Cash flow test for insolvency (s123 Insolvency Act 1986) - Cheyne defines "as they fall due"
The cash flow or commercial insolvency test contains a flexible and fact sensitive futurity requirement in the phrase “as they fall due”, according to Briggs J in Cheyne Finance Plc (in receivership) [2007] EWHC 2402 (Ch).
Cheyne was a structured investment vehicle (“SIV”). It was one of the first SIVs to go into receivership as a result of the credit crunch. The receivers sought the court's directions as they had to identify whether an “Insolvency Event”, which was defined by reference to the cash flow test in s123 Insolvency Act 1986, had occurred.
s123(1)(e) provides that a company is 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”
The wider implications of the Cheyne decision, which is the first time the court has considered this section, are that technical insolvency may be triggered earlier in some cases than might have been expected.
The judge gave the following example:
“The company has £1,000 ready cash and a very valuable but very illiquid asset worth £250,000 which cannot be sold for 2 years. It has present debts of £500, but a future debt of £100,000 due in 6 months. On any commercial view the company clearly cannot pay its debts as they fall due, but it is, or would be balance sheet solvent”.
In other words, if the company can continue to pay its present debts, but it cannot pay a known future debt, it is insolvent.
Consider a company with positive net assets but limited cash, say £100,000, which it is burning at a rate of £50,000 per month. In one month’s time it has to pay a wages bill of £60,000. Provided that on the balance of probability it will continue to burn cash at £50,000 per month, it is insolvent now, not just in a month’s time when it no longer has the cash to pay its present debts.
This decision seems especially relevant during the current credit crunch when companies may have positive net assets but insufficient liquidity. It emphasises the need to take specialist advice early.
If the company has banking facilities like overdraft facilites which was not utilised, if taking into account the OD facilites would the company be deemed insolvent?
Geraldine
In a word, no. Undrawn overdraft facilities would not constitute a known future debt and would not of themselves cause insolvency.
Although overdraft facility liabilities may be contingent upon a drawdown, in the event of such a drawdown there would be no change in the net assets of the company (unless there was another transaction paying away the funds drawn down).
Chris
Chris,
Would it be right to say that if there is OD facilities but not utilised when determing solvency, would the company be deemed solvent if OD facitlities are taken into consideration?
Geraldine
If the company is and will be able to pay its present and known future debts from its cash and overdraft resources when the debts fall due - and if there is no reason to believe that the overdraft facility will be withdrawn before it is required to pay the future debts, such facilities usually being on demand - the company would pass the cash flow test and would be unlikely to be deemed insolvent on those grounds.
Chris
This Judge has unfortunately set a hare running that may take many years to shoot - remember Re Specialised Mouldings and Siebe Gorman? Great for us in the insolvency industry but disastrous for businesses generally.
In reality there is probably no such thing as a completely illiquid asset such as theoretically created by this Judge.
I cannot think of any kind of asset that would be so illiquid that, if it was worth £250,000 in 18 months and you needed £100,000 today, you could not discount, sell, pledge, put in trust etc. for a price of £101,000.
Remember the example here excludes other risks such that the illiquid asset might not be worth £250,000 in two years time.
So unfortunately the Judge here has created a theoretical world with no application to either the real or the legal world and yet again illustrates judicial ignorance and lack of commercial awareness.
The point is this - the illiquid asset is still worth a considerable sum in six months time because its value can be realised at a discount. The closer you get to the two years the nearer you get to the value of £250,000.
If the same analysis were applied to any company from a bank (borrowing short to lend long - admittedly they are all in trouble on doing this at present) to Tesco (can they really be sure they will sell anything on a day six months in advance?) would be insolvent.
The analysis should be as follows - the "as and when fall due" test is one to apply close to, at or after a specific date. As you get close to a repayment date you are able to assess whether you have sufficient cash or whether you need to sell another asset. As you get closer still you become aware of the price (i.e. mark to market) of your assets. At the date of repayment you either can and do pay your the debt as it falls due or you do not. It is ridiculous to apply this test six months before the repayment date particularly if it is clear that the balance sheet is as strong as was used in the illustration. I, for one, would be very happy to purchase the "£250,000 illiquid" asset in six months time for a price of £101,000 thereby confirming the solvency of the company. There is some risk but it is worth taking because for an investment of £101,000 I get back £250,000 in 18 months. Not bad.
In my opinion and based on his comments this Judge does not understand business, accounting, commerce, numbers, markets or probably even the law.
James Nicholls