Distressed companies are those facing financial crises not resolvable without a considerable recasting of the firm's operations, structures and finance. This can be brought about through a company's failure to make a substantial payment of principal or interest to a creditor. Distress can also be seen in terms of financial ratios, for example in terms of liquidity and longer-term solvency. The basic and most prevalent forms of corporate distress assessment are the cash flow and the balance sheet tests, which apply both to going concern and break up (insolvency) valuation. In terms of break up valuation, under the cash flow test, a company is insolvent when it is unable to pay its debts as they fall due. Under the balance sheet test, the entity is insolvent if the book value of its assets, as listed on the conventional balance sheet, is less than its reported liabilities. The notions of asset exchangeability/liquidity and time prospect of sale are of great importance, particularly for the balance sheet test, as the latter includes the assessment of assets' value, by definition (UK Insolvency Act, 1986, 123 ). In this article, we first present the international/UK insight and, then, the Cyprus position on the matter.
The long-term assessment required for the application of the balance sheet test is based on the notions of prospective and contingent liabilities (UK Insolvency Act, ibid). Prospective liabilities are '...a debt which will certainly become due in the future, either on some date which has already been determined or on some date determinable by reference to future events.' (R Goode, Principles of Corporate Insolvency Law). This can be the case of a claim which is not disputed, but which remains to be quantified, resulting in a debt of more than one nominal amount. Contingent liabilities may include cases where the debt is for an unliquidated amount, or if its payment is uncertain or dependent upon some future event. An example of contingent liabilities is the obligation of the company to pay an amount in the future, on condition that a lawsuit against it is successful. These concepts induce quantitative and qualitative uncertainty to the balance sheet test.
In Eurosail (BNY Corporate Trustee Services & Ors v Eurosail-UK 2007-3BL PLC & Ors  UKSC 28 May 9 2013), the court realised that the long-term analysis needed to determine the future position of the company concerning its assets and liabilities, was heavily context dependent. The factors affecting the estimations were the currency fluctuations, the real estate market and the movement in the London interbank offered rate (LIBOR) which determined the interest rates of the loans, to be effective until 2045. The implied opinion of this judgment is that the balance sheet test is unstable.
It seems that the cash flow test is a more accurate method to use to provide an indication of insolvency. As the cash flow test focuses on the ability to pay debts when due, it is a more precise and more eligible indication of the actual condition of the company. A business entity cannot get into debt in the ordinary course of its business and then ignore its obligation to pay that debt. Moreover, creditors may not be willing to agree to wait for payment. Apart from the volume of the debt in the capital structure, the timing of the required repayment of the debt is important. A high proportion of debt with a fast-approaching due date can create a risk of insolvency, mainly when the entity's assets are rather illiquid and economic conditions result in cash flow deficiency from business activities.
The cash flow test also has its asset-based side, but this concerns existing asset liquidity and not a long-term assessment (as is the case with the balance sheet test). The test refers not only to presently due debts but also to those falling due from time to time in the 'near future'. The meaning of 'near future' in this context will depend on all the circumstances, particularly the nature of the company's business. In this situation, a decent forecast is feasible, without the danger of subjective long-term projections.
In Cyprus, the relevant parts of the provision on the grounds for court-sanctioned insolvency are Sections 211 e (company unable to pay its debts) and 212 of Cap 113 (Companies Law), which are quite similar to Section 123 of the UK Insolvency Act. Both the above-mentioned tests are applicable (212 c and d) and contingent and prospective liabilities are considered, also, in both. Moreover, two additional indicators can be used: 212 a) 'if a creditor (by assignment or otherwise) to whom the company is indebted in a sum exceeding 5,000 Euros ($5,500) then due has served on the company, by leaving it at the company's registered office, a written demand requiring the company to pay the sum so due and the company has for three weeks thereafter neglected to pay the sum or to secure or settle it to the reasonable satisfaction of the creditor'; or 212 (b) 'execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part'.
The specificity of the circumstances described in Article 212 does not limit the generality of Article 211 as regards the inability of a company to pay its debts. That is, the special provisions of Article 212 constitute a number of circumstances which create a legal presumption of non-payment of debt, but do not exhaust the scope for any other testimony which might produce the same effect (C Phasarias [Automotive Centre] v Skyropoiia 'Leonik' Ltd,  1 Supreme Court of Cyprus 1457). These options demonstrate the flexibility of the Cyprus jurisdiction in this matter and its capacity to accommodate various cases of corporate insolvency, both, also, relating to the jurisdiction's common law nature.
Originally published by IFLR.
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