Vol 1 (2004) - Issue 6

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Proving Insolvency - A Financial Perspective

Introduction

Even though it has a whole statute and a host of diverse rules to its name, the term ‘insolvency’ is not properly defined anywhere in the UK’s company legislation. The Insolvency Act 1986 uses the phrase ‘unable to pay its debts’ - rather than the term insolvency - to describe that stage of a company’s financial problems when the duties, powers and sanctions that can flow from insolvency law can be invoked. It has been left for the Court to interpret the precise meaning of this somewhat vague term. Historically, this has led to a lack of certainty, even among practitioners, as to when a company is - or is not - ‘insolvent’.
As a forensic accountant specializing in insolvency litigation, I am often instructed to comment on the viability or solvency of a company. Frequently, when directors or insolvency practitioners examine a claim for recovery of a preference or a transaction at an undervalue, they presume insolvency simply because a company has subsequently entered into formal insolvency proceedings. Of course, the two things do not go hand-in-hand. In my experience, there is generally an insufficiently rigorous analysis of the question of if, and when, a company becomes insolvent.
Some recent cases have highlighted how the Courts will now pay more attention to the financial position and solvency of a company before committing it to a formal insolvency procedure or prior to reversing a pre-appointment transgression. There have also been some developments in how accountants are dealing with certain items in companies’ accounts. Now is therefore an appropriate time to bring law and finance together in reviewing the concept of ‘insolvency’, at least as it applies in the UK.

The current legislation

Winding-up companies

The Insolvency Act 1986 states that a company may be wound-up by the Court if ‘the company is unable to pay its debts’.1
The Act goes on to set out when the Court is entitled to conclude that a company is unable to pay its debts. It deals with two sorts of insolvency: the first being unable to pay debts as they fall due, otherwise termed ‘cash flow insolvency’,2 and the second being situations when the company has a deficit of assets, known colloquially as ‘balance sheet insolvency’.3
Section 123 of the Act defines ‘inability to pay debts’. The most common situations are:
1. A statutory demand has gone unpaid for 3 weeks - s123(1)(a).
2. Execution or other process issued on a judgment debt has been returned unsatisfied, (or the equivalent Scotland or Northern Ireland processes) - s123(1)(b-d).

The Court can deem insolvency when either of the two above situations occurs. A proof of insolvency is not required.
This route does not prove that a company is unable to pay all of its debts, simply that it is unable or unwilling to pay the particular one demanded. Creditors without access to the debtors’ records, therefore without the ability to prove a financial position to the satisfaction of the Court, will generally rely on these deemed presumptions of insolvency.
Apart from exceptional cases, a creditor petitioning under s122(f) who satisfies one of the tests in s123 generally is granted the desired order. The process is not designed to wind-up companies where only one creditor is outstanding, however. The threat of an award of adverse costs, as well as general hurdles and procedures, prevent creditors from pursuing this option simply because of a dispute with a debtor.