From The Jolly Contrarian
Jump to navigation Jump to search
Negotiation Anatomy™

123 Definition of inability to pay debts.

(1) A company is deemed unable to pay its debts
(a) if a creditor (by assignment or otherwise) to whom the company is indebted in a sum exceeding £750 then due has served on the company, by leaving it at the company’s registered office, a written demand (in the prescribed form) requiring the company to pay the sum so due and the company has for 3 weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor, or
(b) if, in England and Wales, execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part, or
(c) if, in Scotland, the induciae of a charge for payment on an extract decree, or an extract registered bond, or an extract registered protest, have expired without payment being made, or
(d) if, in Northern Ireland, a certificate of unenforceability has been granted in respect of a judgment against the company, or
(e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due[1].
(2) 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. [2]
(3) The money sum for the time being specified in subsection (1)(a) is subject to increase or reduction by order under section 416 in Part XV.

Comments? Questions? Suggestions? Requests? Insults? We’d love to 📧 hear from you.
Sign up for our newsletter.

A credit officer’s blackest fear.

The statutory definition of insolvency in the UK — which only applies to UK persons, of course — appears in Section 123 of the Insolvency Act 1986, and is set out in the panel, and includes cashflow insolvency (123(1)(e)) and balance sheet insolvency (Section 123(2)). Of these two, balance sheet insolvency deserves a bit more coverage:

Balance-sheet insolvency

also known as “technical insolvency” or “accounting insolvency”, “Balance sheet insolvency”, like cashflow insolvency, is a variety of being “unable to pay one’s debts”, an expression which in turn features in many definitions of “insolvency” or “bankruptcy”.

Compared with the carefully crafted prose of other limbs, this seems a dangerously vague expression. But it has a pretty technical meaning — conferred by statute, no less — Section 123(2) of the Insolvency Act 1986, which says a company will be deemed unable to pay its debtsif 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”. This is what we mean by balance sheet insolvency.

English courts have recently had an opportunity consider what this means, and have resourcefully concluded: “what it says”.

In BNY Corporate Trustees v Eurosail the Supreme Court noted that while this test this is often called “balance sheet insolvency” it can’t be satisfied purely by reference to the company's statutory balance sheet, because that may omit important information like contingent liabilities. Nor does it mean that the company has “reached the point of no return because of an incurable deficiency of assets”, which was what the Court of Appeal in this case had hypothesised.

The court decided that for “the value of the company’s assets to be less than the amount of its liabilities, taking into account its contingent and prospective liabilities” the court must be satisfied, on the balance of probabilities, that the company has insufficient assets to be able to meet all its liabilities including prospective and contingent liabilities (I know what you’re thinking by the way — the highest court in the land isn’t adding a whole lot of value at this point is it?) discounted for contingencies and deferment.

Whether that is satisfied depends on the particular circumstances, and the burden of proof will be on the party asserting insolvency.

Insolvency generally

Broadly, it means you do not have sufficient assets to meet your liabilities, and you are no longer a viable business. Your creditors are entitled to apply to the court for the appointment of a receiver who will liquidate your assets, determine your liabilities, and distribute the proceeds of that liquidation to your creditors pro rata. After that, the game is up and you no longer exist.

There are all sorts of special regimes and intermediate statuses in different jurisdictions (such as America's famous Chapter 11 protection - designed to help a struggling company reorganise itself and get out of insolvency without going to the wall - and banks and financial institutions generally will be subject to bank resolution and recovery regimes which make the winding-up process a little bit more complicated.

Termination upon insolvency

Credit officers will hotly deny this, but when it comes to closing out a master trading agreement there are two main triggers: failure to pay and bankruptcy/insolvency. They also tend to be the most lightly negotiated — it’s hard to argue that your counterparty shouldn’t be allowed to pull its trigger if you have gone bankrupt — but there are some nuances both to what counts as an insolvency, which may differ for different entity types (banks and insurers in particular having special local administrative regimes, or bank recovery and resolution frameworks which ameliorate the hard lines between solvency and oblivion. So expect a little jiggery pokery around the edges in defining what counts as an insolvency event. But it is not contentious stuff; just detail.

Bank recovery and resolution: Similarly, some bankruptcy regimes may impede a claimant’s normal rights under the master agreement once the game is finally up. These measures are designed to ensure an orderly resolution of the institution, protect other creditors, depositors, and investors who might hold preferred or secured claims So the insolvent entity’s contractual obligations might be suspended. A counterparty might not be allowed to close out its open transactions. This is lovely for the folk queueing ut they introduce risk to treading counterparties who have not only credit but market risk on the line. It is not a nice feeling to have your transactions suddenly frozen while the market is gyrating like a belly-dancer, and the people who you are trading with wandering around on the pavement outside their office clutching iron mountain boxes.

Effect on netting: Where these suspension rights stop you quickly closing out and netting your exposures they might mean your netting analysis fails altogether. This gives you real-world, present time problems, since you must hold capital against the gross exposure under the contract.

See also