BUSINESS Am I insolvent?
A seemingly innocuous question posed to lawyers and accountants by clients down the ages. The answer used to be fairly simple. As Mr Micawber memorably put it: 'Income twenty shillings a week, expenditure twenty shillings and sixpence; result, misery. Income twenty shillings a week, expenditure nineteen shillings and sixpence; result, happiness.' George Jacobs says the answer nowadays is much more complicated.
rior to the mid 1980s advisers to troubled companies had a good idea of what ‘insolvent’ meant, but like the proverbial elephant, they knew it when they saw it but couldn’t really define it. The Insolvency Act 1986 introduced for the first time a statutory definition of insolvency (or at least 'inability to pay debts', which was generally taken to be the same thing), invoking both cash flow and balance sheet tests.
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Even then, things weren't entirely clear. The cash flow test was fairly simple. If a trading company can’t pay its bills and creditors are at the door, it’s pretty obvious it’s insolvent.
It was the balance sheet test which was always more problematical. What was meant by '… the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities'? Whatever the precise meanings of the individual words – and there was seemingly endless scope for arguments about these, too – it was generally accepted that the test was a numerical one. Assets greater than liabilities = happiness; assets less than liabilities = misery.
However, the Appeal Court decision in the Eurosail case in March 2011 has turned this consensus over the basic meaning of balance sheet insolvency on its head, by introducing an overtly subjective element into the equation: should the company put up the shutters or should it try to refinance or trade out of its problems? No longer is the question simply: 'Are my liabilities greater than my assets?' It now embraces the additional question: 'Is it reasonable for me to continue in business with a view to restoring a surplus of assets over liabilities?'
Of course these are questions which are even more difficult for directors to answer than the purely numerical questions around the extent of their assets and liabilities. As a result, they will undoubtedly need more support from their advisers to help them to come to a defensible conclusion, particularly
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if their view is that they ought to continue trading to restore their asset position.
This will require much more than merely kicking the tyres to test the values of assets and liabilities and reach a conclusion as to the net asset position; there will now need to be a careful assessment by professionals – both accounting and legal – of the steps that will be
// The fi nancially precarious Mr. Micawber
needed to restore the net asset position and of the prospects of success. This is the positive message from Eurosail, that formal insolvency proceedings may be avoided if there is still a reasonable prospect of survival.
However, Eurosail may also have a sting in the tail for creditors, who rely on the ability of insolvency practitioners to use the Insolvency Act avoidance powers to make recoveries for the benefit of creditors. In fact, this is sometimes a key objective of insolvency proceedings and one in which the our Contentious Insolvency team has particular expertise and experience.
In the wake of Eurosail, perhaps one of the most important questions for those who have lost money in an insolvency situation will be how the courts will apply the insolvency test. The determination of whether a company is insolvent at the time of a questionable transaction is often a necessary ingredient for an insolvency practitioner to be able to bring an action to make recoveries from the avoidance of antecedent transactions.
To give a specific example, will preference claims – perhaps even against connected parties – fail because the directors can successfully argue, based on Eurosail, that the company had a reasonable prospect of avoiding insolvency proceedings even though it was insolvent on a balance sheet basis as that term has hitherto been generally understood? Will the 'clarified' Eurosail insolvency definition prove to be a rogues’ charter? Only time will tell, but it is clear that the ramifications of Eurosail have yet to be fully determined or appreciated.
Source: George Jacobs is Principal at BDO in London
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