A seemingly innocuous question posed to lawyers and accountants by clients down the ages. The answer used to be fairly simple, as Mr Micawber memorably put it: "Income, twenty shillings a week, expenditure, twenty shillings and sixpence; result, misery. Income, twenty shillings a week, expenditure, nineteen shillings and sixpence; result, happiness."
Prior to the mid 1980s advisors to troubled companies had a good idea of what “insolvent” meant – but like the proverbial elephant, they knew it when they saw it but couldn’t really define it. The Insolvency Act 1986 introduced for the first time a statutory definition of insolvency (or at least “inability to pay debts”, which was generally taken to be the same thing), invoking both cash flow and balance sheet tests.
So had everything become clear? Well, not exactly! The cash flow test was the one most often invoked in the case of a trading company: when you can’t pay your bills and creditors are beating down your door, it’s pretty obvious that you’re insolvent. Not much argument about that.
It was the balance sheet test which was always more problematical. What was meant by “… the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.”? Whatever the precise meanings of the individual words – and there was seemingly endless scope for arguments about these – it was generally accepted that the test was a numerical one. Assets greater than liabilities: happiness; assets less than liabilities: misery.
However, the Eurosail Appeal Court decision handed down in March 2011 has turned this consensus over the basic meaning of balance sheet insolvency on its head by introducing an overtly subjective element into the equation: should the company put up the shutters or should it try to refinance or trade out of its problems? No longer is the question simply: 'are my liabilities greater than my assets?' It now embraces the additional question: 'is it reasonable for me to continue in business with a view to restoring a surplus of assets over liabilities?'
Of course these are questions which are even more difficult for directors to answer than the purely numerical questions around the extent of their assets and liabilities. As a result, they will undoubtedly need more support from their advisors to help them to come to a defensible conclusion, particularly if that view is that they ought to continue trading to restore their asset position.
This will require much more than “merely” kicking the tyres to test the values of assets and liabilities and conclude on the net asset position; there will now need to be a careful assessment by professionals – both accounting and legal – of the steps that will be needed to restore the net asset position and of the prospects of success. This is likely to encourage directors in many instances to seek out and then follow sound professional advice to pursue a feasible turnaround or restructuring, something that should be widely welcomed by professionals and stakeholders alike. This is the positive message from Eurosail, that formal insolvency proceedings may be avoided if there is still a reasonable prospect of survival.
However, Eurosail may also have a sting in the tail for creditors, who rely on the ability of insolvency practitioners to use the Insolvency Act avoidance powers to make recoveries for the benefit of creditors. In fact, this is sometimes a key objective of insolvency proceedings and one in which the BDO Contentious Insolvency team has particular expertise and experience.
In the wake of Eurosail, perhaps one of the most important questions for those who have lost money in an insolvency situation will be how will the courts apply the insolvency test. The determination of whether a company is insolvent at the time of a questionable transaction is often a necessary ingredient for an insolvency practitioner to be able to bring an action to make recoveries from the avoidance of antecedent transactions.
To give a specific example, will preference claims – perhaps even against connected parties – fail because the directors can successfully argue based on Eurosail that the company had a reasonable prospect of avoiding insolvency proceedings even though it was insolvent on a balance sheet basis as that term has hitherto been generally understood? Will the “clarified” Eurosail insolvency definition prove to be a rogues’ charter? Only time will tell, but it is clear that the ramifications of Eurosail have yet to be fully determined or appreciated.