As a general rule, managers and directors of a financially troubled business should manage the business in good faith and work to maximize the business’s value for all of its constituents. In an effort to maximize the business’s value, managers and directors should closely review the financial condition of the business before taking any action that may adversely affect owners or creditors.

Anticipating enhanced scrutiny when a business is facing financial difficulty, managers and directors should take extra steps to ensure that they follow procedures to make informed decisions that serve a proper purpose for the business. To avoid potential pitfalls, it is important to work with an attorney that has experience successfully working with distressed businesses.

Bankruptcy/Balance Sheet Insolvency

Under the bankruptcy test, a business is insolvent when its liabilities exceed the fair value of its assets.  The Bankruptcy Code provides an insolvency test for entities: an entity is insolvent where the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of—

(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and

(ii) property that may be exempted from property of the estate under section 522 of this title.”

11 U.S.C. § 101(32).

In applying the bankruptcy test, debts are broadly defined to include contingent, unliquidated, and disputed debts that may not be reflected on a balance sheet.  See 11 U.S.C. § 101(5) and (12).

Equitable Insolvency Test

Under the equitable insolvency test, a business is insolvent where it lacks sufficient assets to pay its debts as they become due.  See Odyssey Partners, L.P. v. Fleming Cos., 735 A.2d 386, 417 (Del. Ch. 1999).