Appearances are often deceiving:

Corporate insolvency and disputed debts

Read our article in the Cayman Financial Review Magazine, eversion 

 It is well understood that it is an abuse of process for a party to use an application to court based on an unpaid debt to attempt to liquidate or bankrupt a debtor in order to try to compel payment of a debt which is genuinely disputed.  

The underlying rationale of this principle is that the consequences of such an application, and publication of the application, can be disastrous to the alleged debtor and it is unconscionable that the court process should be used to exert commercial pressure on an alleged debtor to pay a disputed debt lest it suffer such consequences. 

To emphasise the message, the court will frequently make the applicant pay all the costs of the alleged debtor for having had to defend the application, if it deems that it should never have been brought due the existence of a dispute about the debt.

A recent case in the Cayman Islands revisited that principle and provided a timely reminder of how the courts in the Cayman Islands will decide whether or not a debt is genuinely disputed, and when they will do so.

On 18 April 2012, the Grand Court of the Cayman Islands delivered its judgment in the Matter of FIA Leveraged Fund. The case concerned the application by three US pension funds for the liquidation of FIA Leveraged Fund (FIAL), a Cayman-based feeder fund into which the petitioners invested $100 million.

Their grounds for seeking the winding-up were two-fold: Firstly, that FIAL was unable to pay a debt owed to them and was therefore insolvent on the basis that it was ‘unable to pay its debts” and secondly that it would be just and equitable that FIAL be wound up.

One focus of interest arising from the case was FIAL’s attempt to discharge the debt, owing to the pension funds as redeeming shareholders, by transferring assets rather than paying cash – a “redemption in kind”. The Grand Court of the Cayman Islands considered the value of the assets, which FIAL attempted to use to satisfy the pension funds’ debt. It concluded that FIAL had not tendered something of equivalent value to the debt and so the debt had not been paid. On that basis the Grand Court found that FIAL was insolvent and should be liquidated. This result has been widely mentioned in the legal press and recently the Cayman Islands Court of Appeal upheld the decision, although the reasons for it doing so are yet to be given.

It is hardly revolutionary that the court found that payment “in kind” needs to have equivalent value to the debt being paid and the decision is certainly not the death knell for all “in kind” payments that has been suggested in some reports. We think it is another factor in the Court’s ultimate decision to permit the winding up of FIAL which is far more interesting.

Another limb of FIAL’s defence to the application for liquidation was based on the assertion that there existed a dispute as to whether the liability of FIAL to the pension funds had been paid by the tender of the offered assets.

As we said at the start of this article, it is well established law that if there is disputed debt then a debtor can’t be insolvent or bankrupt on the basis of that disputed debt. FIAL, therefore, asserted that the pension funds had no standing to apply to have FIAL liquidated, pending resolution of the dispute on whether there was an unpaid debt due to them from FIAL. FIAL said that must be decided in a separate action, not the winding-up application.

The Grand Court considered that argument by looking at what constitutes a dispute starting with the case of Mann v Goldstein [1968] 1 W.L.R. 1091, that states that where a debt is disputed “on some substantial ground (and not just on some ground which is frivolous or without substance and which the court should, therefore, ignore) and the company is solvent”, the court will dismiss a petition to wind up a company.

The Court then looked at the finding in Re A Company (No.006685 of 1990) [1991] BCLC 464 that “it is clear that mere honest belief that payment is not due is not sufficient. There has to be substantial ground for disputing liability to justify non-payment”.

Finally, and which we consider the most telling reference in the Cayman Court’s decision, the court referred to the finding in Re A Company (No.006685 of 1996) [1997] 1 BCLC 639 that “it was clear that the general rule under which the Companies Court refused to entertain a petition founded on a disputed debt applied only where the dispute was a genuine dispute founded on substantial grounds.

It did not preclude the court from determining, or entitle the court to decline to determine, the question whether or not there were substantial grounds for dispute. Indeed, the court necessarily had to take a view whether on the evidence there really was substance in the dispute which was raised by the alleged debtor.” 

It was this passage on which the Cayman court relied in order to rule, during the hearing, whether the dispute was “genuine” as opposed to insisting there be a separate debt action as FIAL contended was necessary.

Having decided that the tendered payment in kind, which FIAL had asserted was capable of discharging its liability to the pension funds was, in fact, worthless, the court held that there could be no genuine dispute as to whether FIAL owed the pension funds a debt.

The debt had not been discharged and the court decided that FIAL was not capable of discharging it, having applied the “cash flow” test. In making that decision, the court rejected an assertion by FIAL that it was not insolvent as it was able to pay its debts using the “balance sheet” test, as that was not the applicable test for insolvency in the Cayman Islands. 

The FIAL case helpfully serves as a reminder to companies looking to resist winding-up petitions on the grounds of a disputed debt of just how genuine the dispute must be, and that a court may rule on, and indeed dismiss, the veracity of the dispute during the hearing of the application itself.