A new test for insolvency? Court of Appeal weighs in on the relevance of future payable debts

Understanding whether a company is insolvent, and the date of insolvency, is essential for directors and accountants, as well as liquidators and other parties bringing insolvency-based claims.  In understanding these issues, the analysis may need to go beyond establishing present-day liquidity – for example: what impact do long term-debts have on a company’s solvency and how are they used to prove insolvency? Which debts are relevant to the cashflow test? And is a company ‘able to pay all its debts’ as and when they become ‘due and payable’?

In Anchorage Capital Master Offshore Ltd v Sparkes [2023] NSWCA 88 (Anchorage), the New South Wales Court of Appeal found that the evidence of large debt, repayable in the future, did not necessarily give rise to an earlier date of insolvency for the company in question, Arrium.

Anchorage provides useful guidance for the determination of solvency; particularly in relation to the impact of future payable debts on the solvency of a company where the primary solvency test is cashflow based.  

How is solvency determined in Australia?

The test for solvency is contained in section 95A of the Corporations Act 2001 (Cth). A company is solvent if it is able to pay all its debts as and when they become due and payable. A company which is not solvent, is insolvent.

Cashflow test

Section 95A sets out the principal test for determining solvency, the so-called ‘cashflow test’. This calls for a consideration of a company’s immediate liquidity, its access to new debt or capital finance, and (amongst other things) its ability to sell its assets fast enough to repay its debts as they fall due.

In assessing the solvency of a company at a particular point in time, the court may take into account debts that will arise in the near future and the date each debt will be due for payment, the company’s present and expected cash resources, and the date each inflow item will be received (The Bell Group Ltd (in liq) v Westpac Banking Corporation [No 9] [2008] WASC 239). Considering debts that will arise in the near future is important because the question of insolvency is not necessarily confined to whether a company can pay back the debts that have already accrued at any single point in time.

Basten JA in Box Valley Pty Limited v Kidd & Anor [2006] NSWCA 26 observed that although section 95A uses the present tense – that a person ‘is’ able to pay its debts – it refers to an ability or capacity and not a fixed state of affairs at a particular point in time. This is reflected in the use of the words ‘able to pay’ rather than has paid or is paying and the reference to being able to pay debts ‘as and when’ they become due and payable. Similarly, Bryson JA in the same case, observed that “insolvency is a state of affairs, not an event at a single point of time and the question of solvency cannot be addressed in a narrow timeframe”. The position must be considered “dynamically over a period”. The words ‘as and when they become due and payable’ mean that the determination requires a degree of “forward looking” with regard to commercial reality (Westgem Investments Pty Ltd v Commonwealth Bank of Australia Ltd [2022] WASCA 132).

How far one should look into the future for the purpose of determining solvency is contentious. The relevant length of time and the necessary level of proof to support the conclusion that future debts are not (or will not be) repayable are important questions. Their answers can change the point in time at which a company is deemed insolvent, and therefore must be carefully considered by boards, those advising boards (such as accountants), and those bringing claims where proof of insolvency is a necessary ingredient to establish liability.   

Balance Sheet test

In applying the cashflow test, courts have taken into consideration a company’s balance sheet in determining its ability to pay its debts. The balance sheet test compares the value of a company’s total external liabilities against the value of its assets. If the external liabilities outweigh the assets and there are insufficient assets to satisfy all claims on the company, the company is at least ‘balance-sheet-insolvent’. This might also render the company ‘cashflow insolvent’ at a particular point in time (The Bell Group Ltd (in liq) v Westpac Banking Corporation [No 9] [2008] WASC 239).

The balance sheet approach is not without contention: not all the company’s assets are severable or can be readily liquidated; there are also issues with ascertaining the real or realisable value of a company’s assets at a given point in time.

Given the primacy of the cashflow test, a company may be found insolvent even if it has more assets than liabilities but experiences prolonged liquidity issues. Conversely, a company which has a negative balance sheet might be considered solvent as long as it has sufficient present-day liquidity.

