Page 107 - Bankruptcy and Reorganization Services

ness cycle (generally four quarters, unless a different period is more relevant to the company or industry
or under certain economic conditions). It may also be necessary to review the company’s ability to raise
equity (net of related costs). A company passes this test if in the projected period it generates or has ac-
cess to sufficient cash to fund its operations and is able to pay its debts as they come due.

Consideration of Other Factors

Courts can also look at the number of creditors, the proportion of debts not being paid, the duration of
debt nonpayment, and the debtor’s payment history to assist them in understanding the debtor’s inability
to pay its debts. fn 68

Forward-Looking Concept

The use of forward-looking cash flow projections can demonstrate, if appropriate under the debtor’s cir-
cumstances, how the debtor might be able to use additional debt (or equity) financing to remain in or re-
turn itself to a state of profitable operation. However, it should be noted that the ability to prospectively
raise debt does not, in and of itself, make an insolvent company solvent if all that is accomplished by the
debtor is to fund continuing losses by adding additional debt to the balance sheet.

Sensitivity Analysis

It is normally beneficial to perform sensitivity tests of the key operating assumptions of the underlying
business in order to demonstrate the reasonableness of the projections. This may be particularly true
concerning projections supplied by management, especially if they are at odds with past performance or
current and future expected economic and industry conditions.

Special Bankruptcy Considerations

Discounted Cash Flow, Liquidity Discounting, and Tax Affecting

The going concern balance sheet test involves valuation, and valuation requires discounting a company’s
future cash flows (for the time value of money and risk) to present value. fn 69 In Paloian v. LaSalle
Bank, fn 70 the U.S. Court of Appeals for the Seventh Circuit addressed whether a DCF analysis applied
to the determination of insolvency properly applied a 40% tax-affecting discount, which rendered the
debtor insolvent. Regarding the 40% tax-affecting discount allowed by the trial court, the court of ap-
peals held that it was a mistake and found that, although there were two potential bases for such a reduc-
tion, neither applied to the determination of solvency. The first was the illiquidity of the debtor’s (close-
ly held) shares, and the second dealt with the issue that some potential buyers of the debtor (in a hypo-
thetical sale) would have to pay taxes that the debtor did not because it was a Subchapter S corporation.
The court held that neither of these two issues had anything to do with a corporation’s solvency.

fn 68 See also In re Hill, 8 B.R. 779 (Bankr. D. Minn. 1981), where nonpayment of the debtor’s three largest debts constituted non-
payment even though smaller debts were being paid.

fn 69 Heaton, "Solvency Tests," 20.

fn 70 See Paloian v. LaSalle Bank, 2010 WL 3363596 (7th Cir. August 7, 2010).

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