2. Inability to Pay Debts PDF

Preview

Summary

notes...

Description

Inability to Pay Debts Lecture

Overview  This week we are analysing the concept of inability to pay debts in English law o A company can become financially distressed before it becomes insolvent o This just means ‘trouble on the horizon’  In this micro-lecture, we will start with an introduction to the different ways in which a company can be deemed unable to pay its debts  We will also touch briefly on the multiple ways in which ‘inability to pay debts’ is used, returning to this later in the course Specific tests  Specific tests s 123(1)(a)-(b) IA 1986: broken down into two tests o If this specific thing happens then the company is deemed unable to pay debt  Statutory demand: filed by creditor 0 if company doesn’t pay after certain time = unable to pay debt  Judgment debt: court says counterparty owes money and you fail to pay that money o Something specific is happening and in consequence of the thing happening then company is unable to pay its debts o Companies can dispute the debts with a counter-claim o What if I go to court and put the company into insolvency proceedings? My motivation in doing this would pressure the company to pay  Note of caution in Eurosail [2013] UKSC at [28] o ‘If however a debt which has been made the subject of a statutory demand is disputed on reasonable grounds, the petitioner is adopting what has been called a high-risk strategy, and the petition may be dismissed with indemnity costs’ In re A Company (No 0012209 of 1991) [1992] 1 WLR 351, 354 (Hoffman J) o If the court thinks that the reason you lodged the stauturoy demand to pressure the company to pay a genuinely disputed debt, then you might have to pay the indemnity costs and application o Courts are aware of the fact tha thtese tests can be used in an abusive manner by the creditor General tests  important  Cash flow test  So-called balance sheet test

Cash flow test  Cash flow test s 123(1)(e) IA 1986

o ‘deemed 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’  Futurity and the words ‘as they fall due’ Re Cheyne Finance plc [2007] EWHC 2402, particularly at [53]-[57] o Reasonably near future BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL Plc [2013] 1 WLR 1408 at [34] and [37]  ‘as they fall due’  adds an elemnt of futurity to the debt  In Eurosail, the words ‘reasonably near future’ are used  what does this mean? Balance sheet test  Balance sheet test s 123(2) IA 1986 o ‘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’  Assets < liabilities that are due (taking into account contingent and prospective liabilities) o Application of the test is fundamental Application of the test  How easy is it to fall foul of the balance sheet test? How do we know the threshold of failing the balance sheet test?  As a ground for making a winding up order s 122(1)(f) IA 1986 o Inability to pay debts is used as a ground to liquidate a company o Can go to court and request a winding up order  As a ground for the appointment of an administrator (other than by a QFCH) para 11 and 111(1) Sch B1 IA 1986 o Charge holder who has a floating charge over all or substantial number of company’s assets  For these two applications of the test (winding up and administration) we might want different thresholds for companies to be deemed as such  perhaps we need a higher threshold for winding up than administration?  For setting aside transactions ss 238-242 IA 1986 and s 245 IA 1986  Common to cross refer to statutory provisions in contract  Courts have struggled with placing the hurdle of each test in different contexts to an appropriate level Overview  This week we are analysing the concept of inability to pay debts  In micro-lecture 1, we explored the principal features of the 4 ways in which a company can be deemed unable to pay its debts  In this micro-lecture 2, we are taking a deep dive into the Eurosail decision and its implications for the so-called balance sheet test Balance sheet test  ‘A company is deemed unable to pay its debt 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’

