A liquidator is generally concerned with admissibility to proof of contingent liabilities in an entity’s liquidation and its creditors’ entitlement to attend and vote at meetings of the entity.
Contingent liability is a matter for careful consideration by a voluntary liquidator because where a contingent liability is missed and then crystallizes:
i. any distribution made by the liquidator to the exclusion of the contingent creditor prejudices that creditor; and
ii. where the liability so impacts the solvency of the company that it becomes or is likely to become insolvent, the liquidator has a statutory obligation to file a court application (sec. 131) for continuation of the winding up under the supervision of the Cayman Islands court. This results in significant costs and a change in the liquidation procedure entirely.
There is not only a potential risk that the liquidator who fails to identify a material contingency will be in breach of his statutory duty, but also that any resulting prejudice may result in personal liability if attributed to the liquidator’s negligence.
How do entities report contingent liabilities?
Contingent liability from an accountant’s perspective is dealt with and reported from the standpoint of recognition, measurement and disclosure. The exact accounting treatment varies depending on whether an entity’s financial statements are prepared in accordance with Generally Accepted Accounting Principles in the United States of America (US GAAP) or International Financial Reporting Standards (IFRS).
Accounting Standards Codification (ASC) 450 Contingencies is the accounting principle which provides guidance on contingencies under US GAAP. IAS 37 Provisions, Contingent Liabilities and Contingent Assets is the standard which provides similar guidance under IFRS. Whilst the guidance extends to contingent assets, and in the case of IFRS, to provisions, our focus here is on contingent liabilities. Summarized below are some of the differences between US GAAP and IFRS as regards contingent liabilities1.
As demonstrated in the table, accrual or disclosure of contingent liabilities in an entity’s financial statements is dependent on whether the entity prepares its accounts pursuant to US GAAP or IFRS, and further dependent on management’s estimate of the likelihood of the liability materializing.
Under US GAAP, accrual is dependent on an assessment of likelihood. Whilst it is understood that the intent of the principle (ASC 450-20-25) is to proscribe accrual of losses that relate to future periods and to prevent accrual in the financial statements of amounts so uncertain as to impair the integrity of those statements, the subjective judgement and estimates of management ultimately affect the financial information that is reported.
In the case of IFRS, the contingent liability is disclosed but not accrued. This necessitates a review of the accompanying notes to the financial statements. Further, per IAS 37.86 disclosure is not required if payment is remote.
See figure 1.
The challenge for the Cayman liquidator
The above could pose a challenge for a Cayman Islands liquidator seeking an independent or verified basis to identify contingent liabilities in a voluntary winding up of a company. His first point of reference (for material other than the management accounts) is typically the company’s audited financial statements.
As indicated above, these may not contain a reference to a contingent liability. He can also make enquiries of management, but you would assume that management who did not consider liabilities sufficiently likely or proximate to make provision for, might not raise them with the liquidator. And, of course, management may have opted to avoid recording such obligations to enhance performance, or because of an inherent belief that the liability is not real. This is a typical problem in the case of legal disputes, or tax liabilities (the latter a particular risk in offshore entities where the fact of offshore establishment may make management consider they are immune from onshore tax obligations).
The liquidator cannot rely purely on the financial statements and simple management representations to gain that comfort of an independent, verified, or certified confirmation on liabilities. Whilst he is not expected to conduct a “needle in the hay stack” search for liabilities that may not even exist, to gain additional comfort he must look elsewhere.
But the liquidator does not have the benefit of requesting a sworn Statement of Affairs (“SofA”) which includes any contingent liabilities. The provisions of section 101 of the Companies Law (2016 Revision) which provide statutory authority to obtain a sworn SofA from a number of relevant parties, not limited to the directors (and which provide for criminal penalties in failing to comply or the provision of false information) do not apply in a voluntary liquidation2. And yet, for the voluntary liquidator’s purposes, he will want to know of the existence of all contingent creditors who are also entitled to be notified of the liquidation and to prove their claim in the winding up of the company.
A look beyond the financial statements
Apart from the financial statements or inquiries with management, a proper review of company records in the voluntary liquidator’s possession offers a useful means of identifying contingencies. In a recent Cayman Islands voluntary liquidation in which we were appointed, the company’s financial statements failed to disclose the existence of a contingency which, it was determined, was also unknown to management. The contingency was only discovered following discussions with the company’s service provider and our review of the company’s books and records in our possession.
This brings to bear the necessity for some consideration by directors into any contingent liabilities when making a Declaration of Solvency, as they could be liable if they swear that the company is solvent and it turns out that they were negligent in not foreseeing a liability. A person who knowingly makes a declaration without having reasonable grounds for the opinion that the company will be able to pay its debts in full at the specified time commits an offence under Cayman Law (sec. 124).
Notwithstanding the difficulties, it is the duty of a liquidator to find out from the books and papers of the company in his possession who the creditors of the company are [Pulsford v Devenish  2 Ch. 625]. A voluntary liquidator is deemed to have knowledge of potential creditors where information to that effect exists within the company documents in his possession. In re Armstrong Whitworth Securities Company, Limited , Jenkins J held that the liquidator did not fully perform his duty as regards the ascertainment of the company’s liabilities accrued or contingent shown by the company’s records in his possession. It was his duty as liquidator to take all steps reasonably open to him on the information in his possession to ascertain whether any of the potential creditors concerned did make any such claim.
It follows, therefore, that in addition to reviewing the company’s books and records, a liquidator should directly notify creditors whom it appears to him from the company’s records may have a claim in the liquidation, and invite such claims. Whilst advertisement for claims is typically undertaken, mere advertisement is not sufficient. In re Armstrong Whitworth Securities Co. Ltd. , Jenkins J further declined to regard notice by advertisement as absolving a liquidator from individual communication with persons appearing from the company’s records to be persons who have or may have claims accrued or contingent against the company.
In Pulsford v Devenish  2 Ch 625, the court held that the liquidator should communicate with any creditor who omits to put in his claim. Farwell J stated that he considered it to be the duty of a liquidator, namely, not to merely advertise for creditors, but to write to the creditors of whose existence he knows, and who do not send in claims, and ask them if they have any claim. As further illustrated in Austin Securities Ltd v Northgate and English Stores Ltd , in such a case there is a duty to ascertain by direct enquiry whether the claim is being pressed.
Whilst the addition of SofAs to Cayman Islands voluntary liquidations should be a point for consideration by the Insolvency Rules Committee, in the meantime, the voluntary liquidator should be careful to:
- Consider accounting perspectives in his review of financial statements noting that contingencies may or may not be accrued or disclosed;
- Make enquiries of management not only as to the possible existence of unrecorded contingent liabilities, but sufficient to properly understand the nature of the business and, in so doing, form a view on the possible existence of contingent liabilities that may require further enquiry;
- Conduct a proper review of the company’s books and records in his possession to ascertain the existence of contingent liabilities which may not have been disclosed in the company’s financial statements or by management; and
- Once creditors, actual or contingent, have been ascertained, make direct enquiries of them to determine whether they wish to make a claim in the liquidation.
- Document the process of enquiry and review to demonstrate an active and proper enquiry has been conducted.
The matter of proving is one that would require another article entirely, but suffice it to say that, as with the SofA, there is no formal proving process under Cayman statute for a voluntary liquidation.