1. THE INSOLVENCY SERVICE AND UNIVERSITY COLLEGE LONDON THE 6 th INSOLVENCY RESEARCH CONFERENCE Thursday, 19 th April 2012 THE CONCEPT OF BALANCE SHEET INSOLVENCY – A COMPARATIVE ANALYSIS by ROBIN PARSONS and MICHAEL SCHILLIG

2. Section 123(2) Insolvency Act 1986 "(2)[ Proof that assets less than liabilities ] A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities."

3. BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL PLC and Others [2011] EWCA Civ. 227 The "point of no return" test

4. PRINCIPAL PURPOSES OF CONCEPT OF BALANCE SHEET INSOLVENCY Ground for winding up order Ground for administration order Avoidance of antecedent transactions Qualification as members' voluntary winding up Redemption or purchase by a private company of its own shares Wrongful trading and director disqualification

5. ISSUES WHEN LOOKING AT THE BALANCE SHEET Valuation on a going concern basis Assets acquired in the future Contingent liabilities Prospective (future) liabilities Foreign currency conversion rate Unliquidated liabilities Hindsight Costs and expenses of winding up

6. Germany Cash flow insolvency, InsO, §17 Inability to pay due debts General ground for opening proceedings Filing duty/interdiction of payment for corporate management Prospective cash flow insolvency, InsO, §18 Ground for opening proceedings Voluntary filings only Balance sheet insolvency, InsO, §19(2) Ground for opening proceedings for corporate debtors only Filing duty/interdiction of payment for corporate management Case law in the context of directors’ liability for breach of filing duty/interdiction of payment

7. InsO, §19(2) version applicable 1/1/1999 – 17/10/2008 and again as of 1/1/2014 “Balance sheet insolvency is a situation where the debtor’s assets are no longer sufficient to cover its existing liabilities. However, the debtor’s assets are to be valued on a going concern basis if the continuation of the business is, under the given circumstances, predominantly likely.” InsO, §19(2) version applicable 18/10/2008 – 31/12/2013 “Balance sheet insolvency is a situation where the debtor’s assets are no longer sufficient to cover its existing liabilities, unless the continuation of the business is, under the given circumstances, predominantly likely.” Components of balance sheet insolvency

8. Owner’s intention and willingness to continue Objective feasibility test o From an ex ante perspective, a reasonable business manager would decide to continue. Coherent, reliable and realistic business concept o Profitability plan o Cash forecasts on a weekly or monthly basis o Forecasting period: end of the following financial year Comprehensive evaluation of the business prospects Burden of proof on the defendant (directors) Liquidity prognosis or profitability prognosis? Positive going concern prognosis

9. Assets If realizable and likely to increase value for creditors Goodwill only in case of a concrete offer to buy Investment securities/foreign currency: market value/exchange rate on the relevant date Debt receivables: ‘certain’, ‘dubious’, ‘uncollectable’ Receivables not yet due: discounted to present value Liabilities All obligations to be paid out of the debtor’s assets In principle, nominal value Not yet due: discounted to present value Contingent liabilities: ‘probability discount approach’ Shareholder loans unless subordinated to deferred creditors Insolvency balance sheet

10. Equitable (cash flow) insolvency Involuntary filing if controverted by the debtor, 11 USC §303(h) Fraudulent transfers, 11 USC §548; UFTA §4 Dividends and distributions, MBCA §6.40 Breach of fiduciary duties in the interest of creditors Unreasonably small capital Fraudulent transfers, 11 USC §548; UFTA §4 Veil piercing ( Minton v Cavaney 56 Cal.2d 576) Legal (balance sheet) Insolvency, 11 USC §101(32), UFTA §2(a) Fraudulent transfers and preferences Fiduciary duties (Dividends and distributions, MBCA §6.40) United States

11. 11 USC §101(32), UFTA §2(a) “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, …” Production Resources 863 A.2d 772 (DelCh 2004) “a deficiency of assets below liabilities” and “no reasonable prospect that the business can be successfully continued in the face thereof” Two-step process (i) ‘going concern’ or ‘liquidation’ valuation? (ii) Comparison of assets and liabilities on the basis of (i) Presumption for ‘going concern’ valuation Liquidation values only where the company is ‘on its deathbed’ Elements of balance sheet insolvency

12. Financial statements in accordance with US GAAP merely provide a starting point and are not controlling Assets All assets that have value for creditors Goodwill where it can be sold Contingent assets discounted to present value on the basis of probability Valuation on the basis of market conditions at the date of transfer, except ‘retrojection’ and actual asset sales (liquidation) Income approach, market approach or asset approach In general, present value of future cash flows Inclusion and valuation

13. Liabilities All existing debts representing actual liability at face value Contingent liabilities o GAAP: recorded only if ‘probable’ and can be reasonably estimated o 11 USC: ‘claim’ = ‘right to payment’ irrespective of ‘liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed’ o In re Xonics Photochemical, Inc 841 F.2d 198: ‘probability discount analysis’: value = face value * likelihood of occurrence Future claims o Present conduct may cause injury in the future o e.g. product liability, asbestos o Whether debtor’s assessment was reasonable at the relevant time Inclusion and valuation

14. POTENTIAL SOLUTION? When carrying out a transaction that could put the company in jeopardy, management should conduct a balance sheet insolvency analysis by compiling an insolvency balance sheet. If the insolvency balance sheet shows that liabilities exceed assets, management should conduct a ‘going concern analysis.’ If transaction is subsequently challenged and no insolvency balance sheet was compiled there is a presumption that the company was insolvent at the relevant time.

15. QUESTIONS/COMMENTS?