BNY Corporate Services Ltd v Eurosail-UK 2007-3BL plc and others [2013] UKSC 28  Eurosail purchased a portfolio of UK residential mortgage loans as part of a securitisation o Brought a whole bundle of residential mortgages in the UK in Pounds o Against these mortgages, floating rate ntoes were issued in different currencies  Floating rate notes issued in sterling, dollars and euros, secured by fixed mortgage on mortgage loans in favour of security trustee  Currency and interest rate risk hedged with Lehman Brothers Special Finance Inc and swaps guaranteed by Lehman Brothers Holding Inc o If the exchange rate moves too much, there may not be enough cash to pay the interest on the bonds  Default on Lehman group insolvency – Eurosail terminates swaps giving it a claim in insolvencies, but unhedged o The currencies were swapped on an interest rate swap o Swap is called hedging – it is now unhedged because of the swap  Noteholders argue balance sheet insolvency event of default and ‘flip’ should be triggered o When all is well, the payments on the collateral contract can be paid to the issuer o If there is a default, the noteholders start tot get the payments and are right at the top  Eurosail still able to pay current liabilities on notes (interest rates low) o Eurosail say they can still pay their liabilities on the notes because interest rates were so low – they said they are not balance sheet insolvent and there is no reason to think that they cant pay  Security trustee applies to court for determination o The security trustee wants to know fi there has been a flip or not

Mortgage provider

Secured mortgages loan

issuer Coupon repay at maturity

mortgage homeowne rs

Noteholders

 Risk of currency and risk that there is not going to be enough interest to meet the floating rate if rates go up  In Eurosail, the product is structural so the balance sheet test is really rare in case law – question of the flip was so important that it went to the UKSC Using the Eurosail guide to understand the facts of the case  Look at guide

The role of the accounts  Supreme Court had to think about whether there was a flip or not  ‘balance sheet’ test not to be taken literally [1] o Are the assets of the company less than the liabilities? The obvious place to look for proof of this is to look at the balance sheet can see what they are owed, what they own vs what they owe and which laons they have taken out

o If the final number is above 0 (positive) then the assets are greater than liabilities  Court says that the balance sheet test is not literal  don’t just look at the most recent balance sheet and determine what it is o If this was the case, that’s what the law would say o Whilst it is colloquially known as the BS test, it is not actually as simple as looking at the BS o Relationship with cash flow test  court then look at cash flow test  The relationship between s 123(1)(e) and s 123(2) o if I can see that I cant pay my debts on Monday, then I can be deemed cash-flow insolvent o ‘... the “cash flow” test is concerned, not simply with the petitioner’s own presently-due debt, nor only with the other presently-due debt owed by the company, but also with debts falling due from time to time in the reasonably near future. ... The express reference to assets and liabilities is in my view a practical recognition that once the court has moved beyond the reasonably near future ... any attempt to apply a cash-flow test will become completely speculative, and a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test’ [37]  Cant sit here now and say whether or not youll be able to pay debts on the day  The only thing we can really do is say this is how much all the assets are worth and these are the liabilities on the horizon  Contingency  guarantee – if I guarantee a loanf or you, you wi Reasonably near future  ‘What is the reasonably near future ... will depend on all the circumstances, but especially on the nature of the company’s business’  ‘... it [s. 123(2)] is still very far from an exact test’ [36] Burden of proof  ‘... the burden of proof must be on the party which asserts balance-sheet insolvency’  ‘The omission from condition 9(a)(iii) of the reference to proof “to the satisfaction of the court” cannot alter that’  Burden of proof is the balance of probabilities [48] ‘Point of no return’  Lower courts concerned about the implications of a mechanistic test – see the discussion in [40] and [41]  But SC  “ ... with great respect to Lord Neuberger MR I consider that “the point of no return” should not pass into common usage as a paraphrase of the effect of section 123(2)” [42] (see also [48])  Roy Goode: suggests whether the company has reached the point of no return under the balance sheet test o If it is clear today that this company is going to be insolvent in the future, why should I, as a creditor, have to sit back and watch the company spend all its money which could potentially be mine o Some of the lower courts latched onto point of no return ******* vulnerable transactions*********** lent term***************

Case law before the Eurosail decision      

Little case law before the Eurosail decision Ordinarily, financial covenant breach entitles lender to accelerate Company will be cash flow insolvent unless requisite majority waives breach company can refinance loan company has sufficient funds to repay lender

Eurosail and beyond      

Eurosail concerns a structured finance arrangement Consequences of modern finance arrangements which do not have maintenance financial covenants High yield bonds Covenant lite loans Contracts containing statutory language as an event of default Other uses of the tests

