Supreme Court clarifies solvency test

​The Supreme Court this week provided clarification on the extent to which a disputed damages claim should be taken into account when deciding whether a “company is unable to pay its due debts".

At issue was whether the enquiry should be limited to those debts that were or were shortly to become legally due, or whether a more practical and commercial approach be taken? We look at the decision.

The case 

In David Browne Contractors Ltd v Petterson1, a voidable transaction case under section 292 of the Companies Act 1993, the Supreme Court opted for the latter approach, following case law from Australia and the United Kingdom.2

In short, the ability of a company to pay its due debts is to be assessed objectively, taking a “practical business perspective". The assessment should include future and contingent debts where there is “sufficient certainty" that liability will crystallise in a reasonable timeframe. The exact timeframe that is relevant will depend on the nature of the company's business.

The context                                                                                              

The company in question welded pipes. Some of those welds failed, leading to a sizeable claim from its customer. After receiving that claim, the company decided to repay substantial advances to related creditors, confirming in the process the directors' belief that the company was solvent.

The directors were aware that the claim, if upheld, would render the company insolvent. But the directors concluded the company was solvent because, they said, the claim was disputed, there were off‑sets available and insurance would cover most of the loss if required.

The decision

Importantly, the Supreme Court saw the solvency test as an objective one. The genuineness or otherwise of the directors' belief was not relevant. Instead, what mattered was whether a reasonable director in their position would have come to the same conclusion.

On the facts of this case, the Court said the directors had no reasonable basis for omitting the claim from an assessment of solvency. Specifically, expert independent reports available at the time supported the claim, the directors could not point to any set-off sums and no legal advice was taken at the time as to whether the contract works policy would cover the claim. Later legal advice was that insurance cover was not available.

The recipients of the payments argued in the Supreme Court that such a broad and commercial assessment would mean that even unmeritorious claims would need to be considered. The Court rejected this argument, confirming that the relevant perspective is that of a “reasonable and prudent business person". In particular, “specious claims" do not need to be considered. Nor would claims with a “credible defence". Ultimately the question is whether or not there is “sufficient certainty those claims would crystallise into a debt legally due within a reasonably temporarily proximate timeframe".

Chapman Tripp comments

The Supreme Court's approach is unsurprising, given the relatively recent and high authority to the same effect in Australia and the United Kingdom.

It is also consistent with the policy aim of the voidable transaction regime, which targets advantages obtained by creditors relative to the results in a liquidation. Claims provable in a liquidation include, of course, future and contingent claims, as well as those that have already become legally due for payment.

While the Court was not directly considering the solvency test in section 4 of the Companies Act, it did see that test as relevant. We expect that this decision would be influential in any case on the section 4 test, at least in relation to the cash flow aspect of that test. The factors discussed in this case should therefore be considered in other contexts where the solvency test is applied, such as in authorising dividends.

1 [2017] NZSC 116. A copy of the decision can be found here.

2 For our commentary on the United Kingdom Supreme Court decision of BNY Corporate Trustee Services Ltd v Eurosail, see When is broke broke? A UK Supreme Court perspective.

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Related topics: Restructuring & insolvency; Insolvent trading

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