21st December 2016

The tests of insolvency: where do recent cases leave creditors?

At a glance

The case of Evans v Jones examined the approach to the two tests of insolvency used in the Eurosail case, which suggested that such tests should not be separated and isolated from each other. Stuart Evans looks at what the court decided.

The tests of insolvency

In Evans v Jones, the Court of Appeal examined the alternative balance sheet test of insolvency under section 123 Insolvency Act 1986. This provides that a company is 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”. (The other test is the cash flow test, namely whether a company is unable to pay its debts as they fall due) The court had to decide whether a company’s claim for repayment of a dividend – paid unlawfully to shareholders and therefore repayable – was to be treated as an asset.

It held that this was a contingent claim and should not be treated as an asset, as this would not accord with “commercial reality”. The claim could not therefore return the company to notional solvency in the context of preferential payments. This case confirmed the approach taken in the earlier case of BNY v Eurosail, which we reviewed when that was published in 2013.

The tests of insolvency are of considerable importance to creditors, when they are weighing up whether to trigger a contractual insolvency provision or issue a Winding-up Petition against a company. In this context, many lending facility agreements contain two distinct insolvency default events, i.e. a cash flow test and a balance sheet test.  The two are usually drafted as two stand-alone independent defaults, meaning that a lender could call in the loans where a borrower meets only one of those tests.

The Eurosail decision gave fresh insight into the two tests of insolvency. The Court of Appeal decided that in respect of the balance sheet test, a company’s accounts were not to be regarded as the only true and fair view possible, and they were also by their nature historic. In applying the test, described as “imprecise, judgment based and fact specific”, a Court would look beyond the simple balance sheet position in the accounts.  The Court was of the view that if a debtor company failed the first limb of the balance sheet test, it should not follow that a company should automatically be wound up, as this might be unfairly preferential to short term creditors as against longer term or contingent creditors. It was important to assess whether a finding of balance sheet insolvency was commercially fair to both short and long term creditors and whether this reflected the reality of the company’s situation.

In short, the Courts would look more objectively as to whether the company had genuinely reached the point of no return or whether its survival was possible, should the company be allowed to continue and not be required to use its assets to meet short term liabilities, thus reducing the pool available to long term creditors.

What can be learned from Eurosail, as approved by Evans v Jones, is that the statutory tests in section 123 Insolvency Act (cash flow and balance sheet test) should not be mechanistically applied, but applied in a way that has regard to commercial reality. The two tests should not be separated and isolated from each other.

Conclusion

Drawing this together, the Evans v Jones case has confirmed the approach taken in Eurosail, to apply a “commercial reality” test. In practice, this means that there is an increasing reluctance to find insolvency simply on the basis that the borrower satisfies one part of the cash flow/balance sheet test. There would on this basis no longer be two independent stand-alone tests, rather a single test made up of two limbs which interact with one another.

So what does this mean for creditors that have facility agreements containing two distinct, stand-alone insolvency default events, meaning that a lender could call in the loans where a borrower meets only one of those tests?  It follows that a default trigger might arise under the lending agreement but not meet the test for insolvency under English law.  Accordingly, there remains a divergence between standard lending terms and the more general insolvency law that focuses on commercial reality.

For creditors weighing up whether to trigger a contractual insolvency provision or issue a Winding-up Petition, greater analysis is now required and snap decisions may be fatal.  The Eurosail and Evans v Jones cases arguably introduced more uncertainty for creditors who are dealing with companies that they believe may be insolvent.  As ever, professional advice in these circumstances is recommended.

For more information, please contact Stuart Evans by emailing Stuart or by calling him on +44 01293 558525.

This document is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from taking any action as a result of the contents of this document.

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