"Balance sheet" test for insolvency must take account of wider commercial context, says Supreme Court

Out-Law News | 13 May 2013 | 5:15 pm | 3 min. read

Courts must look beyond the assets and liabilities used to prepare a company's statutory accounts when deciding whether or not a company is balance sheet insolvent, the Supreme Court has ruled.

In his leading judgment, Lord Walker said that when using the traditional 'balance sheet' test to determine whether a company was legally insolvent, it was not correct for courts to consider whether the debtor had passed a "point of no return" from insolvency. This was particularly relevant in cases where debts, such as those relating to a mortgage or a pension scheme, would not fall due until some point in the future, he said.

"I consider that 'the point of no return' should not pass into common usage as a paraphrase of the effect of [the Insolvency Act]," Lord Walker said. "In the case of a company's liabilities that can as matters now stand be deferred for over 30 years, and where the company is (without any permanent increase in its borrowings) paying its debts as they fall due, the court should proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency."

In the case under consideration the company's ability or inability to pay all its debts "may not be finally determined until much closer to 2045", he said.  In which case any attempts to determine whether or not the debtor was balance sheet insolvent “if not entirely speculative, are incapable of prediction with any confidence”.

The court had been asked to rule on whether Eurosail, a special purpose entity set up by Lehman Brothers to hold £650 million worth of UK residential mortgages, should be considered "unable to pay its debts" within the meaning of the Insolvency Act. Insolvency was designated as an event of default in the conditions governing the mortgages, which were due to mature in 2027 and 2045. Hedging arrangements between Eurosail and Lehman Brothers collapsed following the insolvency of the bank in 2008, leaving net liabilities of approximately £74.5m on Eurosail's audited financial statements.

Under the Insolvency Act, a company is considered to be insolvent under English law if it is unable to pay its debts. The act specifies two 'tests' which can be used to determine whether or not this is the case. The first, generally known as the 'cash flow' test, concerns the ability of a company to pay its debts as and when they fall due. The second, known as the 'balance sheet' test, is triggered when the value of a company's assets is less than its liabilities - taking into account its "contingent and prospective" liabilities.

Lord Walker helpfully confirmed that the cashflow insolvency test was also forward-looking and not just a mere snapshot of the debtor's current ability to pay.  However the balance sheet test is a practical necessity because, "once the court has to move beyond the reasonably near future ... any attempt to apply a cash-flow test will become completely speculative, and a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test," said Lord Walker in his judgment.

"But it is still far from an exact test, and the burden of proof must be on the party which asserts balance-sheet insolvency," he said.

Restructuring law expert Alastair Lomax of Pinsent Masons, the law firm behind Out-Law.com, said that the court's conclusions emphasised the importance of applying the facts of each case to the wording of insolvency legislation. "This decision gives some guidance to parties who need to establish whether or not the tests in insolvency legislation have been passed.  However, there is still considerable room for uncertainty because of the fact-sensitive nature of the tests.  Uncertainty still surrounds the boundaries between the two statutory tests as well as what discount should be applied to future or contingent liabilities" he said.

The question of when a debtor is insolvent is important in all sorts of contexts.  Many commercial contracts contain insolvency termination triggers.  Loan documents typically include insolvency events of default.  Insolvency is also vital in determining the outcome of a winding-up petition and challenges to potentially unlawful transactions occurring prior to the start of formal insolvency proceedings. 

"Most well-drafted contracts refer to the tests reviewed in this case", said Lomax.  "This decision offers some comfort to debtors with long-term liabilities that negative assets in statutory accounts will not necessarily result in their failing the insolvency test.  Employers liable for defined benefit pension schemes in deficit will no doubt draw some comfort from this.  However, if parties to such contracts - particularly creditors - want certainty, they should be considering including additional triggers based on financial performance with specific, measurable benchmarks."