UK: England and Wales: Court of Appeal considers balance sheet test of insolvency under Insolvency Act (1986)

Yesterday the Court of Appeal gave its judgment in BNY Corporate Trustee Services Ltd v Eurosail - UK 2007 - 3bl Plc [2011] EWCA Civ 227, in which it was required to consider the so-called 'balance sheet test' of insolvency within Section 123(2) of the Insolvency Act (1986) in the context of the interpretation of a commercial contract. The court's decision is the leading English authority on this section and contains much worthy of quotation but the following stands out (to quote from the opinion of Lord Neuberger MR at para. [48] onwards):

In my view, the purpose of section 123(2) has been accurately characterised by Professor Sir Roy Goode in Principles of Corporate Insolvency Law (third edition). Having referred to section 123(1)(e) as being the "cash flow test" and to section 123(2) as being the "balance sheet test", he said this at para 4-06: 'If the cash flow test were the only relevant test [for insolvency] then current and short-term creditors would in effect be paid at the expense of creditors to whom liabilities were incurred after the company had reached the point of no return because of an incurable deficiency in its assets.'

In my judgment, both the purpose and the applicable test of section 123(2) are accurately encapsulated in that brief passage. Subsection (2) was, in my view, included in section 123 to cover a case where, although it could not be said that a company "is [currently] unable to pay its debts as they fall due" (either because it has no debts which are currently payable, or because it has, or can achieve, the cash flow to pay such debts), it is, in practical terms, clear that it will not be able to meet its future or contingent liabilities. A future or contingent creditor of a company can often claim to be prejudiced by the company using its cash or other assets to pay current creditors or even for some other purpose, but, within bounds, that is an inherent risk in the futurity or contingency of the liability. It is only when it can be said that the company's use of its cash or other assets for current purposes amounts to what may be vernacularly characterised as a fraud on the future or contingent creditors that it can be said that it "has reached the point of no return".

I disagree with ... [the] submission that, when carrying out the exercise required by section 123(2), one simply takes future and contingent liabilities at face amount. "Face amount" is not a term of art ... If a company has a liability for £x in ten years or more, it cannot be right to treat that as a present liability of £x, unless, perhaps, it carries interest at an appropriate rate. The idea that one has to carry out a valuation exercise in relation to future and contingent debts is supported by commercial common sense as well as by the provisions of Rule 13.12(3).

The appellants are on somewhat stronger ground in their contention that the figures in the company's balance sheet, and audited and signed off annual accounts, should be accorded weight in the exercise envisaged by section 123(2). I do not think that it is possible or helpful to describe in general terms the weight to be given to such figures in such an exercise. Clearly, the fact that the figures have been audited and are said to convey a "true and fair" view of the company's position in the opinion of its directors should normally have real force. However, the figures will inevitably be historic, they will normally be conservative, they will be based on accounting conventions, and they will rarely represent the only true and fair view. The court will ultimately have to form its own view as to whether the company in question has reached what Professor Goode described as "the point of no return".

It is not really possible, indeed it would be positively dangerous, to give much further general guidance as to the approach to be adopted by the court when deciding whether section 123(2) applies. The ultimate question, at least normally, is that identified by Professor Goode, and it is to be determined with a firm eye both on commercial reality and on commercial fairness. Clearly, the closer in time a future liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123(2) will apply.

Update (8 March 2011): The ICLR, as part of its WLRDaily service, has provided a summary of the decision here.