Negative equity—the balance-sheet test—as grounds for bankruptcy | In Principle

A company whose obligations exceed its assets should file a bankruptcy petition. If it does not, the creditors may file a petition and then seek to hold the members of the debtor’s management board liable for their claims. A rule that generates lots of practical problems remains in force in Polish bankruptcy law.

Polish bankruptcy law starts from the assumption that a company should have the capacity at any time to pay its obligations out of the proceeds of sale or liquidation of its assets. If it loses this ability, it falls into balance-sheet insolvency. This means that the value of its obligations exceeds the value of its assets—referring to the market value, not the balance-sheet value, which often is lower (for example because of depreciation).

In a state of balance-sheet insolvency, a company displays negative equity. In that situation, under Art. 11(2) of the Bankruptcy Law, this is grounds for filing a bankruptcy petition. This is so even if the company is capable of performing its current obligations as they fall due (e.g. servicing debt or paying for goods and services from suppliers), for example because:

• A significant portion of the debtor’s obligations have not yet become due and payable
• Creditors have deferred the payment deadline for their receivables
• Creditors have entered into a standstill agreement promising not to execute against the debtor for a certain time.

Deferral of the payment deadline for amounts owed by the company improves its liquidity but not change the ratio of obligations to assets. Therefore it does not release the management board from the requirement to file a bankruptcy petition due to negative equity. Nor does it eliminate the subordination of shareholder loans to claims of unaffiliated creditors.

It can be difficult to determine when a company’s obligations exceed its assets. The members of the management board themselves may differ sharply in their opinion of the market value of the company’s assets. If the assets happen to be listed securities, the trading price may be used to determine the value at any time. But if the assets are real estate or machinery, it is harder to estimate the potential sale price. What is regarded as an asset of the company may also be controversial. For example, in one judgment the Supreme Court of Poland held that a debtor’s assets do not include receivables and claims the debtor holds against its own debtors (order of 1 April 2003, Case II CK 484/02). This position is typically rejected by management boards, who intuitively regard receivables under invoices the company has issued as being assets of the company.

The shareholders should be aware well in advance of the danger of falling into balance-sheet insolvency, because under Commercial Companies Code Art. 233 §1 (in the case of a limited-liability company) or Art. 397 (for a joint-stock company), if the balance sheet prepared by the management board shows a loss exceeding the sum of reserve capital and supplementary capital and half of the share capital in a limited-liability company (or one-third of the share capital in a joint-stock company), the management board is required to promptly convene a meeting of shareholders to adopt a resolution on the further existence of the company.

Under the Bankruptcy Law and the Commercial Companies Code, shareholders’ claims against a company in bankruptcy are generally satisfied last. For example, under Commercial Companies Code Art. 14 §3, a claim by a shareholder for repayment of a loan to the company is deemed to be a contribution to the company if the company is declared bankrupt within two years after concluding the loan agreement.

The need to adopt a resolution on the continued existence of the company thus forces the shareholders to consider whether they want to risk falling into balance-sheet insolvency, which would:

• Obligate the management board to file a bankruptcy petition within two weeks after this situation occurred, and
• Threaten conversion of their “commercial” claims against the company into a capital contribution.

For the shareholder, a loan to the company may constitute a significant and collectible receivable, particularly if it is secured, e.g. by a mortgage or pledge of the assets of the company which is threatened with balance-sheet insolvency. The loss of that receivable could have an impact on the shareholder’s condition and cause a chain reaction.

Shareholders of a company are not liable for the obligations of the company, which is why from their point of view the company can continue operating despite negative equity. The company’s excess debt is typically not revealed to the creditors until the company loses liquidity and ceases performing its monetary obligations as they fall due. For the creditors, this will be grounds for them to file a bankruptcy petition against the debtor (Bankruptcy Law Art. 11(1)). During the course of the bankruptcy proceedings, it will become clear that by delaying in filing a bankruptcy petition themselves (due to the negative equity), the management board members violated Bankruptcy Law Art. 11(2). This may then serve as grounds for the creditors to pursue the board members for all or part of a claim of theirs that was not satisfied by the company.

In commercial practice in Poland, many companies ignore the existence of negative equity, not without reason protesting that Bankruptcy Law Art. 11(2) is excessively restrictive and unrealistic. The dysfunctionality of this provision is confirmed by the fact that in the amendment of the Bankruptcy Law now under consideration, a company would not be deemed insolvent on this basis until the value of its monetary obligations exceeded the value of its assets for a period exceeding 24 months. This change would be particularly beneficial for start-ups, which at the initial stage typically operate under conditions of negative equity.

Until the amendment enters into force (it has not yet been adopted by the Parliament), the existence of negative equity as grounds for bankruptcy will continue to expose members of management boards to the risk of personal liability for the debts of the company and present a barrier to the company in entering into contracts. More specifically, sale of assets by the company will raise concerns about the effectiveness of the transaction, particularly if the transaction is between affiliated companies, because from a formal point of the view the agreement would be concluded with an insolvent company which should be in bankruptcy.

Konrad Grotowski, Bankruptcy and Restructuring practices, Wardyński & Partners