Friday, May 2, 2014

The Meaning of ‘Inability to Pay Debts’ for the Purpose of Winding-up

The test for statutory winding-up in Indian company law has a long history. Section 434(1)(a) and 434(1)(c) of the Companies Act, 1956 was based on section 223 of the English Companies Act, 1948, and the new Companies Act, 2013, retains this language (see section 271), although the language has been slightly modified in later British legislation (sections 89 and 123 of the Insolvency Act, 1986). The most frequently invoked ground for statutory winding-up in Indian law is that the company is ‘unable to pay its debts’. As Sir Roy Goode explains, there are ‘primary’ and ‘secondary’ tests of inability to pay debts—the secondary tests are the failure of the company to pay a judgment debt or a demand made in a statutory notice (sections 434 and 272 of the 1956 and 2013 Acts, respectively). But sometimes it is not possible to invoke the secondary test, for example where the creditor who wishes to institute proceedings is a contingent or prospective creditor. So the question arises when a company is said to be unable to pay its debts in circumstances where the secondary tests are unavailable.

This is an important question of Indian company law that is yet to be definitively answered in the courts. But it has arisen in high-profile insolvency litigation in the English courts in recent years, most recently in the judgment of the Court of Appeal in Bucci v Carman, which explains how the courts must apply the guidance given by the Supreme Court in the well-known Eurosail litigation following the Lehman insolvency. The starting point is that section 223 of the English Companies Act, 1948, on which current Indian legislation is based, was itself derived from a series of statutes going back to section 80(4) of the English Companies Act, 1862. In interpreting these provisions, it was widely said that there are two ‘primary’ tests of insolvency: the ‘cash flow’ test and the ‘balance sheet’ test. An important difference between the cash flow and the balance sheet test is that contingent and prospective liabilities are disregarded in relation to the former: the question is simply whether the company is able to meet its liabilities as they fall due. However, as Sir Roy Goode explains, if cash flow were the only test, “current and short-term creditors would in effect be paid at the expense of creditors to whom liabilities were incurred after the company had reached the point of no return because of an incurable deficiency in its assets”. Nor, in applying the balance sheet test, said Sir Roy Goode, was it enough to simply show that the liabilities exceeded the assets at a particular point: the company must have reached a ‘point of no return’.

This suggestion was rejected by the UK Supreme Court in Eurosail. The principles emerging from Eurosail were summarised by Lewison LJ in Carman in this way:

(1)   The cash-flow test looks to the future as well as to the present. The future in question is the reasonably near future; and what is the reasonably near future will depend on all the circumstances, especially the nature of the company’s business… The test is flexible and fact-sensitive…

(2)   The cash-flow test and the balance sheet test stand side by side. The balance sheet test, especially when applied to contingent and prospective liabilities is not a mechanical test. The express reference to assets and liabilities is a practical recognition that once the court has to move beyond the reasonably near future any attempt to apply a cash-flow test will become completely speculative and a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test.

(3)   But it is very far from an exact test. Whether the balance sheet test is satisfied depends on the available evidence as to the circumstances of the particular case. It requires the court to make a judgment whether it has been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to meet those liabilities. If so, it will be deemed insolvent even though it is currently able to pay its debts as they fall due.

Lewison LJ thus rejected the argument that there was no room to apply the balance-sheet test if a company was found to be cash flow solvent. He gave the example of a company running a Ponzi scheme: such a company is cash-flow solvent because

[m]oney from new investors is used to pay the promised returns to existing investors. On the face of it therefore the company is managing to pay its debts as they fall due. But the underlying reality is that, sooner or later, the whole house of cards will collapse. The accumulating liabilities to new investors cannot hope to be matched by any real investments: they are dependent on the continued inflow of new money. When that dries up, the game is up. In any commercial sense the company is insolvent from the beginning. 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?

As the Companies Act, 2013, has retained the language of the old legislation, these issues are also likely to arise in India, in addition to related questions such as the valuation of contingent and prospective liabilities. More detailed analysis is available in a lecture given by Lord Hope of Craighead on the Eurosail litigation and the meaning of ‘inability to pay debts’.


Anonymous said...

To all the people who started this blog, I owe my sincere gratitude to all of you for enriching my knowledge and letting me know about the topical issues in this subject. I place on record my warmest gratitude. I know this isn't a relevant comment, sorry!

surya kumar Geda said...

thanks you very much :)