Background in Anchorage

The case of Anchorage is illustrative of the difficulties of establishing insolvency, grappling with the timing of when long-term debts may be taken into account. Arrium was an Australian mining and materials company that had several financial arrangements with lenders that were due to mature between July and December 2017.

In 2015, falling iron ore prices had an adverse impact on Arrium’s business. Concerned about its ability to meet its future debt obligations, Arrium’s board decided to sell part of its business (MolyCop), review its primary enterprise, and restructure existing debt.

Arrium issued drawdown and rollover notices to its lenders, which included representations that its financial position had not suffered any Material Adverse Effect (MAE) as defined under its financial arrangements, and that it was solvent (solvency representations).

In February 2016, final bids were received for the purchase of MolyCop but they were regarded as unacceptable by the board. In April 2016, Arrium’s lenders subsequently rejected a restructuring proposal, and informed the company that they had lost confidence in its management. On 7 April 2016, Arrium was placed into voluntary administration and later the company entered liquidation.

The lenders alleged that the drawdown and rollover notices provided by the company contained misrepresentations particularly because, in the view of the lenders, at the time of issuing the notices, the solvency representations were false.  The defendant argued that, in making the representations, it could have regard to the balance-sheet-solvency of Arrium. The lenders contended that Arrium’s solvency should not be determined solely on the balance sheet test, and that its current cash flow and the failure to sell MolyCop at a satisfactory price had to be taken into account as it would render the payment of future debts (in 2017) impossible. Consequently, the contention was that Arrium was already effectively insolvent regardless of its balance sheet in mid-2016.

The plaintiff, Anchorage Capital Masters Offshore (Anchorage Capital), argued that the solvency representations were misrepresentations, relied upon in advancing funds to Arrium.  Anchorage Capital claimed that, on this basis, had it been aware of the full details, it would not have advanced further funds to Arrium. It argued that the company was insolvent in early 2016, evidenced by the appointing of administrators in April 2016, the unsuccessful sale of MolyCop, and the debts that were due to be repaid in 2017.

The plaintiff advanced the argument that, in the light of the forecasted insolvency of Arrium, an earlier administration would have resulted in more favourable settlements for creditors.

The defendant, Ms Sparkes, who acted as Treasurer of Arrium Group, claimed that Arrium would have been able to meet its future debt obligations on the basis of its balance sheet which was positive at the time of the purported insolvency. This balance sheet formed part of the basis for its representations of solvency to Anchorage.

Supreme Court decision

The first instance decision of Ball J of the New South Wales Supreme Court, held in favour of the defendant.

While multiple issues were considered, on the point of insolvency, his Honour did not find the plaintiffs’ argument compelling. Rather, the court determined that a balance of probabilities test, taken from the vantage of early 2016, was insufficient as to declare Arrium insolvent on the basis of its possible inability to repay debts due in July 2017. Ball J held that there needed to be “a high degree of certainty that the [defaulting] would come about on the basis of the facts known or knowable at the earlier date”, which had not been met. Ball J accepted that future payable debts (ie liabilities on the balance sheet) could be taken into account in considering present-day solvency but that this standard ought to be higher than the balance of probabilities test sought by the plaintiffs.

His Honour also held that the appointment of administrators in April 2016 did not, in and of itself, support a conclusion that Arrium was insolvent earlier in 2016.

Court of Appeal decision

The Court of Appeal also found in favour of the defendant, that there were no misrepresentations.

Until the appointment of the administrators on 7 April 2016, Arrium continued to pay all its debts as and when they fell due. According to half-year accounts as of 31 December 2015, Arrium had net assets worth over $2 billion. On the balance sheet test, it was “manifestly solvent” and given the time available – about 17 months until the facilities matured in July 2017 – it could be expected that, in the normal course of events, Arrium would, if necessary, be able to either sell its assets or raise finance on their security to be able to repay the facilities when they became due.

