The English court of appeal has held that a company should not be held to be balance sheet insolvent on the sole basis that its liabilities (including contingent and prospective liabilities) exceed its assets.

In BNY Corporate Trustee Services v Eurosail & Ors, the Court of Appeal considered in detail, for the first time, the construction of section 123 of the UK Insolvency Act 1986, which sets out circumstances in which a company can be deemed to be unable to pay its debts.

The relevant portions of section 123 provide as follows:

“..[a company shall be deemed to be unable to pay its debts ] …

(1)(e) if it is proved to the satisfaction of the court that the company is
unable to pay its debts as they fall due."

(2) 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 liabilities,taking into account its contingent and
prospective liabilities."

The previous position in English law

In Byblos Bank SAL v Al-Khudhairy, which considered section 223(d) of the English Companies Act 1948 (a predecessor of section 123 of the Insolvency Act 1986), the English Court of Appeal held that it must assess the ability of a company to pay its debts on its assets as they currently stood and that the prospect of a company acquiring further assets before contingent or prospective debts became due went only to the discretion of the court in deciding whether or not to make an order winding up the company.

In Eurosail the court held that Byblos was of limited assistance in construing section 123 of the Insolvency Act 1986, as the provisions were phrased differently.

The position in Irish law

The Irish jurisprudence in relation to section 214(c) of the Companies Act 1963, which is in identical terms to section 223(d) of the English Companies Act 1948, is substantially at variance with Byblos. The leading Irish case on the test for solvency is re: Creation Printing, a case decided in the context of the validity of a floating charge under section 288 of the Companies Act 1963. In that case the Supreme Court held that:

"Solvent" and "insolvency" are ambiguous words. It has now been established by the decided cases that, for the purposes of s. 288 of the Act of 1963, the test to be applied in determining this question is whether immediately after the debenture was given, the company was able to pay its debts as they became due. The question is not whether its assets exceed in estimated value its liabilities, or whether a business man would have regarded it as solvent…” [Emphasis added]

Accordingly, it appears that in importing the phrase “as they became due” into the test for insolvency, the Irish courts foreshadowed the implementation in section 123 of the English Insolvency Act 1986 and in so doing adopted what is perhaps a more commercially reasonable position than the judgment in Byblos.

Judgment in Eurosail

In Eurosail the Court considered first the application of the balance sheet test for insolvency set out in section 123(2) of the Insolvency Act 1986.

It considered, among other things the following paragraph from the Cork Report, which fed into the white paper that became the Insolvency Act 1986:

"A balance has to be struck between the right of an honest and prudent businessman, who is prepared to work hard, to trade out of his difficulties if he can genuinely see a light at the end of the tunnel, and the corresponding obligation to 'put up the shutters', when, by continuing to trade, he would be doing so in disregard of those business considerations which a reasonable businessman is expected to observe."

The court held that the application of section 123(2) did not simply depend on whether the liabilities of a company exceeded its assets. Rather its application was limited to cases where, although a company was currently able to pay its debts as they fell due, it was, in reality, clear that it had reached the point of no return.

The court also held that the figures set out in the audited accounts of a company were likely to be historic, based on accounting conventions, overly conservative and rarely represented the “only true and fair value”. Accordingly, it was for a court in each case to decide if a company had “reached a point of no return”.

The court declined to set out detailed guidance on the application of the section but noted that “the closer in time a future liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123(2) will apply”.

Comment

Despite the differences between the applicable English and Irish legislation, this judgment gives some comfort to directors that they may continue to trade in circumstances where the company can pay its debts as they fall due and where the directors believe on reasonable grounds that they can trade out of a net liability position on the balance sheet.

It appears to have moved the balance sheet test of insolvency from a mechanistic test to an objective but imprecise question of fact as to whether a company has “reached the point of no return”.

It also provides some welcome guidance on how account should be taken of contingent and prospective liabilities in an assessment of solvency.