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Coronavirus, businesses and potential insolvency

Business | Published:

AT THE moment many businesses on the island are unable to trade as a result of the pandemic. Eventually, and hopefully sooner rather than later, they will be able to commence trading again.

Advocate Raymond Ashton. (28272599)

In the interim they are receiving no income and in addition suffering additional costs attributable to dilapidations to their property as a result of lack of repair through absence of use. A number of businesses have said to me that they can just about manage the lockdown for another month but after that it will be more problematical. Unfortunately the short-term prospects are not good as a result of the pandemic and its probable aftermath in terms of visitors to the island, whether for business or private purposes.

A businessman has said to me ‘what can they do against me’, in practical terms, during the lockdown and for a period thereafter. In the case of businesses trading as sole proprietors there is a possibility of saisie and in extreme cases bankruptcy. In the case of companies of all descriptions there is the possibility of insolvent proceedings. This might be the case but it is less likely to be the case if a company is involved, the focus of this short paper.

When trading is allowed to commence again many companies will operate at a loss, not because they are inefficient by any means but because trading volumes will be insufficient to result in a profit because although revenues will be greater than variable costs they will not be of sufficient magnitude to cover the fixed costs, such as rent and arguably wages if they are classified as fixed. What are the implications of these losses?

The answer is that a creditor may be able to put the company into liquidation. Under section 407 Companies Law 2008 (as amended) a company can be put into liquidation if it does not satisfy the solvency provisions of section 527 of the same law. This section prescribes two tests. One is to the effect that a company is unable to pay its debts as they become due irrespective of what level those debts are: the second is that its liabilities are greater than its assets.

The former is known as ‘the cash flow’ test and the latter ‘the balance sheet test’. In the latter case the law prescribes that in evaluating whether the liabilities are greater than the assets the directors must take into account: (i) the most recent accounts; (ii) all other circumstances the directors know or ought to know regarding the value of the company’s assets and liabilities; but (iii) they may rely on the valuation of assets and liabilities that are reasonable in the circumstances.

In England and Australia there have been a number of cases on both subjects and the main points will be referred to below. What the court expects to see is a cash flow statement prepared by an accountant taking into account the points made below. However, one practical point before the detail is explained is that one suspects that the longer the coronavirus carries on, any accounts completed for the period which straddle this time are likely to show losses which should, in most circumstances, be able to be carried back and offset with a consequent refund of tax which should be included in any balance sheet and also cash flow, although the timing might be problematical, computation.

The other general point to make is that debt generally has a wider meaning for the balance sheet test than the cash test. The former focuses on the longer term, by contrast to the cash flow, which has a short-term focus.

In terms of the cash flow test, debts due and payable at the date of exercise (of whether the company is able to pay its debts as and when due) would focus on those due in the near future and would exclude a bank overdraft if it has not been demanded. In this exercise account can be taken, if realistic, of short-term borrowing possibilities and any other additional finance.

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The focus in terms of assets will include both trade debtors and creditors as reflected in the cash flow headings of sales and purchases and the extent to which in the former case they can provide liquidity. The statute refers to debts, which means you must look at the succession of debts and so sales forecasts will be important in terms of the possible cash coming in.

In terms of contingent and prospective liabilities, only those liabilities which are due around the date of the statement are taken into account. Overall the court has to take a view based on the forensically determined facts and overall position.

In terms of the assets comprising the balance sheet test, this is equally as difficult given the valuation issues which can arise. As stated above, debt is given a wider definition so all liquidated (and most prospective) liabilities are taken into account. Account can be taken of work in progress but any potential obligations such as repayment of advances in respect of subsequent deficient work in progress must also be taken into account. One thorny area where there can be some debate is whether assets should be valued on a going concern basis or a piecemeal basis. In valuation terms the difference can be very significant.

The guiding light, subject to facts to the contrary, must be that the going concern basis is justified if the business can survive for more than a year. The other issue which is ignored and it can be significant is that increasingly the accountancy bodies focus on economic substance rather than strict legal rights and obligations. For example, accounting for leases, hire purchase and even consolidation. The answer is that the statement must be based on the legal realities.

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The two tests expounded in this paper are also relevant to other issues such as wrongful trading, administration orders, transactions at undervalue and disqualification as a director.

Based on the above analysis what are my recommendations, given all these potential hazards? I know and appreciate businesses will be short of money but they should employ their accountants to prepare these two statements on a regular basis not only for information purposes but as a defence in marginal cases where a business and its proprietors might be attacked for other reasons as it will provide valuable forensic evidence to a court, particularly if prepared on regular basis.

Will Green

By Will Green
Business Editor

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