What does it mean and why does it matter?
 
The Supreme Court has held that the balance sheet test for insolvency is not whether the company has "reached the point of no return", but neither is it an objective test taking the company’s assets and liabilities at face value.

What does the decision mean?

The Supreme Court was dealing with contingent liabilities, and its decision makes it clear that the more remote a prospective asset or liability is, the harder it will be for significant value to be attached to it. The court will need evidence as to:

  • How likely the liability is to arise
  • How long it will take
  • What will happen to the company in the meantime
  • The overall loss if the liability occurs

The same approach would have to be taken in relation to contingent assets, for example, the value of a claim being litigated by the company.

Why does it matter?

  • Winding up petitions - the decision is likely to be least significant in relation to winding up petitions, which are the main subject of section 123. In reality, creditors’ petitions are almost always based on a failure to pay the debt due to the creditor on the due date, and significant disputes as to the company’s balance sheet are rare, and will continue to be rare.
  • Administrations - again, the decision is likely to make no difference to the vast majority of administrations, where the company is undoubtedly insolvent. It should be taken into account in cases where a proposed pre-pack sale or management buy-out is likely to attract hostile criticism from a creditor. If there is any likelihood of an allegation that a company could in fact have survived, and the administration procedure is being used to get rid of particular creditors (such as HMRC, a pension fund shortfall, or the other party to litigation), the proposed administrator and the company’s advisors both need ensure that there is evidence to demonstrate that the company has more than a short term liquidity problem.
  • Commercial and financial contracts - incorporating section 123 of the Insolvency Act 1986 into commercial contracts is widespread and often beneficial to one of the parties, but it has always created uncertainty because the grounds on which the court may make a winding up order against a company are not always the same as those which should give rise to the right to terminate a contract. Terminating a commercial or financial contract based on balance sheet insolvency will be risky if there is a serious argument that a contingency should be taken into account. If there is no real possibility of the contingency arising, the balance sheet test is likely to be able to be determined by up to date management accounts if they are available.
  • Liquidators’ claims - under section 240 of the Insolvency Act 1986, a transaction at undervalue or a preference can only be challenged if it occurred at a time when the company was unable to pay its debts within the meaning of section 123. It is not certain how far contingent and prospective liabilities will be valued with the benefit of hindsight. Defendants will argue that they should be discounted to reflect the chance that they would not arise. Otherwise a company with a 99 per cent chance of avoiding a huge liability could be found to have been insolvent if the one per cent worst case scenario occurs. Liquidators will argue that insolvency under section 123 is only a precondition to the exercise of the court’s discretion, and that injustice can be avoided by looking at whether any of the other defences exist: for example, if there is only a one per cent chance of the company failing, it might be hard to prove that there was any desire to prefer anyone, as insolvency was so unlikely. This will have to be decided by future litigation.

Background

Section 123 of the Insolvency Act 1986 provides two main tests of when a company is insolvent:

  • The "commercial" test, defined as it being proved to the satisfaction of the court that the company is unable to pay its debts as they fall due
  • The "balance sheet" test, defined as the value of the company’s assets being less than the amount of its liabilities, taking into account its contingent and prospective liabilities

Section 123 is concerned with the grounds on which a creditor can present a winding up petition against a company. The same test is applied in deciding whether a company was insolvent at a particular time for the purposes of claims by liquidators, particularly transactions at undervalue and preferences. The wording of section 123 is also frequently incorporated into financial and commercial contracts. Many agreements make insolvency within the meaning of section 123 an event of default which allows the other party to a commercial contract to terminate it, or which allows a lender to withdraw facilities and sometimes even to demand immediate repayment of outstanding loans.

BNY Corporate Trustee Services Limited v Eurosail UK plc

An underlying problem with the balance sheet test is that many successful companies are insolvent if it is given too literal a meaning. For example, a relatively new company which is financed by loan capital from its bank and its shareholders could easily find itself in a situation where the market value of its depreciating assets is less than the loans and interest which are outstanding.

BNY v Eurosail concerned the events of default in a complex financial instrument involving sub-prime mortgages. The question was whether changes in the financial market meant that a bond issuer was insolvent on the balance sheet test, despite having sufficient liquidity to pay its debts.

The Supreme Court was faced with two competing interpretations of section 123:

  • An objective test, where one takes the assets and liabilities at their respective face values, which are those in the company’s balance sheet unless good reason is shown to the contrary
  • A more restrictive test, where the court looks at whether the company has "reached the point of no return", which was the approach upheld in the Court of Appeal

The Supreme Court adopted a definition between these two extremes. It regarded the phrase "point of no return" as the wrong test to apply, and concluded that all that section 123 means is that it must be shown that the company is more likely than not to have insufficient assets to meet its liabilities, including prospective and contingent liabilities.