Contents
Introduction
Cash flow testand balance sheet test
The reasons ofnot having a single test
The definitionand treatment of the debts and liabilities under the both tests
Bibliography
Introduction
The company's inabilityto pay debts is the most common ground for the winding up of companies and,by definition, all-encompassing in the case of insolvent companies.
Under Malteselaw section 214 (a) (ii) of Company Act 1995 states that the company may bedissolved and wound up by the court in case of the company is unable to pay itsdebts. The definition of this ground is to be found in sec. 214 (5) of CompanyAct. Based on it the inability to pay debts of the company can be proved by theway of two alternative tests : cash flow test and balance sheet test.These tests have different purposes. In simple words, cash flow test is ingeneral about the debts which have already become due; balance sheet test isabout the liabilities, e.g. contingent and prospective debts.
Before theconsideration of these tests I would like to mention that even though MalteseInsolvency law is mainly based on UK Insolvency law, there are some differencesbetween Maltese law and UK law in this question. The first difference isthat under UK law the ground inability to pay debts can be applied in fourscenarios, while in Maltese law there are only two of them. UK law describesthe inability to pay debts in Insolvency Act 1986 [1]. Also there is adifference between UK and Maltese cash flow test, it will be considered lateron in this paper.
Cashflow test and balance sheet test
Cash flowtest ismore for the lawyers because you do not have to work with accounting documentsof the company. All you need is the state of a fact that there is a debt unpaidfor the period of 24 weeks after the issue of executive warrant on the basis ofexecutive title.
The scheme ofcash flow test can be represented as followed. There are two companies A and B.A owns B some money and does not pay it when it is due. B starts the case in acourt against A and wins it, e.g. court issues a judgment in favour of B. A judgmentis an executive title [2].In perfect situation A must pay its debts to B on the basis of this judgment.But usually companies do not do it. Then a judgment creditor is appointed. Thejudgment creditor has a power to issue an executive warrant [3]. Usually it can be inthree copies to the different banks where A has its accounts. The banks, intheir turn, freeze the accounts of A and send the debt money on the accounts ofB. If this scenario does not work, then B has to wait 24 weeks from the momentof issue the executive warrant and after can start the winding up proceedingsagainst A.
Under UK lawthe cash flow test is different [4].The company is deemed to be unable to pay its debts if a creditor to whom thecompany owes more then ВЈ 750 immediately payable has delivered to it atits registered office a notice and the company has for three weeks thereafterneglected to pay the debt. Moreover, these twenty-one days should be clear. Ifthe creditor presents the petition for winding up before the expiration of thetime, he will not be able to rely on the company's failure to comply with hisdemand for payment in the notice as proof of its inability to pay debts [5]. Above all, it must beshown that the company has neglected to pay the debt demanded. If the company,in good faith, disputes its liabilities, it can not be said to have neglectedto pay the sum demanded [6].
Observing theauthors, we find Sealy stating that cash flow test is the most common reasonfor making the winding up petition. Another author, Pennington, makes thedefinition of cash flow test very simple. Everything reduces to the presence ofcurrent cash. If a company does not have a cash to pay to a creditor, it isdeemed to be insolvent.
Balancesheet test is more for the accountants. The balance sheet test for insolvency was firstintroduced in UK law in Insolvency Act 1985 [7].Balance sheet test will is to be satisfied if the company is unable to pay itsdebts on prospective and contingent liabilities. Maltese legislation endorsedbalance sheet test. It is described under Maltese law in section 214 (5) (b) ofCompany Act 1995, and under UK law in section 123 (2) of Insolvency Act 1986.
Balance sheettest is a "red light" for the potential creditors. This solvency is veryimportant for the creditors who are in a position to invest their money in acompany. Usually, balance sheet test is more preferable than cash flow testbecause the creditors are more protected with it by giving them an opportunityto take into consideration future liabilities of the company and not only itspresent financial position. In other words, this test is much fair both to thecompany and the creditors. So, this test is all about the future possibleliabilities, and the circumstances are varied depending on the particular case.
Thereasons of not having a single test
These twotests are alternative. The test is to be chosen by a person who brings theapplication to the court. The reasons of having not a single test arefollowing:
1.Thecompany may fail cash flow test but satisfies balance sheet test (eg bebalance sheet insolvent), and it still may be liquidated. And reversesituation: Prof. Prentice shows that the company may be balance sheet solventbut cash flow insolvent. As an example we can consider the CornhillInsurance case [8].The insurance company owned some amount of money to a certain person. For somereason it decided not to pay it. According to contingent and prospectiveliabilities it was solvent, but according to the fact of not paying the debt itwas insolvent. In conclusion court stated the inability to pay debts.
2.It ismuch easier to state the fact of satisfaction of cash flow test than balancesheet test because the latter one needs the access to information (which noteverybody will be glad to give on request) and special expert knowledge to readand understand that information. Besides, it is not so easy for a person toconstruct a true and fair value of the company. On the other hand, there can besome problems of accuracy connected with cash flow test.
3.Theminus of having cash flow test on its own can be illustrated with the followingsituation. There can be a sole creditor having a small claim against thecompany. That creditor because of some reason decided to request the winding upof the company. Therefore the remedy is excessive and not proportional to theclaim. The main interest and purpose of the Insolvency law is the protection ofthe creditors. The creditors can not be sufficiently protected with cash flowtest on its own. Prof. Goode states that balance sheet test adds moreprotection to the companies, while cash flow test makes individuals moreprotected.
Thetreatment of the debts and liabilities under the both tests
Thedefinitions of debts and liabilities are to be found in UK Insolvency Act 1986.According to it,
" 'debt' isto be construed in accordance with following: the bankrupt is deemed to becomea subject to that liability [a bankruptcy debt] by reason of an obligationincurred at the time when the cause of action accrued "[9].
" 'liability' means a liability to pay money or money's worth, including any liability tounder an enactment, any liability for breach of trust, any liability incontract, tort or bailment and any liability arising out of an obligation tomake restitution "[10].
In theInsolvency Rules 1986 we can find following:
"'debt' meansany of the following -
(a)anydebt or liability to which the company is subject at the date on which it goesinto liquidat...
