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What does “insolvent” mean anyway?

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Professionals in general and insolvency professionals in particular use the phrases “insolvent” and “insolvency” on a very regular basis and the assumption is that everyone knows exactly what those phrases mean.

Since the introduction of the Insolvency Act 1986, there has been a statutory definition of insolvency on both a “balance sheet” basis and an “inability to pay debts” basis.

The inability to pay debts test is pretty clear – if a company cannot pay its debts when they fall due then it is insolvent.

The balance sheet test is slightly more problematic – how should assets be valued, what abut contingent liabilities and unresolved claims etc?  Nonetheless most professionals think they would generally be able to agree whether a balance sheet showed solvency or not.

However, the recent Court of Appeal decision in the Eurosale case which was given in March 2011 means that the position is now less clear when considering the balance sheet test of insolvency.  The Eurosail decision introduced a new and potentially complicating factor, namely the question of whether having recognised that the company is teetering on the brink of insolvency, the directors should in fact try to trade on and trade out of those difficulties.

Those familiar with wrongful trading claims will see elements of Section 214 Insolvency Act 1986 within this concept – the test in that section referring to there being “no reasonable prospect” of the Company avoiding insolvent liquidation.

The Eurosail decision brings similar considerations into the more general question of the meaning of “insolvency”.  Directors may consider that whilst technically insolvent the company can refinance or restructure within a reasonable period and thereby overcome the financial difficulties.  No doubt, such a conclusion would have to be a reasonable conclusion and not one reached with the directors wearing the famous “rose tinted spectacles”. 

In order to reach the correct conclusion directors will rely heavily upon professional advice from, in particular, their agents and valuers assessing the value of assets, equally from their accountants in accurately establishing the liabilities and how these can be dealt with.

One other, related issue for insolvency practitioners in particular to consider, is the impact which the Eurosail decision might have on claims such as preferences and transactions at undervalue.  These rely on establishing “insolvency’” as a starting point and this will potentially be more difficult if the definition is less clear due to the Eurosale decision.  Only time will tell to what extent the Courts may allow directors to escape the liability for such claims in light of the Eurosale insolvency test.

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