Establishing Corporate Insolvency: The Balance Sheet Insolvency Test

Cash flow and balance sheet insolvency tests are the two predominant means of determining insolvency. A company is cash flow or commercially insolvent if it is unable to pay its debts as they fall due. Balance sheet or technical insolvency occurs where the value of a company’s assets is less than the amount of its liabilities, taking into account both contingent and prospective liabilities. The term liabilities is broader than debts as it encompasses liquidated and unliquidated liabilities arising from contracts, tort, restitution, etc. In a recent article I compare the two insolvency tests and discuss the English approach to the balance sheet insolvency test.

Commercial insolvency is the more prominent of the tests. It is also comparatively easier to establish. In restructuring, a creditor’s immediate concern is often the debtor’s ability to make payments as they mature as opposed to whether its assets are sufficient to meet its present and future liabilities. Despite its seeming obscurity, a balance sheet insolvency test is commonly employed in commercial transactions as an event of default. This provides counterparties with early warning signs in long-term contracts where there are no avenues of making demands capable of triggering commercial insolvency.

Although a commercially solvent company has a greater prospect of satisfying the technical insolvency test, a company which is commercially solvent may be technically insolvent. Such commercially solvent company may have long-dated liabilities (eg pension deficits) which its assets may be incapable of reasonably meeting. A technically insolvent company may pay its due debts from its assets or with assistance from third parties. In Re a Company [1986] BCLC 261, the debtor company paid its debts through loans it received from associated companies. Nourse J held that the company was not commercially solvent notwithstanding its recourse to loans for payment of its due debts. In contrast, a commercially insolvent company may be technically solvent (Wema Bank Ltd v Bioku Investment & Property Ltd [1987] FHCLR 275, 293). Commercial insolvency may be due to a company’s cash being locked-up in investments and not immediately realizable to pay due debts. Although the company may be unable to pay due debts, the value of its assets may be sufficient to meet its liabilities.

A technically insolvent company which borrows to pay due debts merely burrows deeper into technical insolvency. Each borrowing increases the company’s liabilities as it will incur further debts prospectively due to the lender(s). Although commercially solvent, such a technically insolvent company is like a pyramid scheme. In a pyramid scheme, contributions by new ‘investors’ are used to repay old ‘investors’. Although repayments may be made on due dates, in reality repayments are made with the contributions of new investors. The pyramid scheme will inevitably collapse when there are no new investors/contributions. Likewise, a technically insolvent company relying on third parties to stay commercially solvent is merely postponing its doomsday, albeit temporarily.

In BNY Corporate Trustees Services Ltd v Eurosail-UK 2007-3BL Plc [2013] UKSC 28, the English Supreme Court stated that a balance sheet insolvency test required a court to be satisfied that, on the balance of probabilities, a company has insufficient assets to meet its liabilities, taking into account prospective and contingent liabilities. This is easier said than done. It has been rightly observed that valuing  assets and liabilities is not an exact science but a matter of judgment as to the amount a willing buyer would pay in the market when dealing with a willing seller. The valuation process may understandably be laborious, detailed and complex. Courts may not be capable of effectively dealing with such intricacies.

Kubi Udofia is a Barrister and Solicitor of the Supreme Court of Nigeria.