Overview

The IMF, in a January 2016 update to its World Economic Outlook, revised its global growth projections for 2016 and 2017 down by 0.2%, citing a decline in emerging markets' growth and lower prices for energy and other commodities.[1]

With the trough in the global economy set to continue, there is unlikely to be any respite for the marine and trade industries, where counterparty insolvency will become more prevalent. 

In this Insolvency Series consisting of 5 articles, we will be covering topics relating to current concerns in the area of counterparty insolvency.

The first article in this Series covers the early stages of insolvency – identifying the warning signs, and the legal tests for when a company is deemed to be insolvent.  Early identification of insolvency is crucial in order to take protective steps before a counterparty enters the "twilight zone" of insolvency.  We will also highlight the mechanism of insolvency set off, which is one of the more important "self-help" remedies available to reduce the impact of counterparty insolvency.

In the next 4 articles in this Series, we will deal with the following topics:

  1. Insolvent trading and antecedent transactions;
  2. Rescue, rehabilitation and restructuring procedures;
  3. Liquidation; and
  4. Cross-border insolvency.

Legal tests for insolvency

Under the Singapore Companies Act, a company is considered insolvent if it is unable to pay its debts.

A company would be deemed unable to pay its debts where:[2]

  1. It is unable to satisfy a statutory demand for a debt exceeding S$10,000 within 3 weeks from the date of service of that demand, or
  2. It is unable to satisfy a judgment, decree, or order of court whether in whole or in part, or
  3. It is proved to the satisfaction of the Court that the company is unable to pay its debts.

Where a company's inability to pay its debts falls to the determination of the Singapore Courts, the Courts will apply the following legal tests:

  1. The "cash-flow" test i.e. whether the company is able to pay its debts which are presently due as well as those falling due in the near future; and
  2. The "balance-sheet" test i.e. is the value of the company's assets less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

The above tests require looking at the company's financial position as a whole to determine whether it can continue in business and still pay its way. The Singapore High Court has expressly noted that the Court adopts a commercial, not a technical, view of insolvency.[3] In other words, the Court has to consider if a company's liquidity problem is temporary and curable, or (conversely) if the company has the available funds to meet claims which are falling due in the near future.

At the same time, the "balance-sheet" test takes into account not only a company's debts but also questions whether it has assets available to meet its liabilities.

In summary, there is no one-size-fits-all approach to determine a company's solvency. It is a fact-sensitive query and the Courts will be alive to the commercial realities of each case.

Spotting the warning signs of insolvency

In practice, where one is simply a contractual counterparty without access to a company's financials, ascertaining whether your counterparty has met either of the abovementioned tests of insolvency is difficult.

As stated above, one method of establishing a company's insolvency is to issue a "statutory demand" for a debt not less than S$10,000, giving 3 weeks to pay, upon the expiry of which arises a statutory presumption of an inability to pay debts.  However, as Hemingway's Mike Campbell knew, when insolvency happens, it happens suddenly – 3 weeks may be too long to wait.

Therefore, it is important to look out for the warning signs of insolvency. These would include:

  1. Late or non-payment of undisputed claims;
  2. Failed or rejected payment attempts e.g. dishonoured cheques, delayed electronic authorisations, etc;
  3. Physical aspects of the business e.g. a poor upkeep or maintenance of a business's premises may be an indication of financial difficulties;
  4. Legal proceedings commenced against the company – this can be ascertained from public searches;
  5. Various indicators from the company's filed audited accountse.g. failure to file statutory annual accounts, auditors' opinion that the company is unable to continue as a going concern, ageing of the company's creditors, withdrawal of loan financing or tightening of financing terms.

While the warning signs may not in and of themselves prove a company's insolvent status, they are nevertheless important to look out for so that a party can make an informed decision as to its next steps in dealing with the risky counterparty.

Further, the recent Court of Appeal decision of The STX Mumbai [4] demonstrates that the Singapore judiciary is alive to the potential commercial necessities of taking precautionary measures when such warning signs become apparent.

In that case, the appellant supplied bunkers to the respondent's vessel, the STX Mumbai, on terms which required payment to be made within 30 days.  In the week leading up to the payment date, the appellant noted the following:

  1. There was a default in payment to the appellant for the supply of bunkers to a different vessel within the respondent's group;
  2. There was a news report that STX Pan Ocean, which was listed as "group owner" of the STX Mumbai, had one of its chartered vessels arrested in Seattle for unpaid bunkers in excess of US$1 million; and
  3. The same article reported that STX Pan Ocean had filed for bankruptcy protection in Korea.

As a result, 3 days before payment was due, the appellant demanded immediate payment by the close of business that same day.  When the respondent failed to make payment as demanded, the appellant arrested the vessel the next morning. 

The Court of Appeal held that on the facts, which included the above warning signs of insolvency, there was an arguable basis for the appellant to allege that the respondent had committed an anticipatory repudiatory breach of the contract and therefore, terminate the same.

However, the Court of Appeal cautioned that insolvency per se is not a breach of contract and that each case must be considered on its particular facts.  Therefore, when the warning signs are spotted, it is important to take legal advice promptly before acting.

Mitigating the impact of counterparty insolvency

When a company goes insolvent, most Anglo-American legal systems impose some form of moratorium against proceedings.  This means that a creditor will be unable to recover any uncollected debt directly from the counterparty, leaving them to prove their debt in the insolvency.  Further, an unsecured creditor will receive a distribution in the insolvency only after secured and preferential creditors are paid.  In practice, this generally means that the unsecured creditor will receive a fraction (if any) of the total amount owed.

However, that does not mean that a creditor is powerless to act when it has noticed the above warning signs.

One useful "self-help" remedy which is not affected by any moratorium is insolvency set-off, where mutual debts are automatically set off against each other on the commencement of liquidation, such that only the balance due to the solvent party is provable.

For example, if the counterparty owes S$1 million and is owed S$750,000, after the set-off, your liability to the counterparty is discharged and you need only prove for the balance S$250,000.

Therefore, an insolvency set-off allows you to immediately "receive" the benefit of S$750,000, as you are no longer liable for the same to the counterparty.  In effect, this places you in the economic position of a secured creditor to the amount of S$750,000.

Whilst insolvency set-off operates automatically, there are nevertheless circumstances in which a creditor can have an active role to play.

Take the situation where the counterparty trades with several of your group companies.  One of your group companies has a net debt and another, a net credit. 

In such situations, upon learning of a pending insolvency, you should immediately act to assign the debt from the net creditor to the net debtor, such that the latter can rely on an insolvency set-off. 

Note that any assignment of debt after the commencement of the liquidation will be void.  Therefore, upon spotting any warning signs of insolvency, it is important to act fast to effect an assignment. 

Conclusion

When faced with a counterparty insolvency, a creditor frequently has to make decisions under time pressure.  For example, it may have to decide whether to immediately abort performance and terminate the contract.  It may also have to act fast in assigning debts between group companies so as to benefit from an insolvency set-off.

In this regard, an ability to recognise the warning signs early can make a significant difference in a creditor's management of a counterparty's insolvency risk.