The question as to when is a company deemed unable to pay its debts, with the result that it is insolvent, was considered in the recent Court of Appeal case of Joanne Marie Bucci v Russell John Carman (Liquidator of Casa Estates (UK) Limited)  EWCA Civ 383. The issue arose following an application by the liquidator of Casa Estates (UK) Limited (the “Company”) to recover monies paid out by the Company to Mrs Bucci, which were deemed to be transactions at an undervalue.
Mr and Mrs Bucci jointly owned the Company as equal shareholders. The Company was under the day to day management of Mrs Bucci’s husband, whilst Mrs Bucci was the company secretary. The Company acted as an introducer of investors to properties in Dubai. Casa Dubai Real Estate Brokers LLC (“Casa Dubai”) was the Company’s agent and intermediary in Dubai. It is not entirely clear as to the precise business model used by the Company and Casa Dubai, however it is understood that the Company received payments (mainly deposits) from investors wishing to acquire property in Dubai. These monies would be transmitted to Casa Dubai who would in turn forward them on to the property developer. Again, although the precise relationship between the Company and Casa Dubai was unclear, it appears that by written agreement the Company agreed to pay Casa Dubai a monthly retainer of £10,000 and Casa Dubai agreed to pay the Company commission on sales at an average rate of 6%. The arrangements between the Company and Casa Dubai were subject to an oral set-off arrangement whereby Casa Dubai was able to withhold commission due to the Company by setting off those commissions against new client monies received from the Company’s clients. Casa Dubai would pay over the withheld monies to developers in Dubai and the Company would transmit to Casa Dubai any shortfall in payments due to developers. The key point here in regard to the set-off arrangement was that there were never any funds flowing from Dubai to the UK; money always flowed from the UK to Dubai.
Cash Flow Test v Balance Sheet Test
Following the collapse of the Dubai property market, the Company ceased trading in December 2008 and went into insolvent liquidation in March 2009. In the course of 2007 and 2008 the Company made payments in the aggregate sum of £103,988 to Mrs Bucci (the “Payments”).
Section 238 of the Insolvency Act 1986 (the “Act”) enables a liquidator to apply to the court for an order reversing a transaction made at a significant undervalue by an insolvent company within the two years preceding the onset of insolvency. Further, where the transaction was with a connected person, the company is presumed to be unable to pay its debts unless the contrary is shown. As Mrs Bucci was deemed to be a person connected with the Company she had the burden of rebutting the statutory presumption that the Company was insolvent at the time the Payments were made to her.
Section 123 of the Act sets out when a company is deemed unable to pay its debts:
• section 123(1)(e) of the Act states that a company is deemed to be 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 “Cash Flow Test”); and
• section 123(2) of the Act states that a company is “…also deemed to be 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” (the “Balance Sheet Test”).
The Judge at first instance held that Mrs Bucci had rebutted the statutory presumption that the Company was not insolvent at the time that the Payments had been made to her. However, on appeal, the High Court held that the presumption had not been rebutted and the Company was insolvent at the time that it made the Payments to Mrs Bucci. Mrs Bucci appealed the High Court’s decision.
Court of Appeal’s Decision
Mrs Bucci’s argument was that if the Cash Flow Test could not be satisfied there was no need to go on to consider whether the Balance Sheet Test could be satisfied, unless the Company had contingent or prospective liabilities. The Judge at first instance, HH Judge Purle QC, agreed that as the Cash Flow Test was not satisfied (in that it was found that the Company was able to pay its debts as they fell due at time the Payments were made to Mrs Bucci), there was no need then to apply the Balance Sheet Test to the Company. He further held that the Company’s liabilities to depositors were contingent and that, taking into account those contingent liabilities, the Company had not reached the “point of no return” until the end of 2008.
Following the decision at first instance, the Supreme Court subsequently confirmed in the case of BNY Corporate Trustee Services Limited v Eurosail-UK-2007-3BL Plc  EWCA Civ 227 that the “point of no return” test was no longer the right test to apply when determining whether a company was insolvent. Referring specifically to Lord Walker’s judgment in the Eurosail case, the Court of Appeal in the present matter (Lord Justice Lewison giving the leading judgment), agreed that:
1. the tests set out in section 123 of the Act were not intended to significantly change the law as it existed before the implementation of the Act;
2. the Cash Flow Test is a flexible and fact sensitive test which looks to the reasonably near future as well as to the present;
3. The Cash Flow Test and the Balance Sheet Test stand side by side and the Balance Sheet Test is not a mechanical test, especially when it is applied to contingent and prospective liabilities – once the court has to move beyond the ‘reasonably near future’ any attempt to apply the Cash Flow Test will become purely speculative and the only sensible test is to then compare a company’s present assets with present and future liabilities; and
4. whether the Balance Sheet Test is satisfied depends on the evidence available in relation to the particular circumstances of the case – the court must make a judgment as to whether a company can reasonably be expected to meet its liabilities when looking at that company’s assets and making a proper allowance for its prospective and contingent liabilities; if it cannot, it will be deemed to be insolvent even though it is currently able to pay its debts as they fall due.
The Court of Appeal used a Ponzi scheme company as an example to show that a company which was not considered insolvent under the Cash Flow Test could still be insolvent under the Balance Sheet Test. Under a Ponzi scheme the deposits paid by new investors are used to pay old investors rather than being invested. Consequently, such practice gives the appearance that the company is managing to pay its debts as they fall due. The reality is much different in that in order to pay the top tier investors, the company will accumulate greater liabilities by bringing in further investors. If the company failed to attract new investors or the incumbent investors sought their money back, the Ponzi scheme would collapse as, in a commercial sense, the company was insolvent from the beginning. Using this Ponzi scheme analysis, the Court of Appeal confirmed that:
“What a commercial approach requires the court to do is not to stop automatically at the answer to the question: is the company for the time being paying its debts as they fall due? In an appropriate case it must go on to inquire: how is it managing to do so?”
In light of the Eurosail decision, Lord Justice Lewison noted that the Balance Sheet Test should not be excluded merely because when applying the Cash Flow Test a company was, for the time being, paying its debts as they fell due; the two tests stand side by side as a realistic examination could reveal that a company was, on a commercial view, insolvent. The Balance Sheet Test is an alternative test and the two tests are part of a single exercise in determining whether a company was unable to pay its debts. Therefore, the Court of Appeal dismissed the appeal, holding that the High Court Judge, Warren J, was correct in finding that Mrs Bucci had not rebutted the presumption that the Company was cash-flow insolvent at the time it made the Payments to her. The Court of Appeal noting, in essence, that the Company was only able to continue to pay its debts as they fell due by taking new deposits and using them to pay off old debts. As such, the Company was, on a commercial view, insolvent, whether under the Cash Flow Test or the Balance Sheet Test.
Assessing whether a company is insolvent is not as straightforward as it first might appear, as it will very much depend on the surrounding circumstances at the material time. This decision is helpful in that it serves to highlight the need to look at the specific circumstances of each case and to undertake a careful examination of a company’s contingent and prospective liabilities. Although on first sight it may appear that a company was able to pay its debts as and when they fell due, one needs to look behind such initial evidence so to understand how those debts were being paid. The decision serves as a welcome reminder that when assessing a company’s solvency, a company should not be considered solvent simply because it is paying its short term debts if it is paying those debts by getting deeper into long term debt, which it is unable to repay.
For further information, please contact James Walton or the Partner with whom you usually deal.