While it might sound simple to determine whether a company is unable to pay its debts as they fall due (either a company is paying its debts or it isn’t), on closer inspection the test reveals itself to be more difficult to apply in practice.
In the recent decision of Re Cheyne Finance plc (in receivership) [2007], Justice Briggs considered to what extent consideration should be given to debts falling due in the future, as part of the cash flow insolvency test under section 123(1)(e). Such debts are expressly relevant for the balance sheet insolvency test in section 123(2). While holding that contingent and future debts are to be considered as part of the cash flow insolvency test, the decision offers little clarification how and makes the cash flow insolvency test harder to apply.
Cheyne Finance plc was a structured investment vehicle with investments in mortgage-backed securities. Following the credit crunch in the summer of 2007, it was forced to liquidate its assets to repay maturing commercial paper issued to fund its investments. By September, receivers had been appointed over its business and assets.
In the receiver’s first application, Briggs had decided that until the occurrence of an insolvency event (as determined by the receivers under the terms of the financing documentation), the receivers should apply monies coming into their hands by paying first debts of the senior creditors as and when they fell due - a ‘pay as you go’ approach. ‘Insolvency event’ was defined as a determination by the receivers that the company ‘is, or is about to become, unable to pay its debts as they fall due [to certain senior creditors] as contemplated by section 123(1)’ of the Act. The parties agreed that the cash flow insolvency test in sub-paragraph (e) was relevant here.
It subsequently became clear that the company would not be able to pay its senior debts in full as they fell due merely by letting its own investments run to maturity and collecting the resulting cash. There would need to be a high level of discounted asset sales in an uncertain market. This would deplete the company’s balance sheet at the expense of late-maturing senior debts. The receivers therefore applied to court for assistance as to whether they should have regard to senior debts falling due in the future when considering the company’s cash flow insolvency for the purposes of an insolvency event determination.
Senior creditors with short maturity dates preferred the ‘pay as you go’ approach and argued future debts were not relevant for cash flow insolvency purposes. Those with medium or long-term maturity dates - for whom the ‘pay as you go’ approach meant they were unlikely to receive payment - argued that future debts were relevant and that there should be an insolvency event determination.
Relying heavily on Australian case law, in the absence of any significant English authority, Briggs held that cash flow insolvency should not be ascertained “by a slavish focus” on debts presently due. Future debts were relevant and to ignore them would be to adopt a “blinkered approach”.
There are no separate tests for cash flow or balance sheet insolvency under Australian law. Under English law, it was not until the insolvency Act 1985, repeated in the Act, that commercial and balance sheet insolvency were set out separately (in what is now section 123(1)(e) and (2) respectively). Briggs held that the alterations then made in s123(1)(e) - removing the requirement to include contingent and prospective liabilities but adding the words ‘as they fall due’ - merely replaced in the commercial solvency test “one futurity requirement, namely to include contingent and prospective liabilities, with another, more flexible and fact-sensitive requirement encapsulated in the new phrase ‘as they fall due’”. He held that the words “as they fall due” were synonymous with the words used in the statutory test of insolvency in Australia. This is based on an inability to pay debts as they “become due”. Australian case law regards these as key words of futurity.
Accordingly, Briggs held that future debts do play a role in the commercial or cash flow insolvency test of s123(1)(e).
Insolvency event of default clauses in contracts will often include cash flow insolvency as a trigger. If the drafting simply incorporates a reference to section 123(1)(e), then it would seem that future debts must be taken into account in determining whether the clause is triggered. In many cases, this may not have been what the parties intended originally. The decision could now allow creditors to leverage their negotiating position with a financially troubled debtor - for example, by seeking to extract a fee for a waiver of a ‘default’ of a cash flow insolvency trigger.
Ultimately, Briggs held that the addition of the words “or is about to become” to the insolvency event definition (they are not found in the statutory test) added nothing and were simply a piece of “thoughtless drafting”. Is that right? Are those words not, in fact, a piece of thoughtful drafting specifically included to amend the statutory test which, the parties recognised, would otherwise only include currently due debts? Had Briggs accepted this, then arguably there would have been no need to get involved in the analysis of s123(1)(e). Unfortunately, despite accepting that this was the best argument on behalf of those senior creditors with short maturity dates, Briggs devoted just three paragraphs of the judgment in dismissing the point.
Given the scarcity of cases on the meaning of section 123(1)(e), it is likely that this decision will be relevant beyond questions of contractual drafting. Although in most cases creditors would be unable to muster sufficient evidence of cash flow insolvency for debts payable in the future so as to obtain a winding up order on cash flow insolvency grounds, creditors might seek to use a winding up petition in the hope of getting hold of financial information about a debtor. Of course, a similar approach in the context of administrations was criticised by the judge in Re COLT Telecom Ð an allegation of insolvency is a serious matter and needs a solid foundation.
While expressing that future debts are relevant to the cash flow insolvency test, the decision offers little assistance as to how far into the future it is appropriate to look. Such uncertainty will be particularly relevant if one party to an agreement is seeking to argue that there has been an insolvency trigger. For example, would a debt due in three months’ time be relevant? Or nine months? The inclusion of future debts in the cash flow insolvency test makes it more complicated to apply than if only debts presently due are included. The distinction between the balance sheet and cash flow insolvency tests has, as a result, become blurred.
Ken Baird is head of restructuring and insolvency and Paul Sidle is a knowledge management lawyer at Freshfields Bruckhaus Deringer in London.