When is a company insolvent?

Supreme Court ponders and restates the blindingly obvious

Every now and again a Court judgment is released on which it is almost impossible, as an insolvency lawyer, to avoid passing a little more comment than the usual casual tweet. This happened on 9 May 2013 with the handing down of a Supreme Court judgment with the somewhat unwieldy name BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL PLC [2013] UKSC 28.

The facts of the case were utterly dull and the content of the judgment objectively unremarkable, since it represents little more than a common sense return to the status quo which had prevailed prior to the (rather more surprising) Court of Appeal judgment in the same case in 2011. However,  it is the wide reach of such a judgment which is interesting.

Every day hundreds and thousands of contracts around the world are drafted with English law and jurisdiction clauses and with insolvency or termination provisions, a large number of which are triggered if one or other party undergoes an “insolvency event”. 9 times out of 10 these will be defined somewhere (amongst all the lists of formal insolvency appointments, many of which are so obscure they only really appear in such clauses) by reference to s.123 Insolvency Act 1986. Every day parties enter into sale transactions based on warranties that the vendor is not insolvent and will not become insolvent by entering into the sale, by reference again to s.123 Insolvency Act 1986. It is possibly the most widely used statutory provision in the whole of English insolvency law.

Section 123 has survived largely unscathed for decades and does not in fact define “insolvency” per se, but tells us when English law deems a company to be “unable to pay its debts”, which is the trigger for so many other things in English insolvency.  This can of course happen rather gradually, such that no normal person would be able to identify any “event” as such, but what inability to pay debts breaks down to is two, pretty clear, but above all separate and alternative, tests:

1. A company is unable to pay its debts if it fails to meet a valid statutory demand for a sum of more than £750 for a period of 3 weeks from valid service, or if a judgment creditor levies execution against the company and the company cannot meet the sum required, or if a court is otherwise satisfied they are unable to pay their debts as they fall due (the cashflow test); OR
2. A company is unable to pay its debts if a court is satisfied that the value of its assets is less than the value of its liabilities, taking into account its contingent and prospective liabilities (the balance sheet test).

It is often said – half in jest – that many of the largest companies in the world are insolvent on the balance sheet test, particularly when you take account of things like pension fund deficits but the reality is that the application of the test requires evidence to satisfy a court on a balance of probabilities and is highly fact specific. The balance sheet test has to take into account liabilities below the line, but above the line will sit all sorts of (often somewhat nebulous) assets, some of which do not make it to the formal balance sheet for accountancy purposes, such as options on future contracts, rights of action and (as in the Eurosail case) a very large proof of debt in the insolvency of Lehman Brothers, likely to result in an eventual dividend. Except for the purposes of very specific post-insolvency claims brought by an office holder, the burden of proof in establishing insolvency on the balance sheet test would always lie on the party asserting that the company was insolvent.

The potted version of the judgment is that the Supreme Court found the Court of Appeal in 2011 had rather confused the two tests, trying to import an element of the cashflow test into the balance sheet test and going so far as to suggest that in order to satisfy the court that a company was unable to pay its debts on the balance sheet basis, the company would have to have reached “the point of no return”. One hopes that this test was not drawn from some very similar terminology used in the criminal law (that’s a crass in joke for lawyers; my apologies) or, for that matter, from Phantom of the Opera (“the final curtain” test?). Wherever it came from, however, it was roundly rejected by the Supreme Court, who thereby wafted away a fog of uncertainty which has hung over the correct application of the test for the past couple of years.

So, well done Supreme Court. More of the same please. As for those of us at the coalface, doing deals and drafting contracts, let this serve as a reminder that parties should always give their minds very seriously to what their agreement should actually provide in the (hopefully unlikely) event of one or other party becoming insolvent. It is perfectly possible, after this judgment, to have a company which is insolvent notwithstanding it is meeting all of its current liabilities as they fall due. Whilst insolvency of a party on either basis might seem unthinkable at the time, history is littered with unthinkable events which nevertheless came to pass. Please, please, please be aware of the risks and manage them accordingly, with careful advice from the right people and in good time.