03 April 2014
[2014] EWCA Civ 383
Court of Appeal (Sullivan, McFarlane and Lewison LJJ)

Further guidance from the Court of Appeal on the meaning of insolvency and the relationship between the cash flow and the balance sheet tests.  A company that can only pay its debts as they fall due by incurring further debt is still insolvent. 

In an action under s.238 of the Insolvency Act Mrs. B, the director’s wife, sought to rebut the presumption of insolvency in s.240(2) that at the time of the payments to her C was unable to pay its debts as they fell due.

C introduced property investors to Dubai, through C Dubai Ltd in Dubai.  It appeared that C paid C Dubai a monthly retainer and C Dubai agreed to pay C commission on sales.  C passed investors’ moneys to C Dubai who was in turn to pass them to the developer.  C Dubai set off the sums it was due to pay C against the investors’ money it was to receive from C and would pay the withheld money to the developers in Dubai, with C transmitting any shortfall in payments due to developers.  This meant that money only went from C to C Dubai and not vice versa.

At the time payments were made to Mrs. B, C was marginally insolvent on a balance sheet test if a loan to another company, G, owned by Mr. and Mrs. B, was recoverable, which it was not as G was loss making from the start.

Following Eurosail and Cheyne Finance, the cash-flow test and balance sheet test stand side by side and the balance sheet test is not excluded simply because the company is in fact able to pay its debts as they fall due.  The two tests are part of a single exercise to determine whether a company is unable to pay its debts.  When applying the cash-flow test it is not enough for the court merely to ask whether the company is for the time being able to pay its debts as they fall due.  In an appropriate case it must inquire how it was managing to do so.  If a company is only able to pay its debts by borrowing new money (taking deposits from new investors) to pay off old debts, then unless it is able to trade out of insolvency, it is insolvent whether on a cash-flow or balance sheet test.  Further, in the absence of credible evidence that the balance sheet would improve shortly, as a trading company C was insolvent on a balance sheet basis, as the loan to G was of no value.  There was no underlying material to substantiate the claim that C Dubai’s assets exceeded the amount owed by C to depositors.  The inference was that C had used investors’ deposits for its own ends and so was using new deposits to pay old deposits.

Since Eurosail it is clear that the cash-flow test and the balance sheet tests stand side by side as part of a single exercise in determining insolvency.  If a company is apparently cash-flow solvent, it may nevertheless be unable to pay its debts if it is only paying its debts by going further into the red: that means it is robbing Peter to pay Paul.