THE Insolvency Act 1986 deems a company to be unable to pay its debts following the satisfaction of any one of a number of tests, the most important of which are cash-flow and balance-sheet insolvency. The cash-flow test states that a company shall be deemed to be unable to pay its debts if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due (s. 123(1)(e)). The balance-sheet test states that a company shall be deemed to be 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 (s. 123(2)).

The question of what triggers these deeming provisions is important, and not just because the answer determines the availability of a range of processes designed amongst other things to turn a company around or wind it up. It has wider significance because many financial instruments governed by English law make reference to the provisions of the Act as “events of default”. Triggering an event of default can change the relationship between creditors and debtors, such as allowing the former to accelerate the maturity of an underlying debt, and between classes of creditors, for instance regarding priority of repayment of the principal debt and interest. Given the importance in the financial markets as well as in insolvency proceedings of these provisions, it is perhaps surprising that there has previously been such limited authority on their interpretation. The Supreme Court has now considered the matter.

The facts of BNY Corporate Trustee Services Limited and others v Eurosail-UK 2007-3BL [2013] UKSC 28, [2013] W.L.R. 1408 reflect the role of the tests for insolvency in the financial markets. A portfolio of residential mortgages in the UK was securitised. The events of default in the issued notes included the insolvency of the securitisation vehicle, Eurosail-UK 2007-3BL plc, with express reference to the relevant sections of the Act. The rights of the creditor classes shifted on default. Before a default, the A2 Noteholders had priority over the A3 Noteholders as regards repayment of the principal but both ranked equally as regards interest. After a default, both also ranked equally as regards the principal. The A3 Noteholders argued that a strict interpretation of the balance-sheet test should be adopted, on which basis Eurosail was insolvent and the noteholders ranked equally as regards principal and interest. The A2 Noteholders argued for a more flexible interpretation of the balance-sheet test, on which basis Eurosail remained solvent and the A2 Noteholders retained their priority.

Lord Walker, giving the leading judgment in the Supreme Court, started with the cash-flow test. His Lordship noted that it is “significantly different” from a true deeming provision in that it goes to the “very issue” of inability to pay debts (at [25]). Focusing on the words “as they fall due”, Lord Walker reviewed the authorities to show that this concept existed at common law before its inclusion in the 1986 statutory regime (at [32]). The insertion of the words was therefore construed as emphasising that the test took into account debts falling due in the “reasonably near future” as well as those presently due. The question of what was “reasonably near” would depend on all the circumstances (at [37]). The test should be applied in a flexible and fact sensitive fashion (at [34], approving dicta of Briggs J. in Re Cheyne Finance plc (No. 2) EWHC 2402 (Ch), [2008] Bus. L.R. 1562 at [56]).

The construction of the cash-flow test formed the first and most crucial step in Lord Walker's approach to the balance-sheet test. Where the cash-flow test ventures beyond the reasonably near future and becomes “speculation”, the balance sheet test becomes “the only sensible test” (at [37]–[38]). But, having established when the balance-sheet test should be used, His Lordship provided significantly less guidance on how it should be used. Contingent and deferred debts must be discounted but no detail was given as to their calculation (at [37]). The party asserting the insolvency bears the burden of proof, it being particularly difficult to discharge where the company is cash-flow solvent or where the liabilities particularly distant (at [37], [38] and [42]). As Lord Walker confessed, this is “not an exact test” (at [37]).

On the facts, Eurosail was found not to be balance-sheet insolvent. The vehicle's solvency depended on future currency and interest rate movements, and the wider economy's performance. To find Eurosail insolvent, a court would have to be capable of a confident prediction as to these external factors for the life of the debt: a tall order for economists, let alone judges, given that the debt was due to mature 30 years hence. As such, the burden of proof was not discharged (at [49]).

There are sound policy reasons against aggregating and mechanistically comparing a company's assets and liabilities. Many companies enter a “twilight zone” where their assets are momentarily eclipsed by their liabilities only then to escape and thrive. Defining such entities as balance-sheet insolvent leaves them vulnerable to opportunistic petitions, and makes insolvency event of default provisions in many finance documents akin to hair triggers. But uncertainty and judicial discretion in the application of the test, which will be encouraged by the sparse detail provided by Lord Walker, are equally undesirable to struggling companies and financial markets alike. To return to the facts of the case, the Supreme Court was considering a passive securitisation vehicle whose solvency merely depended on a limited number of external factors; without more guidance, how can lower courts and legal advisers be expected to come to consistent and coherent views on the solvency of active trading companies operating in much more complicated circumstances?

Lord Neuberger's judgment in the Court of Appeal [2011] EWCA Civ 227, [2011] 1 W.L.R. 2524 similarly rejected a mechanistic approach but offered more guidance as to the application of the test. First, unless there is good reason, the company's audited accounts should be treated as the “starting point” for the test, which is then “amended” to reflect other factors (at [64]). Lord Walker did not directly engage with this structure. In the absence of criticism it is to be hoped that it is adopted in the future. Statutory accounts are prepared to offer creditors protection by way of disclosure. Bringing the Companies Act 2006 and the Insolvency Act 1986 together in this manner helps create a coherent framework under which creditors and companies can interact whilst bypassing the risks associated with looking no further than the accounts. Such a structure also brings with it a greater degree of certainty, which would reassure the financial markets that incorporate the tests into their products on such a regular basis.

Secondly, in the Court of Appeal Lord Neuberger held that s. 123(2) tests whether a company “has reached the point of no return” (at [49]). Toulson L.J. disagreed: no return merely referred to the purpose of the test but could not be treated as a paraphrase of it (at [119]). On appeal, Lord Walker was more emphatic still, holding that it “should not pass into common usage as a paraphrase of the effect of section 123(2)” (at [42]). The simplicity of the “no return” approach is attractive. It also has strong foundations in insolvency law: both Lord Walker and Toulson L.J. acknowledged that “no return” represents the underlying policy of the test. As such, some might consider it inconsistent not to allow it to inform the construction of the provision. To flip the concept on its head, it would seem odd to be able to wind up a company not at the point of “no return” on the basis of balance-sheet insolvency, particularly in light of the “corporate rescue” reforms of the Enterprise Act 2002.

The difficulty with Lord Neuberger's construction of s. 123(2) may be that he treated “no return” as “encapsulating” the test, thereby seeming to change what had been understood to be its fundamental nature. But there are less radical alternatives by which s. 123(2) could be based in the “no return” concept. It could be allowed to influence the burden of proof. Lord Walker hinted at such an approach, suggesting that the threshold for balance-sheet insolvency was raised where a company is cash-flow solvent (at [42]). But His Lordship eventually adopted a consistent test of “balance of probabilities” (at [48]), and rightly so, because this also risks leaving findings of insolvency to judicial discretion. The preferable approach would be to allow the “no return” concept to inform the valuation of a company's assets when aggregating them for the purposes of the test. As Professor Goode argues (Principles of Corporate Insolvency Law at [4–35]), a company's assets should be valued more highly when part of a viable, going concern than when part of a business that has sunk past the point of no return (i.e. on a break-up basis). The courts should adopt this approach with vigour to ensure that the policies underlying insolvency law are reflected in its most fundamental tests.