Operating in the Zone of Insolvency
Operating in the Zone of Insolvency
Operating in the Zone of Insolvency
As business owners continue to navigate an increasingly complex business and financial climate, there are certain aspects about operating a business as it approaches possible insolvency that are extremely important for all business owners to be cognizant of regardless of the current financial strength of their business.
What is a Zone of Insolvency?
In it simplest form, a business is insolvent if it is unable to pay its debts as they become due. Insolvency may take many variations. It may mean a short term cash shortage that necessitates an infusion of capital via the business's owners or a line of credit, or it may mean total financial failure.
While most businesses experience episodes of short term insolvency at certain points in their life span, this generally is not a cause for major concern.
However, an increasing number of businesses are experiencing total financial failure as a result of an inability to generate sufficient cash flow to support operations, or an inability to obtain credit to weather short term cash shortages.
The Zone of Insolvency is generally a certain period of time in the future where the persons operating a business know that the business is no longer going to be able to pay its debts as they become due. This may range anywhere from thirty (30) days to more than one hundred eighty (180) days.
Concerns for the Zone of Insolvency
Of foremost concern for business owners when a business is about to enter a Zone of Insolvency are actions by the business or its owners that could subject the owners to personal liability. The most prevalent of these actions is the continued withdrawal of funds from a business by its owners, despite the business's inability to pay its debts. Such a withdrawal may take the form of a significant salary or distributions.
While a business owner may be able to justify receiving a nominal salary for work performed despite a business's dire financial situation, under no circumstances can a business owner justify distributions or draws if a business is not generating a profit.
The withdrawal of distributions by the owners of an insolvent or soon to be insolvent business can lead to a creditor asserting a claim that the business was undercapitalized. This is one of many factors a court can use to determine whether to subject a business's owners to personal liability for the debts of the business. These factors are generally referred to as "Piercing the Corporate Veil."
A successful corporate veil piercing claim is the goal of any creditor, and should be the worst nightmare of any business owner. Accordingly, business owners must be acutely aware that they subject themselves and their businesses to significant liability if they continue to withdraw considerable sums of money from a failing business.
The transfer of business assets is another topic of importance. As a business approaches insolvency, its owners must also be aware that any asset transfers must result in the business receiving the fair market value of the assets in return.
Transfers or sales of assets at less than fair value- or at less than arm's length - can allow a creditor to assert a claim to pierce the business's corporate veil. It may also allow the creditor to initiateaclaim against the purchaser of the assets.
Most notably, transfers from the business to its owners or to relatives or associates of the owners will be closely scrutinized and should generally be avoided- unless a legitimate fair value situation is present.
These issues are extremely important, especially if there is a possibility that the business or its owners may seek bankruptcy protection. A bankruptcy trustee may look to invalidate any transfers occurring prior to a bankruptcy filing if the transfers were for less than fair value or at less than arm's length.
In a worst-case scenario, such transfers prior to a bankruptcy filing may cause the bankruptcy court to determine that the business's or the business owner's debts are not dischargeable or that a fraud was committed upon the bankruptcy court, resulting in potential criminal liability.
Contact us at 612-746-2560 or visit us at skjold-barthel.com for additional information.
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