Soft Dangerous Shores – the solvency test and contingent liabilities

A recent Supreme Court decision about a liquidator’s challenge of voidable transactions highlights an issue about the need to consider contingent liabilities when assessing the question of solvency. To some readers, this signals the problems faced by a dynamic business and the risk that decision-making will be brought into question by a liquidator and ultimately the Courts – with the benefit of hindsight.

The test applied by the Supreme Court was that contingent liabilities should be taken into account where there is sufficient certainty that the liability will crystallise into an actual debt within a reasonable timeframe.

Background

Mr & Mrs Browne operated a group of 20 companies, including David Browne Contractors Ltd (“Contractors”), David Browne Mechanical Ltd (“Mechanical”) and Polyethylene Pipe Systems Ltd (“Polyethylene”). The issue on appeal was whether payments by Polyethylene to Contractors and Mechanical should have been repaid – because they were voidable.

In March 2007, Polyethylene entered into a subcontract with McConnell Dowell to weld polyethylene pipes to be laid on the seabed in Lyttelton Harbour. Two of the welds failed during the installation process and a third was identified as defective.

McConnell Dowell informed Polyethylene in May 2008 that it intended to seek recovery of its costs due to the failures in accordance with the indemnity provisions of the subcontract.

In June 2008 Polyethylene’s directors resolved to repay unsecured advances from Contractors and Mechanical of over $900,000 and also to repay a further debt owed to Mr Browne. It was also resolved that Polyethylene would enter into a general security agreement (“GSA”) with Mr Browne to secure $450,000 to fund its ongoing operations. The directors’ resolution was supported by a solvency certificate dated 1 July 2008. In doing so, the contingent liability to McConnell Dowell was addressed by stating that the claim was disputed, would be offset by counterclaims for extras and variations and, in any event, would be covered by McConnell Dowell’s insurers.

The GSA was executed on 28 July 2008 and the loans were repaid on 2 September 2008 – less than a week after McConnell Dowell had written to Polyethylene with a detailed breakdown of the losses it claimed as a result of first weld failure (which were over $2.5m).

McConnell Dowell took further procedural steps in early 2009 and succeeded in its claim against Polyethylene in July 2009 (for $2.9m).

Mr Browne responded by putting Polyethylene into receivership under the GSA – and Polyethylene was then put into liquidation in October 2009 on the application of McConnell Dowell.

The liquidator issued High Court proceedings against Contractors, Mechanical and Mr Browne for an order requiring repayment. He also applied to have the GSA set aside. These applications were declined in the High Court. The Court of Appeal overturned that decision – and ordered that the GSA be set aside and that Contractors and Mechanical repay the amounts paid to them.

The Supreme Court unanimously dismissed the appeal in relation to the decision ordering repayment by Contractors and Mechanical. It held that, if a reasonable and prudent business person would be satisfied that there is sufficient certainty that a claim will become a legally due debt at a temporally proximate point, then it will be a due debt for the purposes of section 292(2)(a) of the Companies Act. It concluded that there was such sufficient certainty in the case of the McConnell Dowell claim.

Key issue

The key issue for the Supreme Court was whether the payments to Contractors and Mechanical were made at a time when Polyethylene was insolvent (unable to pay its due debts). Such insolvent transactions are voidable by a liquidator under section 292 of the Companies Act. To do so, the ‘insolvent transaction’ must:

• be entered into with 2 years prior to liquidation; and
• enable a creditor to receive more than it would receive, or would be likely to receive, in the company’s liquidation.

The directors had signed a solvency certificate at the time the payments were made – giving three reasons to support their view that Polyethylene was solvent. The Supreme Court found that, assessed objectively, none of these reasons was valid, either at the time of the solvency certificate (July 2008) or at the time of the impugned transactions (September 2008). Specifically:

• The debt was disputed – there were no proper reasons for the directors to dispute the debt. Indeed, the reports and other material available to the directors in September 2008 clearly showed that Polyethylene was responsible for the pipe failures.
• That McConnell Dowell owed money for extras and variations – no details of were provided of amounts allegedly owing.
• That McConnell Dowell’s insurance would cover the claim – the Court noted that Mr Browne’s view on this issue was subject to a number of uncertainties, with the result that a prudent business person would have sought advice promptly on the insurance position (or not relied on such cover – which seemed the likely outcome because of the wording of the subcontract).

As a result, the directors’ focus on “due debts” for the purposes of cashflow solvency at the time of the transactions should have included debts that were present and contingent debts.

The Court accepted the liquidator’s submissions that a contingent debt can be a due debt if it is “reasonably temporally proximate” (which must be considered in light of the facts of the case) to the transactions being considered.

The Court found cashflow solvency must be assessed objectively, taking a “practical business perspective” (rather than one which is unduly technical). And that “If a reasonable and prudent business person would be satisfied that there is sufficient certainty that a contingent debt will, within the relevant period, become legally due then it must be taken into account”.

Whilst the Court accepted that there is a difference between debts and damages but noted that, once liability and quantum have been established in any claim for damages, the resulting judgment sum will be a debt owing. This means that the question is the same if
there is sufficient certainty that a claim will crystallize in the relevant period, then it must be taken into account.

The Court also noted that it was significant that the directors put in place a scheme to strip Polyethylene of its assets (through payments to related parties) which showed that they considered there was, at least a real and substantial risk that the McConnell Dowell claim would succeed.

Concluding comments

Overall, the Supreme Court’s approach appears to be consistent with that taken by the courts in Australia.

The direction to take a practical business approach (armed with the relevant facts and, where appropriate, advice) when considering the question of solvency – does not lend itself to criticism that the Courts have had the benefit of 20/20 hindsight. Instead, the conclusion was that contingent liabilities must be factored into any assessment of solvency when (viewed objectively) from the perspective of a reasonable and prudent business person, there is sufficient certainty as to both liability and quantum to indicate that they will crystallise within a reasonable timeframe.

In the present climate, with traditional retail models under some stress, the key contingency is the liability for future lease payments. A fact-specific assessment here is relatively simple – is there a ready market to take the premises off your hands? But what about other contingent liabilities such as unused gift cards. Here, there are industry models and trading history available to provide the directors with the data needed to make the necessary fact-specific assessment to determine whether the company is cash flow solvent.

And finally, the Courts will also view negatively any transaction, particularly one moments before detonation, which has the effect of stripping the company of assets – for the benefit of related parties.