Abstract

It is well understood that the equity of an insolvent firm can trade for a positive price so long as there is some positive probability that the firm will become solvent at some future point. Currently, however, this insight exists in the case law in an informal sense, while its use in the financial economics literature is highly formalized and not tied to the legal solvency tests that experts, lawyers, and judges must apply in solvency litigation. A simple model of a debtor firm shows why a positive-equity value does not imply solvency under either of two widely-used legal solvency tests. This links a well-known financial economic insight to legal solvency tests. This is of practical importance as market evidence becomes more important in solvency litigation and as directors continue to face important questions of shifting fiduciary duties when the firm becomes insolvent.