It appears likely that creditors may in future use current laws more aggressively in order to expedite payment by putting a company into liquidation.
Tomorrow's debts can put you out of business today
Commercial lawyer Gina Leighton-Jones of Hatchers Solicitors in Battlefield, Shrewsbury, warns directors that a harsh new approach to cash flow insolvency tests should set alarm bells ringing round British boardrooms
The credit crunch, slowing economic growth and other recessionary pressures have led many experts to forecast a significant increase in company liquidations in 2008. Experian, the global information services company, reports that business failures in the UK increased by 8.5 per cent in the first quarter of 2008 whilst the number of corporate rescue packages such as administration and company voluntary arrangements continues to rise.
Following a recent court case which found that debts due to arise in the future may be taken into account when questioning a company’s solvency, it appears likely that creditors may use current laws more aggressively in order to expedite payment by putting a company into liquidation.
Under current legislation a company director can be prosecuted for wrongful trading if his company continues to trade in circumstances where he knew, or ought reasonably to have known, that the company could not avoid insolvent liquidation. A director found guilty in such circumstances may be liable to compensate creditors for the losses caused by his conduct and may face disqualification from acting as a director for up to 15 years.
The recent decision in Cheyne Finance Plc (in receivership) [2007] EWCH 2402 (Ch), which examined whether future debts could be considered when deciding (using a cash flow insolvency test) whether a company is insolvent, should set alarm bells ringing round British board rooms.
This case is particuarly relevant when viewed in light of the current credit crunch, when many companies may find themselves in the position of having positive net assets but insufficient liquidity. Section 123 of the Insolvency Act 1986 provides six scenarios in which a company will be deemed unable to pay its debts. However in the Cheyne case, the court concentrated on just one of them, section 123 (1) (e) Insolvency Act 1986, to identify whether an ‘Insolvency Event’ had occurred as defined in the security documentation being considered.
The section in question 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 court held that cash flow insolvency should not be ascertained ”by a slavish focus” on debts presently due and that ignoring future debts would be to adopt a “blinkered approach”. 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 two years. It has present debts of £500, but a future debt of £100,000 due in six months. On any commercial view the company cannot clearly pay its debts as they fall due, but it is, or would be balance sheet solvent.”
The implications of the court’s decision in this case demonstrates that technical insolvency may be triggered at an earlier stage than may previously have been expected. How far into the future it is appropriate to look to examine future debts when using a cash flow insolvency test, this case doesn’t stipulate. Naturally each case will need to be considered on its own facts.
However, the inclusion of future debts does now complicate the cash flow insolvency test and is likely to be used to challenge the solvency of companies particularly where this is to the advantage of a particular creditor. Sadly, current economic circumstances will doubtless expose more companies to possible insolvency and thus more directors to the risk of a ‘wrongful trading’ prosecution and disqualification. Prudent directors should regularly satisfy themselves that the company is able to pay its debts and when financial difficulties arise seek professional guidance sooner rather than later.
Gina is a member of Hatchers' company and commercial services team, which acts for large and small businesses as well as individuals requiring specialist advice in all aspects of corporate and employment law.
Contact Gina on 01743 452852 or g.leighton-jones@hatchers.co.uk.
