The Handbook of Board Governance, 3rd Edition

30What Every Director Needs to Know About Insolvency

Virginia Torrie, JD, LLM, PhD

Insolvency refers to the inability to pay one’s debts as they become due. While there are tests to determine whether a company is solvent or not, it is not always feasible to pinpoint the exact moment of insolvency for a company. Sometimes a company may be operating near, or in the “vicinity of insolvency,” and the discussion in this chapter will also be helpful for directors who find themselves in such a situation. Navigating such circumstances is challenging. At all times directors must continue to act honestly and with the company’s best interests in mind. Generally speaking, doing this will allow a director to avoid personal liability that may otherwise attach. This chapter highlights key areas where extra care and attention are often required.

What Is Insolvency?

One often hears about “insolvent” companies in the news, and this financial condition is commonly used to mean “bankruptcy.” However, legally, these two terms are distinct. According to Canadian statutes, insolvency is “the financial state of being unable to meet your debt obligations as they come due”—this is called the liquidity or cash-flow test.¹ In other words, it is when a company cannot pay its bills. If the value of a corporation’s assets is lower than the amount of debt owed to its creditors, then it is generally an indication that the company is already insolvent, or heading in that direction—this is called the net assets ...