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Legal Focus

JULY 2013

Insolvency and the "Balance Sheet" Test

Continuing with our focus on insolvency and the ‘balance sheet’ test, Lawyer Monthly speaks to Adrian Harris, Partner & Chief Executive Officer of Gregory Rowcliffe Milners (GRM), an English law firm based in Holborn which can trace its history back to 1784.

What are the key legal issues facing businesses at the moment?

The issues currently facing businesses, particularly SMEs, are legion due in large part to the aftermath of the financial crisis which has taken a number of destructive twists and turns over the past five years and is continuing. As we all know however, this is not just the case in the UK but is also a major influencing factor on problems being experienced within the Eurozone, particularly in the peripheral jurisdictions.

It is not so much a case of legal issues

that businesses have to face but rather, financial and commercial issues which arise or often take place within a legal context that businesses then have to contend with.

What is the effectiveness of the balance sheet test?

The test is now very commercial in nature - that is a good thing because it is more representative of reality. However, proving balance sheet solvency is going to be increasingly difficult the more distant the liabilities. This will be good news for directors and bad news for creditors.

What will be the impact of the Eurosail Supreme Court judgment?

Takeaways from the decision are as follows:-

• whilst there has been clarification, the test cannot, by its very nature, be precise

• the cash flow and balance sheet tests have become aligned because they both share the element of futurity although the "reasonably near future" requirement of the cash flow test will mean that its application will quickly run out of road and the balance sheet test will then become more relevant as the only sensible test to apply

• the statutory balance sheet is only a starting point for the balance sheet test

• the test will be increasingly difficult to apply the more distant the due dates of liabilities are

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Use the statutory balance sheet only as a starting point. Ensure that there is a thorough grasp of the company's business and a detailed understanding of its assets and particularly, its liabilities. Consider very carefully the degree of discount that should reasonably be applied to future liabilities - this could easily become the fulcrum of the argument being put forward by those upon whose shoulders the burden of proof falls.

do you see any need for legislative change regarding insolvency in the UK?

Although Chapter 11 has many drawbacks, I have felt for some time that debtor in possession or "DIP" financing would be enormously helpful to

tel: +44 (0) 20 7504 1159 Mobile: +44 (0) 7808 493 350 Email: a.harris@grm.co.uk Website: www.grm.co.uk

because of the increasing effect of imponderables over time, particularly in cases where macro-economic factors are of relevance and where uncertainty exists concerning how much discount to apply to future or contingent liabilities

• if an inability to pay debts provision is to be incorporated into legal documentation, it will be prudent to include direct reference to the balance sheet test (and cash flow test)

• as each case will have to be considered in light of the circumstances that exist and will be heavily fact specific, an understanding of the nature of a company's business will be of crucial importance

• the commercial approach to the balance sheet test now in operation following the Eurosail case will be welcomed by those who are company- side, particularly directors as the hill just got a whole lot steeper for those upon whom the burden of proving insolvency lies e.g. creditors who will not have available to them the kind of detailed financial and commercial information which will be necessary to build evidence to support a strong case.

What are the main considerations when using the test?

companies trying to raise finance in order to trade through and eventually exit an Administration. In addition, an extension to the current moratoria that we have for Administrations and CVAs (for small companies) preventing contract termination by customers and suppliers would be helpful. This is the case in the Chapter 11 process in the US. Often it is these counterparties whose ongoing commitment is so essential to the rescue of the company and its business. In relation to company voluntary arrangements, I would like to see the small company moratorium extended to larger companies. Finally, and although not an insolvency process itself, we must keep our Schemes of Arrangement out of the hands of the bureaucrats in Brussels. If it becomes a recognised insolvency proceeding for the purposes of the EU Regulation on Insolvency Proceedings we will lose our competitive edge for this extremely useful and flexible restructuring tool for both UK and foreign companies (where the conditions are met). LM

Contact: Adrian Harris

Partner & Chief Executive officer GRM Law

1 Bedford Row London WC1R 4Bz