The balance sheet test of insolvency – New guidance

The Court of Appeal’s (CoA) recent judgment in BNY Corporate Trustee Services v Eurosail & Ors (2011) provides important guidance on the interpretation of the “balance sheet test” of insolvency set out in Section 123(2) of the Insolvency Act 1986.

That section, on which a winding-up petition can be based, provides that “a company is also deemed 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”.

The CoA rejected the argument that if a company’s last set of audited accounts showed a negative balance this should be enough for it to be deemed insolvent. While the figures in an audited balance sheet would carry some weight for the purposes of Section 123(2), the court held that the ­section could only be relied upon by future or contingent creditors of a company that has reached the “end of the road” or the “point of no return” – and this was a ­question to be decided by the court “with a firm eye both on commercial reality and ­commercial fairness”.

The requirement that companies must have reached the point of no return, a test that the court acknowledged is “imprecise, judgment-based and fact-specific”, will make it harder for a creditor to petition for a company to be wound up on the basis of balance sheet insolvency.

The cashflow insolvency test contained in Section 123(1) – that the company is “unable to pay its debts as they fall due” – is currently the most common basis for a winding-up petition, and this is likely to remain the case.

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