Overview  In this final micro-lecture we will be analysing what we have learnt about the balance sheet test, and its relationship with the cash flow test, in the cases since Eurosail  We will finish by analysing o What we have learnt o What we still don’t know o The ‘big questions’ 1. The role of the accounts  Case built on Eurosail  HLC Environmental Projects (in Liq) [2013] EWHC 2876 o Role of the company’s accounts  ‘strong prima facie evidence’ [81]  ‘the question of whether, under published accountancy standards, good or best practice would have required its [the contingency] inclusion in company accounts is not a central consideration’ o We only take into account contingency or protective liabilities  the extent to which we take them into account isn’t about putting them on the balance sheet – the legislature does not say this o 2. Relationship between s 123(1)(e) and s 123(2) Re HLC Environmental Projects o Ss 123(1)(e) is ‘a flexible and fact sensitive requirement’ to which balance sheet insolvency is not irrelevant’ [81] o S 123(2) requires the court to make a judgment [84] o Questions about how judgment is to be made and interaction between ss 123(1)(e) and s 123(2)

Casa Estates [2014] EWCA Civ 383  ‘the balance-sheet test is not excluded merely because a company is for the time being in fact paying its debts as they fall due’  ‘the two tests ... standing side by side’  ‘the two tests feature as part of a single exercise, namely to determine when the company is unable to pay its debts’  ‘even when applying the cash-flow test it is not enough merely to ask ... whether the company is for the time being able to pay its debts as they fall due .. a realistic examination may reveal that a company is on any commercial view insolvent, even though it may continue to pay its debts as they fall due’ [29] 3. Commercial reality Casa Estates  ‘even when applying the cash-flow test it is not enough merely to ask ... whether the company is for the time being able to pay its debts as they fall due .. a realistic examination may reveal that a company is on any commercial view insolvent, even though it may continue to pay its debts as they fall due’ [29]  It is not merely enough to ask if the company can pay its debts at the time being as they fall due  If we look at the factual matrix and it is blindingly obvious that the company cannot pay its debts Evan v Jones [2016] EWCA Civ 660  ‘One of the lessons that emerges clearly from Eurosail is that the statutory test in section 123 must not be mechanistically applied, but must be applied in a way that has regard to commercial reality .... even though a company may continue to pay its debts it may yet be ‘on any commercial view insolvent’  Must look at the commercial reality  under any commercial view, it is clear company will ont be able to continue to pay its debts 4. What is taken into account? Contingent assets (not liabilities but assets)?

 Evans v Jones [2016] EWCA Civ 660  At first instance in Eurosail Morrit C had held that it was not possible to take contingent assets into account (and Lord Neuberger MR took the same approach in the Court of Appeal). Not expressly dealt with in Supreme Court, but infer that SC content with that statutory interpretation  ‘On these very peculiar facts’ dividend was a contingent asset until it was discovered and could be pursued  Could not be taken into account and 4 payments company had made before it entered insolvency were vulnerable  Contingent liabilities can be taken into account but not assets Myers v Kestrel Acquisitions [2015] EWHC 916 (Ch)  Kestrel not cash-flow insolvent [81]  ‘the defendants accept that from 2012 onwards, while there may be argument over the detailed numbers, Kestrel’s liabilities have far exceeded its assets and that some form of restructuring of Kestrel’s debt will be necessary to ensure that its liabilities do not exceed the funds available to meet them’ [78]  In the future it is clear that the liabilities are going to exceed its assets so company will need restructuring  court says that we cant really take into account future restructuring in the balance

