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This Article explains the basic economic function of solvency tests and the relations among the three solvency tests applied in bankruptcy and corporate law. It also explains why solvency diagnoses can differ, depending on the test that is applied. Although one of these tests-the ability-to-pay test-is probably best, it may suffer from significant measurement error in practice. Multiple solvency tests ultimately make sense because the costs of failing to detect insolvency when it exists exceed the costs of detecting insolvency when it does not exist.
INTRODUCTION
Three solvency tests appear in bankruptcy and corporate law:
* a test of whether a firm1 reasonably can be expected to pay its debts as they come due (the ability-to-pay solvency test, sometimes referred to as cash-flow solvency or equitable solvency),2
* a test of whether the fair value of a firm's assets exceed the face value of its liabilities (the balance-sheet solvency test, performed on either a going-concern or liquidation basis),3 and
* a much less well defined test of whether a firm has adequate capital (the capital-adequacy solvency test).4
It is easy to identify these tests but hard to apply them in practice.5 This is nothing new. Commentators in a 1929 Columbia Law Review article lamented that "courts have not yet developed any clear-cut principles or rules" for solvency testing.6 Seventy-five years later, Delaware's Court of Chancery complained that "it is not always easy to determine whether a company even meets the test for solvency."7 Practitioners often complain that uncertainty about the application of solvency tests makes it difficult to advise on corporate restructuring.8 Those involved in high stakes financial litigation spend as much time litigating how to determine insolvency as they do litigating whether a given firm is insolvent. As the leading bankruptcy treatise notes, litigation on the meaning of insolvency "generates a formidable and, on the surface, not always consistent stream of adjudications."9
This Article begins by explaining the basic economic function of solvency tests in bankruptcy and corporate law. Limitations on a firm's activities based on solvency tests-embedded in laws such as fraudulent transfer law, preference law, and the law of fiduciary duties-allow a borrower to increase its debt capacity ex ante by protecting creditors ex post from actions that make it less...