The basic balance sheet test of insolvency: liabilities exceed assets. Simple for creditors? On the basis of the BNY case, not any more, says Stuart Evans.
Reaching the Point of No Return?
Under section 123 Insolvency Act 1986, there are two basic tests
of a company's solvency. The first, being the cash flow
test, is whether a company is unable to pay its debts as they fall
due. The alternative test, known as the balance sheet test,
provides that a company is also deemed unable to pay its debts
"if it is proved to the satisfaction of the Court that the
value of the company's assets is less than the amount of its
liabilities, taking into account its contingent and prospective
liabilities". Arguably, the last eight words have been
taken for granted until now.
In the case of BNY –v- Eurosail, which examined
whether a contractual provision concerning insolvency had been
triggered, those extra words concerning contingent and prospective
liabilities were scrutinised in some detail. The Court of
Appeal decided that in respect of the balance sheet test, a
company's accounts were not to be regarded as the only true and
fair view possible, and they were also by their nature
historic. In applying the test, described as "imprecise,
judgment based and fact specific", a Court would look beyond
the simple balance sheet position in the accounts. The Court
was of the view that if a debtor company failed the first limb of
the balance sheet test, it should not follow that a company should
automatically be wound up, as this might be unfairly preferential
to short term creditors as against longer term or contingent
creditors. It was important to assess whether a finding of balance
sheet insolvency was commercially fair to both short and long term
creditors and reflected the reality of the company's
situation.
In short, the Courts would look more objectively as to
whether the company had genuinely reached the point of no
return or whether its survival was possible, should the company be
allowed to continue and not be required to use its assets to meet
short term liabilities, reducing the pool available to long term
creditors. It must equally follow that a company that has
assets exceeding liabilities on the balance sheet in its accounts
is not necessarily out of the woods either.
Conclusion
What this means for creditors is that when weighing up whether to
trigger a contractual insolvency provision or issue a Winding-up
Petition against a company, in applying the balance sheet test it
may not be enough simply to look at the latest accounts to
determine whether or not the company's assets exceed its
liabilities. The Court will go on to take into account the
company's contingent and prospective liabilities, and decide
whether or not the company has reached the point of no
return. This will require a greater analysis by creditors,
snap decisions may be fatal. The BNY case arguably
introduces more uncertainty for creditors who are dealing with
companies that they believe may be insolvent. As ever,
professional advice in these circumstances is recommended.
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