Understanding basic insolvency terms

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Too often the basic terms in bankruptcy and insolvency law are used incorrectly and in a way which just makes things more confusing. Even professionals can be guilty of this. If on the other hand you understand the terms, then you will quickly understand the process and be able to identify and analyze the issues that may arise.

A. Insolvency

The starting point is “insolvency”. There are two types:

Equity insolvency

“Equity insolvency” arises when a debtor is unable to pay debts as they fall due or in the usual course of business or the inability to pay debts as they mature.

This simply means that a debtor, whether a corporate entity or an individual, cannot meet their obligations as they fall due. It therefore relates to the income or cash flow of the debtor and is not necessarily related to what they own or what their net worth may be.

This is confirmed by section 1 of the Business Corporations Act of British Columbia, which provides that a BC company is “insolvent” if it is unable to pay the company’s debts as they become due in the ordinary course of its business.

This is also confirmed in section 2 of the Bankruptcy and Insolvency Act of Canada (“BIA”), which defines an “insolvent person” (thus being either a corporate entity or an individual) as someone who is for any reason unable to meet his obligations as they generally become due or who has ceased paying his current obligations in the ordinary course of business as they generally become due.

Insolvency therefore is a recognition of the debtor’s ability to pay debts or not. Insolvency is not a formal legal status. On the other hand, as will be discussed below, the terms “bankruptcy” and “receivership” describe a formal legal status of the debtor that is the result of the insolvency of the debtor.

Balance sheet insolvency

“Balance sheet” insolvency arises when the debtor’s liabilities exceed the debtor’s assets.

This is also included in the definition of “insolvent person” in section 2 of the BIA, being someone, the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due.

So this definition of insolvency relates to the net worth of the debtor.

In every situation when determining whether a debtor is insolvent, you must consider both definitions of insolvency because they may impact on each other. They cannot necessarily be considered in isolation.

B. Receivership

Receivership is a formal legal state of an insolvent debtor where a receiver is appointed over the assets of the debtor. Receivership arises at the hands of a creditor, usually who holds security over those assets. Receivership can be granted voluntarily by the debtor or the creditor can seek a court appointment of a receiver.

Likewise, Black’s Law Dictionary (Eighth edition) defines “receivership” as the state or condition of being in the control of a receiver.

The role of the receiver is to bring in the assets of the debtor with a view to realizing their net worth so that the secured creditor may be paid what it is owed.

Section 64(1) of the Personal Property Security Act of British Columbia provides that a receiver must be licensed as a trustee under the BIA.

It is important to note however that a receiver does not take any authority from nor have the same obligations as a trustee under the BIA. This is yet another example of the importance of using the appropriate terms in the correct context.

C. Bankruptcy

Bankruptcy is a formal legal state of an insolvent debtor where there is an assignment of their assets to a trustee in bankruptcy by operation of the BIA, whether voluntarily or by court order. The purpose of that assignment is to then allow the trustee to liquidate the assets so that the creditors may hopefully be paid some amount in a fair and orderly manner.

Specifically, section 2 of the BIA defines bankruptcy” as the state of being bankrupt or the fact of becoming bankrupt and a “bankrupt” as a person who has made an assignment or against whom a bankruptcy order has been made or the legal status of that person. Again, those terms refer to the formal legal state of the insolvent debtor.

D. Bankruptcy protection

Under the BIA and under the Companies Creditors Arrangement Act of Canada (“CCAA“) an insolvent debtor may invoke bankruptcy protection as a temporary means of allowing the debtor to present a proposal to the creditors, to be voted upon by the creditors, as a means of preventing the bankruptcy of the debtor.

Under the BIA, “proposals” are dealt with in two distinct divisions, being Division 1, which provides the general scheme for proposals by commercial enterprises, and Division 2, which provides for consumer proposals. Each division has numerous distinct provisions.

On the other hand, the CCAA applies only to a corporate entity with more than $5.0 million of debt and likewise is intended for larger scale bankruptcy protection and reorganizations. The CCAA is invoked by the insolvent debtor through court proceedings.

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