Is “Insolvency” Required Before Filing A Bankruptcy Petition?

Does a debtor have to be insolvent in order to file a Chapter 11 case?  How is this word interpreted?  These are the key questions that were addressed in the recent Ninth Circuit Court of Appeals case In Re Marshall III, 2013 WL 3242478 (9th Cir. June 28, 2013).  The parties involved may be familiar to readers.

Texas millionaire J. Howard Marshall died, leaving almost all of his estate to his son Pierce.  His wife Vicki (pop culture figure Anna Nicole Smith) and other son Howard were given nothing.  Vicki and Howard contested the will in Texas probate court, and lost.  In the probate proceedings, son Pierce won a significant judgment against brother Howard for fraud.  Howard then filed for bankruptcy protection.

Pierce tried to contest brother Howard’s bankruptcy and plan.  He moved to dismiss Howard’s case, arguing that debtor Howard was not “insolvent” under the “balance sheet” test.  Looking at the debtor’s schedules and forms that were filed, Pierce noted that the debtor’s assets and income exceeded his liabilities.  Under the Bankruptcy Clause of the Constitution, Pierce argued, a bankruptcy court could only deal with situations where a petitioner was insolvent.  But what does the word actually mean?

The bankruptcy court first addressed the meaning of “insolvency.”  Pierce believed that the court should apply the definition contained in section 101(32)(A) of the Bankruptcy Code.  That section provides, in relevant part, that “insolvent means . . . with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.”  Section 101(32)(A) basically uses the “balance sheet test” as the test for insolvency.

But this isn’t the end of the story.  The word “insolvency” does not appear often in the Bankruptcy Code.  One such instance is in Section 109(c)(3), which requires a municipality to be insolvent prior to filing for bankruptcy protection.  But the meaning of “insolvency” in this section is governed by Section 101(32)(C) of the Bankruptcy Code, which uses a “cash flow test” for solvency.

The cash flow test is thus the only measuring stick that has some authority in the Code.  And even there, it was only to describe a yard stick for a municipality.  Should the same test be applied to persons or corporations?  The bankruptcy court in the Marshall case rejected the “balance sheet test” as a proper guide for a debtor’s solvency.

The court noted that the Bankruptcy Code is designed to help people who have cash flow difficulties, even if they are “solvent” when looking at their balance sheet.  Trying to apply a “balance sheet standard” would be unfair and inappropriate.  The cash flow test (even assuming we should apply any test at all) would be the more appropriate test.  There are sound reasons for this logic.  The prospects of crafting an effective reorganization are better when a debtor is still solvent by any measure; erecting roadblocks and tests as barriers to filing a case would not be good policy.

A debtor should not have to wait until he is insolvent before filing a case.  From studying other nations that had adopted such rules, the court found that substantial economic value was lost in applying those rules.  In addition, a review of American and British common law demonstrated that “insolvency” was never a determinative factor in filing a petition until the 1978 adoption of the Bankruptcy Code.

Balance sheet insolvency is irrelevant even there; under Section 303(h)(1), an involuntary filing, for example, only requires a showing that the debtor is “not paying such debts as they become due.”

Thus, a debtor who is solvent (under any test) can file a voluntary Chapter 11 case and seek to have a plan of reorganization confirmed.  A debtor is not required to wait until things are hopeless or nearly so.

This case highlights a principle that should be understood clearly:  there is no reason for a debtor to wait until he becomes insolvent before filing a bankruptcy case.  In almost all situations, his situation will be dramatically improved by getting a case filed as soon as cash flow problems begin.  Waiting too long is neither required, nor advisable.

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