big enough to entail a security agreement or contract. This, of course, is intangible logic and cannot be proven. However, knowing the consequences of not paying the secured financial or collateral loans can definitely overshadow the meek consequences of facing an angry or discontent unsecured creditor. The aspect that I don't agree with however is the fact that in majority of the instances, most of the unsecured creditors are left unpaid or partially paid. I feel that this aspect must be modified and the unsecured creditors must also be paid back fully, despite being paid late.

In case of liquidation, we often see that the unsecured creditors are left unpaid and they cannot take any legal action against such a policy because of the fact that they have no agreement or contract. In cases, where bankruptcy has left the directors completely empty handed, one can let the non-payment of the unsecured creditors slide to an extent but efforts must be made to ensure that they are treated fairly in this regard if and when the financial liquidation allows it. In the United States, however, if and when the unsecured creditor is also liable to pay the debtor for a loan taken by him in another case -- the unsecured creditor can use the liquidation payment process as a way to see off the debt he owed as well as attain a matured liability from the debtor, allowing the unsecured creditor to attain a strong and legal pre-preferential position against the debtor.

In terms of formal restructuring, the unsecured creditor rarely every see the money being paid back to the full or even partially till the company is fully restructured and in a position to make profits again. Same is the case in out-of-court restricting processes where the unsecured creditors are rarely ever involved in the restructuring negotiations.

Question #6: Corporate Insolvency Laws

The United States approach to preferences, which revolves around the preferential effect of a payment or a transaction for a creditor, mainly encompasses the payment to a creditor for a debt taken during insolvency. The overall preferential treatment here is that the creditor is, in case of liquidation, will end up receiving more than he was due as opposed to when the debtor would go bankrupt. While the United Kingdom's approach to preferences, which revolves around the debtor influenced by a desire to prefer a creditor, is one where irrespective of the liquidation or bankruptcy situation, the debtor will most likely choose the creditor he/she wants to pay off and thus will pay them off first. Both methods have their pros and cons which are discussed below.

For the approach taken by the U.S., the obvious advantage is that the extent of creditor investment will be the determinant of priority for repayment. Another advantage is that the creditor will always be paid back his investment outside of the collateral that he had given to the debtor. And, finally, the advantage for the creditor is that a timely action from him could result in getting back his investment with an interest gained. The disadvantages for this method include an integral flaw which instigate two different debt ratios for the liquidation and bankruptcy i.e. The debtor will have to most likely pay off more than what is owed to the creditor in the liquidation process if and when the U.S. Bankruptcy Code comes into play. Another disadvantage is that most debtors are forced to substitute a high-valued property against a currently low-valued property which leaves them insecure in the complete payment of the debt. Another disadvantage is that only some of the unsecured creditors are paid off ad not all. Furthermore, the time restraints in this setting are tough on the creditors. The outside creditors have to wait at least 90 days before the preferential property can be transferred to them. It is even lengthier for an insider creditor, who could be relative/friend/business partner, as the wait becomes 12 months before the preferential property is transferred. This method if adopted by Country X could prove to be heavy on both the creditors and the debtors. Despite that fact, there is really only one major flaw with this system which is the difference between the debts paid to creditors in the liquidation and bankruptcy situations under the U.S. Bankruptcy Code. It is suggested that the U.S. Bankruptcy Code be avoided by Country X and that they look to adopt a modified bankruptcy code so as to balance out the difference in debt.

The UK approach prioritizes the unsecured debtors over the interest payments and members which is a big advantage as it ensures that the debtor will most likely be able to pay off all the unsecured debtors. Another advantage is that it gives the unsecured creditors a pari passu which means that if the unsecured creditors owned the debtor financially, he could subtract it against the payment owned by the debtor and thus become a pre-preferential investor as well. The third advantage of this system is that if you are an inside creditor and have good relations with the debtors, you will most likely be preferred to be paid first by the debtor.

In term of disadvantages, the UK approach to preferences is by far the most unfair in its application. The debtors have the complete control in the choice of who gets paid first and who doesn't get paid at all. While it can be viewed as an advantage by some creditors, it is not viewed similarly across the board. Another disadvantage is that the timeline is restrained to 30 days which is not good for the debtors. It is suggested that Country X does not adopt this particular approach as it will most likely result in increasing pressure on the corporate finances and economy. It can also lead to a heavy bank debt or bank loan ratios for the country in the long run.