In the current economic climate, directors must be careful to check the solvency position of their company, says Rupert Wright, a corporate services lawyer with Charles Lucas & Marshall.
In the event that a company later goes into liquidation, a liquidator can argue that a dividend payment made to a shareholder of the company could constitute an unlawful dividend which they could recover.
Also, if a director’s loan is repaid at the time the company was insolvent, this could constitute an unlawful preference and the liquidator might be entitled to recover this, depending upon the solvency position of the company.
Under the Insolvency Act, a company is deemed to be unable to pay its debts if the company is unable to pay its debts as and when they fall due – and also if the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
The first factor is the so called cashflow test and the second consideration is the balance sheet test. A recent Supreme Court decision which related to Eurosail-UK concerned the interpretation of what constitutes balance sheet insolvency and in this context, the treatment of contingent and prospective liabilities.
Eurosail was set up in 2007 by Lehman Brothers which purchased a portfolio involving sub-prime mortgage loans secured on UK residential property.
As a result of the collapse of the swap agreements with Lehmans and the accounting standards to which Eurosail’s accounts were prepared, there was a deficit shown on its balance sheet. Therefore, the question was whether this balance sheet in fact reflected the commercial outcome for creditors.
The liquidators applied to the Court for a ruling as to whether Eurosail could be considered to be unable to pay its debts and therefore whether it could be placed into liquidation, notwithstanding that the principal amounts under the loan were not yet due and payable.
The Supreme Court upheld the Court of Appeal’s Decision that the values on the balance sheet must involve consideration of the relevant facts of the case including when the prospective liability fell due. Therefore, they did not consider that Eurosail could be considered to be insolvent.
This case shows the importance of the commercial context and reality of a company’s financial position in making an assessment as to whether a company is balance sheet insolvent.
Contingent and future liabilities should be considered in all the commercial circumstances of the case. The larger, closer and more likely the contingency is, the more likely it is that the company will be deemed insolvent. However, such assessment will always be dependent on all the circumstances of the case and legal advice should always be sought.
For further information contact Rupert Wright on 01635 521212 or email@example.com
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