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Section 123 of the Insolvency Act 1986 defines insolvency in two ways:

• The “cash flow” test of whether a company is able to meet its liabilities as and when they fall due for payment; and

• The “balance sheet” test of whether the company’s liabilities, including future and contingent liabilities, exceed its assets.

One of the problems with the balance sheet test is that many successful companies would be considered insolvent if it is given too literal a meaning. That becomes an issue because some finance agreements contain a clause which makes insolvency as defined by s123 a default event, allowing the lender to terminate it, perhaps demanding immediate repayment.

The facts in BNY Corporate Trustee Services Limited v Eurosail UK PLC involve a complex financial instrument relating to sub-prime mortgages and a post-enforcement call option (whatever that may be!), and documentation described by Lord Neuberger as “regrettably and forbiddingly voluminous”. Happily, the details are not important. The question which the Court of Appeal had to decide was whether it should look simply at the face values of the company’s balance sheet, or apply a more restrictive test of whether the company truly had “reached the point of no return”.

The Court decided in favour of the second option. Hence a company is only insolvent against the balance sheet test if it can be said that, looking at its assets and liabilities (including future and contingent liabilities), it is paying current and short-term creditors at the expense of creditors payable at some point in the future. It held that, whilst the balance sheet may be a useful starting point, there is a need to keep “a firm eye on both commercial reality and commercial fairness”. The Court accepted that as a test this is imprecise, subjective and fact-specific, and unhelpfully said “It is not really possible, indeed it would be positively dangerous, to give much further guidance as to the approach to be adopted by the Court when deciding whether s 123(2) applies”.

Almost all winding-up petitions are based on a debtor company’s failure to meet an undisputed debt on its due date, and a detailed examination of the company’s financial position is therefore rare.

The case may have relevance to a company which has, for example, a large director’s loan account balance. In such cases it may well be that the director is treating that balance as long-term funding for the company rather than a current liability. Just because a company has more liabilities than assets does NOT mean that it should immediately be put into liquidation to avoid “trading whilst insolvent”.

Some commentators, however, have suggested that where there is creditor hostility perhaps to a pre-pack sale in an administration, and an allegation that the administration procedure is being used simply to “dump” creditors, then that the company’s advisers may need to be able to demonstrate that the company really has reached “the point of no return” and not just suffering from a short-term liquidity difficulty.

NOTE: This document is intended for general information only. It is not a substitute for specific advice which should be sought for specific cases. Although we endeavour to provide accurate information, there is no guarantee that such information is accurate as of the date that it is provided, nor that it will continue to be accurate in the future. We cannot accept responsibility for any action (or decision not to take action) made in reliance of the content of this document.