Ward P, Brereton JA, and Griffiths AJA held that the failure to affect the sale of MolyCop could only support a conclusion of insolvency if that sale was deemed to be essential and that it would have to have been conducted within a limited window (the beginning of 2016) to sustain solvency. Expert evidence did not show that Arrium would run out of cash before the July 2017 facilities were due and payable.

Their Honours stressed that, while the question of solvency is to be determined with reference to circumstances as they were known or ought to have been known, this approach cannot be conducted in hindsight. However, the Court can have regard to what actually happened and any subsequent events can serve to prove what facts were known or ought to have been known at the time. Analysing the events after 7 April 2016, their Honours found that the appointment of administrators was not evidence that Arrium was insolvent before the date of appointment. The appointment was only consistent with the conclusion that the directors believed Arrium was likely to become insolvent at some future time.

The significance of long-term debts

The Court laid down the following principles with respect to the significance of long term debts:

1. The test of insolvency is directed to discover a present inability to pay all debts as and when they become due and payable, including debts that will become payable in the immediate future but a liability that will not fall due until some time in the future may found a conclusion of insolvency if the debtor could not have had any expectation of paying it when it does become due.
2. The extent to which future debts are relevant will depend on the particular facts. Where a company is still trading and the profile of future cashflow is uncertain, regard to future debts may make little difference whereas if business is experiencing a down-turn or has stopped trading, future cashflow may be critical.
3. How far into the future debts are to be considered is a matter to be assessed objectively, taking a business perspective that considers past performance and the financial situation of the market. Future debts must be ‘reasonably temporally proximate’ and due within 12 months of the assessment to be considered.
4. The Court determined that Ball J was correct to find a distinction between the proof of present insolvency and a prediction of an inability to pay a future debt. In considering the future debt, the question is not whether, at the date of the alleged insolvency, it is probable that the company will be unable to pay the debt when it arises. Rather, at the date of the alleged insolvency, the company must already be in a state of inability to pay those debts when they fall due. That is the distinction between a company that is likely to become insolvent in the future and one that is already insolvent.
5. Generally, the more time before a debt falls due, the greater the potential for events to occur impacting the company’s ability to pay. Consequently that debt will present a less convincing argument for insolvency the further it is in the future.
6. A high degree of probability is required to establish that a company would be unable to repay debts as they became due. Even if the company’s balance sheet shows that it has more liabilities than assets, it may be necessary to consider whether the company will be able to generate enough profit or liquidate assets to pay long-term debts. Conversely, if the company’s balance sheet shows more assets than liabilities, that will usually support a case for solvency.

Practical takeaways

1. Anchorage confirms the relevance and applicability of the balance sheet test in Australian law; not as the primary or even an alternative test of insolvency, but rather a method of establishing factual matters relevant to the cashflow test. A positive balance sheet, where liabilities (regardless of their due date) are less in value than the assets of a company, may be relevant evidence to prove solvency. An exception is made when debts are due very soon and the company is unable to liquidate its assets or cannot sell its assets for a satisfactory price to cover those debts.
2. Directors should not merely consider whether the company has sufficient liquidity to meet its present-day liabilities, but they should turn their minds to the company’s ability to meet future payable debts. This is a relevant matter for accountants to be aware of when advising companies.
3. Liquidators, and other parties (such as creditors and investors) considering bringing claims based on alleged misrepresentations of solvency (such as insolvent trading, breach of creditor duty claims, or misleading and deceptive conduct) should consider whether future payable debts would have rendered the company insolvent earlier.  However, the corollary should also be considered: does a future realisable asset render the company solvent, notwithstanding present-day, temporary, liquidity issues.  
4. To support a finding of insolvency based on future payable debts, it will need to be established that there is “a high degree of probability” that such future payable debts will not be repaid when they are due. This will require a deep consideration of not only the company’s known immediate financial circumstances, but its future prospects and plans.
5. Given the range of cash generating activities that a company can engage in to address liquidity issues, such as selling parts of its business, reducing costs, reaching compromises with creditors, debt and capital raising with access to alternative finance and international markets, it may be difficult to demonstrate insolvency based on the expectation of failure to satisfy future debts.