sheet test  restructuring hasn’t actually started it is just speculative – cannot just take a thought or prediction into account as it is simply hot air! Myers v Kestrel Acquisitions  Balance-sheet insolvency requires consideration of whether restructuring could be taken into account o the nature of any scheme of arrangement, if one is needed, is at best no more than an aspiration’ [91] 5. Where do the cases leave us? What we have learnt  Not mechanistic – accounts and accounting practices not determinative o The test is more than that  Not the ‘point of no return o This isn’t the search for the moment where the company clearly has no way back – this phrase is not to pass into common usage according to Lord Walker in Eurosail  Fact specific – what is the reasonably near future? Assessing assets and present and future liabilities o Context is entirely relevant  RNF = case-by-case basis  Tests are part of a single exercise [having regard to commercial What we don’t know  How the court will approach the reasonably near future o Not really sure – some case law but not a lot  How the court will assess assets v present and future liabilities o Cannot predict individual circumstances of cases  How the question of a discount for contingency and deferment will be approached o May depend on the size of the contingent liability o How can we count or discount things that are due to be paid in the future? o There is a great deal of uncertainty The question  Search for commercial reality o Merits versus certainty o Why might we think looking at commercial reality is important? o Is it better to have a test which is more certain? o Is there any value in any mechanistic way of analysing the risk? o Does this leave us with problems?  Implications of multiple uses of ‘inability to pay debts’

Reading Textbook Reading What is failure?

 Some companies can be rescued, survive difficult times or become insolvent  R3 reported in 2004 that 21% of businesses survived insolvency and continued to operate in one form or another and administration procedures resulted in 66% job preservation  Distressed companies: those which encounter financial crises that cannot be resolved without a sizeable recasting of the firm’s operations or structures o can be if a company defaults on significant payments of principal or interest to a creditor o distress can also be seen in terms of ratios (calcualations based on a company’s accounts can be used to reveal profitability rations, liquidity rations and longer-term solvency ratios o central issue is whether the company is in such a state of crisis that drastic action is required  Insolvency: a company is insolvent in law if it is unable to pay tis debts o No legal consequences attach to a firm o The consequences only follow the institution of a formal proceeding such as a winding up or the appointment of an administrator or administrative receiver o Under IA there are a lot of insolvency related statutes and a number of tests which relate to the purposes of different legislative provisions o Main reference points = ‘cash flow’ and ‘balance sheet’ tests o Cash flow test: s.123(1)(e) IA 1986 – company is insolvent when it is unable to pay its debts as they fall due  Further issue is whether future debts can be considered as part of the cash flow test – this eas considered in Cheyne Finance – Briggs J said that although parliament had removed the requirement ot include contingent and prospective liabilities in framing what is now s.123(1)(e), it had added the words ‘as they fall due’ which merely replaces ‘one futurity requirement with another’ and accordingly, future debts could play a role in the cash flow test  Insolvency under this test is a ground for a winding-up order or an administration order or for setting aside transactions at undervalue, preferences and floating charges given other than for specified forms of new value o Balance sheet/ asset test: s.123(2) IA 1986 – considers whether the company’as assets are insufficient to discharge its liabilities ‘taking into account its contingent and prospective liabilities’  May involve assessing the value of assets and judging the amount the asset would raise in the market  Difficulty arises through the Act’s failure to indicate whether valuations should be made on the basis of ‘going concern’ or ‘break-up’ sale  Issues arise where there is no established market value for the commofity  No statutory definition of prospective liabilities  Section does not include any basis for measuring assets and liabilities  Test is for the purposes of winding up, administration or the avoidance of transactions at undervalue, preferences and certain floating charges  Test is also relevant in considering the disqualification of directors  It is the one test used in identifying insolvent liquidation for the purposes of assessing directorial liabilities for wrongful trading  Defining insolvency is even more difficult due to other tests in different statutes: o Company Directors’ Disqualification Act 1986: company becomes insolvent for the purposes of potential directorial disqualification if its assets are insufficient for the payment of its debts and other liabilities as well as the expenses of winding up if it goes into admin or insolvency, or if an administration order/receiver is appointed o ERA 1996/ employee rights to payment from the National Insurance Fund on employer’s insolvency and the employee’s job termination, the employer is deemed insolvent when a winding up order or administration order has been made; administration order or administration receiver has been appointed; possession is taken by holders of debentures by floating char...