The retail sector and its suppliers operate at the sharp end of the economy and feel the impact of tighter consumer spending with more immediacy than most other sectors.

Although Northern Rock has grabbed the headlines over recent months, there have been retail casualties also. On 14 December 2007 Marston Mills Group, a homeware and soft furnishings retailer, appointed joint administrators. Reduced consumer spending, higher utility costs and rising rents were blamed. More recently, joint administrators were appointed to nationwide shoe retailer Dolcis on 21 January 2008. The administrators blamed “tough trading conditions”. Shortly after the administrators’ appointment, 89 stores and concessions out of 185 were closed and nearly 600 of the chain’s 1,200 staff lost their jobs. The administrators continue to trade the remaining stores while a buyer is sought. In these market conditions, directors will be keen to ensure that they are kept fully up to date with the financial affairs of the relevant company and adequate safeguards are in place to ensure that all material matters are brought to the attention of the board of directors.

Directors may be held liable for wrongful trading if they allowed the company to continue in business when they knew or ought to have known that there was no prospect of meeting the company’s liabilities as they fell due. A recent case has considered the cash flow test on insolvency. This will be relevant when directors are considering the solvency of a company.

The inability of a company to pay its debts is considered to be evidence of its insolvency. The definition of “inability to pay debts” is found at section 123 of the Insolvency Act 1986 (“IA 1986”).

Section 123(1)(e) IA 1986 states that: “A company is deemed unable to pay its debts if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.” This is usually referred to as the commercial or cash flow test. Section 123(2) IA 1986 states that: “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 its liabilities, taking into account its contingent and prospective liabilities.” This is usually referred to as the balance sheet test. Both the cash flow and balance sheet tests are determined by the court as amatter of fact, after evidence has been placed before it.

In the recent case of In the Matter of Cheyne Finance PLC (in receivership) [2007] EWHC 2402 (Ch), the Receivers of Cheyne Finance PLC applied to the court for a direction as to how to work out whether an “Insolvency Event” had occurred under a trust deed (the “Trust Deed”). In the definition of Insolvency Event, the Trust Deed included a reference to section 123(1) IA 1986. The court noted that whereas for the balance sheet test in section 123(2) IA 1986, the court had to consider contingent and prospective liabilities, the cash flow test in section 123(1)(e) IA 1986 talked about “debts as they fall due.” After considering a wealth of Australian authorities, the court decided that the definition of Insolvency Event did permit the Receivers to have regard to the company’s ability to pay debts falling due sometime in the future. The court also held that the standard of proof regarding the inability to pay debts was on the balance of probabilities. The Receivers had to be satisfied that inability to pay is more likely than not.

If directors have concerns regarding the solvency of the company then they should take legal advice as soon as possible and consider appointing independent financial advisers or independent insolvency practitioners to assist the board in reviewing its financial position.