Business owners can limit liability by spinning off a high-risk activity into a separate company. When you set up your main business as the owner of the new company, it is considered the parent of a subsidiary. While the creation of a subsidiary prevents its creditors from reaching the assets of the parent, the subsidiary's assets can be exposed to the parent's creditors, especially if the parent becomes insolvent.
Definition of Insolvency
A company is insolvent when its liabilities exceed its assets and it can't pay its bills. Insolvency doesn't necessarily mean that a company is going out of business or must declare bankruptcy. Some businesses are insolvent because they hold assets that can't be easily turned into cash to pay monthly bills. Often, a business can work out arrangements with creditors to halt payments on monthly debts until a big order comes in, or take out a working capital loan that can keep the business afloat until monthly cash flow improves. In this case, the business is technically insolvent but still operationally viable.
Insolvency of Parent Companies
Wholly-owned subsidiaries are independent businesses that are owned by a single shareholder that is also a business. Consequently, the insolvency of the parent doesn't necessarily have to affect the operations of the subsidiary, since the parent's debts are its own. However, the parent's ownership interest in a subsidiary is an asset, and the parent has the right to liquidate it to pay the bills, in the same way that a person can cash in stocks or sell the family car to relieve financial difficulties. The parent company also can pull money out of the subsidiary to pay its own bills. Basically, a subsidiary with an insolvent parent is at risk of complete upheaval at any time.
An insolvent parent company can elect to file for bankruptcy, either reorganizing or liquidating the company under federal bankruptcy laws. A bankruptcy trustee will be put in charge of managing or liquidating the parent's assets, which will include its ownership of the subsidiary. The trustee may sell off the subsidiary, liquidate its assets, or do anything else in his power to maximize the value of the subsidiary to satisfy the parent's debts. The subsidiary's board of directors and employees would have no say in the matter because the parent company is the subsidiary's shareholder-owner.
While an insolvent parent can continue in business without necessarily affecting the operations of the subsidiary, creditors can try to force it into involuntary bankruptcy to access the subsidiary's assets. Typically, the mere fact that a business is insolvent is not enough for most courts to approve an involuntary bankruptcy petition, but if the parent is not able to borrow money to stay afloat or renegotiate debt terms and has no revenue prospects that will eventually relieve the insolvency, the risk of a court approving an involuntary bankruptcy petition by one or more creditors grows.
Terry Masters has been writing for law firms, corporations and nonprofit organizations since 1995. Her online articles specialize in legal, business and finance topics. She holds a Juris Doctor and a Bachelor of Science in business administration with a minor in finance.