JULY 2013

Legal Focus

81

Back to the dilemma for directors in the “zone of insolvency”, the balance sheet insolvency test contained in section 123(2) of the IA 1986 is a critical component of a wrongful trading claim as it can only be made if: (a) the company has gone into “insolvent liquidation,” which in turn is defined as assets being “insufficient for the payment of its (the company’s) debts and other liabilities” and (b) at some point prior to that time directors knew or ought to have concluded that there was no reasonable prospect of avoiding an insolvent liquidation. A company is balance sheet insolvent if the “value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities” (s. 123(2) IA). Courts have agreed this test does not involve a simple aggregation of a company’s assets and liabilities at their face value. This would have the effect of dooming a vast number of otherwise solvent companies, especially those prone to cyclical ups and downs.

Rather, it involves a factual assessment of whether, on the balance of probabilities, and making proper allowance for a company’s prospective and contingent liabilities, a company cannot be reasonably expected to be able to meet those liabilities. The test needs to be viewed together with the ‘commercial’ cash flow insolvency test, being a company’s inability to pay its debts “as they fall due” as this test also contains an element of futurity (as per the 2007 Cheyne Finance PLC1

case and

confirmed in the Eurosail case to be discussed below). In practice, it is not easy to determine how the two tests interact, but once you move beyond the reasonably near future, applying the cash flow test will become speculative, and arguably only the balance sheet test will make sense.

How effective do you think it is in determining whether or not a company is insolvent? What impact has the significant decision by the UK Supreme Court in the case BnY Corporate trustee Services Limited and others v Eurosail-UK 2007-3BL PLC had on this assessment?

Although many loan agreements include events of default which reference all or various parts of the s.123(2) test, borrowers tend to resist the inclusion of a stand-alone balance sheet insolvency test primarily because of the inherent uncertainty of, and difficulty in, proving for future and contingent liabilities. Consider for example a scenario where multiple companies in a group provide guarantees for the entire debt. Unless you qualify the test, the contingent liability under the guarantee could in itself trigger a default.

The Court of Appeal in the BNY Corporate Trustee Services Limited and others v Eurosail case2 , in its

commendable attempt at avoiding a too literal reading of the balance sheet test which may have caused the unintended consequence of causing otherwise solvent companies to breach the balance sheet test, stated that a company would, before it could be wound-up, have to have reached a “point of no return” such that the directors should have to “put up the shutters”3

. The

Supreme Court, although it agreed that the balance sheet test should not be approached literally, firmly rejected the ‘point of no return’ test and instead emphasised that it must be shown on the balance of probabilities, that a company cannot be reasonably expected to meet its (prospective and contingent) liabilities. That exercise, and eventual determination, the Court continued, must be capable of prediction and calculation with some degree of confidence. In the Eurosail case, the Court felt the determination of the company’s ability to pay debts due more than 30 years in the future would be more akin to speculation, and so refused to make the call.

The difficulty of quantifying contingent and prospective liabilities to the satisfaction of the court remains. However, administrators and liquidators are guided by accounting standards and the Insolvency Rules in this regard, as well as common-sense, which allows them to put a present value on future and/or contingent liabilities without being hindered by the burden of foresight; by no means an easy task though.. LM

Contact:

John Houghton Partner, London

tel: +44.20.7710.1847 Email: john.houghton@lw.com

1 2 3

[2007] EWHC 2402_2 (Ch) [2011] EWCA Civ 227

This principle was coined by the eminent Prof Goode in his Principles of Corporate Insolvency Law (third edition)

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