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’.

About the author

V. Niranjan

3 comments

  • 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!

  • […] However, this proposition may not not supported by Section 434 of the Companies Act, 1956 that stated, inter alia, that a company would be deemed to be unable to pay its debts if after receiving a statutory notice in terms of the said Section if the company “neglected to pay the sum”. At the same time, the courts have examined the balance sheets of the debtor company to examine if it is insolvent so as to be unable to pay its debts – thereby not applying the phrase “neglected to pay the sum” stricto sensu [ Kailash Prasad Mishra v. Medwin Labs, 1985 : Harinagar Sugar Mills v MW Pradhan, AIR 1966 SC 1707 : WT Henley’s v. Gorakhpur Electricity Supply Co., AIR 1936 All 840]. In VV Krishna Iyer Sons v. New Era Manfc, the Kerala High Court held that if a company has assets far exceeding its liabilities, a winding up cannot  be ordered against such a company. In order to determine if the company was unable to pay its debts, the Court held that it could look into the balance sheet of the company and its cash flow statements. This, it is submitted is in line with English law where the courts apply two ‘primary’ tests of insolvency: the ‘cash flow’ test and the ‘balance sheet’ test [BNY Corporate Trustee v. Eurosail, (2013) UKSC 28 : See also the post on Indiacorplaw here] […]

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