Like many legal tests, the test for insolvency is easy to state, but hard to apply in practice.
The United Kingdom Supreme Court (UKSC)has recently issued an important clarification, which confirms that an element of forwards projection must be applied – extending in extreme cases to assessments of balance-sheet as well as cash-flow solvency.
This liberal approach is likely to be followed in New Zealand, despite differences in statutory wording.
The concept of inability to pay debts is woven throughout the Companies Act 1993. Ability to pay debts is a prerequisite for the making of a distribution, such as a dividend (see the section 4 solvency test), and a transaction entered into at a time when the company is unable to pay its debts is voidable by a liquidator (section 292). A company may also be placed in liquidation if is unable to pay its debts (section 241(4)(a)). This will be the case if fails to comply with a statutory demand or if there is proof by “other means” that it cannot pay its debts. Section 288(4) provides that “[i]n determining whether a company is unable to pay its debts, its contingent or prospective liabilities may be taken into account”.
But what does this important test mean in practice? In particular:
- how far into the future does the test extend? What result if a company is able to pay its debts today, but is highly unlikely to do so in three months’ time?
- in what circumstances will a contingent or prospective (but uncertain) liability render a company unable to pay its debts?
The UKSC decision in the Eurosail Case
The UKSC came to consider these questions in the context of loan notes issued in the course of a 2007 Lehman Brothers transaction, which incorporated by reference (with small modifications) section 123 of the Insolvency Act 1986 (the UK Act).
Section 123 – which roughly, but not precisely, corresponds to our sections 287 and 288 – contains two relevant limbs under which a company is deemed unable to pay its debts:
- the “cash-flow” insolvency limb: “if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due” (s 123(1)(e)), and
- the “balance-sheet” insolvency limb: “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”
The issue was whether an event of default had occurred with respect to the loan notes, in that Eurosail, the issuer of the notes, was unable to pay its debts within the meaning of s 123. If so, repayment priorities would alter. Thus different classes of noteholders had different interests in the argument.
Key conclusions were:
- the cash-flow test is concerned not simply with the company’s presently-due debt, but also with debts falling due from time to time in the “reasonably near future”. What is the reasonably near future will depend on all the circumstances, but especially on the nature of the company’s business
- once the court has to move beyond the reasonably near future, any attempt to apply a cash-flow test will become “completely speculative”. Hence “the only sensible test” is to consider assets and liabilities, including contingent and prospective liabilities, and
- as this is still “very far from an exact test”, the court should proceed with the greatest caution in deciding that the company is balance-sheet insolvent.
On the facts, the court agreed that it could not be said that Eurosail was unable to pay its debts. This is unsurprising. Eurosail was not an operating business, but what was described as a “closed system”. Its ability or inability to pay its debts, present or future, may not be finally determined until 2045, depending upon future currency, interest rate and general economic conditions.
These factors, if not entirely speculative, cannot be predicted with any confidence in 2013. The court could not therefore be satisfied that there will eventually be a deficiency.
Application of the Eurosail decision for New Zealand?
The New Zealand statutory context is different from that of the UK. While the solvency test refers to both cash-flow and balance-sheet insolvency, the test for liquidation on account of inability to pay debts does not expressly refer to balance-sheet insolvency. It has accordingly been interpreted as being focused solely on cash-flow issues.
But a strictly cash-flow approach has always been difficult to apply far into the future. The UKSC’s decision emphasises that the possession of assets insufficient to meet liabilities was historically recognised as one species of inability to pay debts. In other words, the phrase “unable to pay its debts” implicitly embraces elements of a balance-sheet insolvency test. This is especially so when, as in New Zealand, the court may take account of contingent and prospective liabilities.
The Eurosails decision is accordingly likely to be used in New Zealand to undermine a rigid distinction between the cash-flow and the balance-sheet tests for the purposes of liquidation applications. It is already established in New Zealand that the solvency test must be applied with a sense of “commercial reality so that the directors may look to the immediate future and past, as well as the present, in determining whether the test is satisfied”. A more far reaching approach may now be taken to liquidation applications, such that there is really a single sliding scale of inability to pay debts, encompassing aspects of the traditional cash-flow and balance-sheet tests. On this approach, a company would be unable to pay its debts both:
- where, due to liquidity constraints, it cannot do so in the present or reasonably near future, and
- where, due to fundamental balance-sheet weakness, it cannot be reasonably expected to meet all of its contingent and prospective liabilities.
It is obviously a very difficult decision for a court to place a company into liquidation where it is able to meet its debts as they presently fall due. Thus, arguments based on futurity will often be labelled, as they were in Eurosails, as mere speculation. But the door to such arguments is now firmly open in the United Kingdom, and ajar in New Zealand.