When a company has a debt that is not due for over 30 years, but there is a concern about the company's long term commercial viability, can an anticipated inability to repay that debt trigger a state of 'insolvency'?
This was the question asked of the UK Supreme Court in BNY Corporate Trustee Services Ltd & Ors v Eurosail-UK2007-3BL plc and others [2013] UKSC 28 (the Eurosail case). The UK Supreme Court unanimously dismissed the appeal and, in doing so, turned to Australian legal precedent to help decide the answer.
The Court decided, consistent with the position in Australia, that a company's solvency is not accurately captured by a 'balance-sheet' test; rather, a company's financial position should be viewed in its entirety. Put another way, a company should not be deemed as "unable to pay its debts" simply because, taking into account contingent and prospective liabilities, a company's assets are exceeded by its liabilities.
The legislative position
Sections 123(1)(e) and (2) of the UK Insolvency Act 1986 (the UK Insolvency Act) provide as follows:
- A company is deemed unable to pay its debts –
-
- if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.
- A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
A company in the situation described in subsection (1)(e) is often said to be "cash-flow" insolvent. A company in the situation described in subsection (2) is often said to be "balance-sheet" insolvent.
In Australia, section 95A of the Corporations Act 2001 (Cth) sets out the conditions of insolvency, referrable only to the "cash-flow" test:
- A person is solvent if and only if, the person is able to pay all the person's debts, as and when they become due and payable;
- A person who is not solvent is insolvent.
Prior to the Eurosail case, there was consensus between the two jurisdictions as to the application of the cash-flow test. It involves an examination of a company's ability to pay present debts and debts due in the reasonably near future. Often this will be a fairly straightforward exercise, particularly where a company is clearly in financial difficulty.
The Australian Courts had rejected the balance-sheet test as the test of insolvency. The balance-sheet test was rejected because it looked only at the assets and liabilities at a point in time and did not permit consideration of a company's commercial viability. In Australia, the position is that there must be consideration given to the liquidity of a company within a trading environment.
Background to Eurosail
Eurosail was a single purpose entity set up by the Lehman Brothers group (but off the balance-sheet of any of that group's companies) shortly before its collapse.
In 2007, Eurosail acquired a portfolio of mortgage loans, secured on residential property in England and Scotland, to the amount of approximately £650 million. This purchase was funded by the issue of loan notes. The notes were categorised into five classes and were scheduled to be redeemed through until 2045, with the different classes of noteholders to be paid in succession. The investors were issued with interest bearing loan notes secured by the mortgage loans.
At the time of the trial, the noteholders within the first category had been paid out. All other categories of noteholders were receiving interest payments on their notes. The category 2 noteholders were to have priority of redemption over the category 3 noteholders, unless an 'Event of Default' occurred.
Under the conditions of issue of the loan notes, the trustee for the noteholders, BNY, was entitled on the occurrence of certain specified events of default to serve on Eurosail an enforcement notice declaring the notes to be due and payable. The specified events of default included Eurosail being "deemed unable to pay its debts" as contemplated by section 123(1)(e) and (2) of the UK Insolvency Act.
Eurosail was not insolvent in "cash-flow" terms as it was meeting its payment obligations. However, five category 3 noteholders had become concerned that there may be insufficient assets for them to ultimately recover the cost of their investment. Consequently, they contended that Eurosail's balance-sheet showed that its assets were less than the amount of its liabilities and was such that it should be "deemed unable to pay its debts" under section 123(2) of the UK Insolvency Act.
This challenge, if successful, would have the effect of ranking category 3 noteholders equally with category 2 noteholders for repayment of principal (where ordinarily, without a default, category 2 and 3 noteholders would rank equally for interest payments, but category 2 noteholders would rank in priority over category 3 noteholders in receiving repayments of principal).
The category 3 noteholders decided to take action to protect their position and sought to enforce a default event after Eurosail suffered losses following the collapse of Lehman Brothers. Eurosail and the category 2 noteholders denied that an "event of default" had occurred.
The category 3 noteholders' matter was dismissed at first instance and then by the Court of Appeal. The matter was then appealed to the UK Supreme Court.
The decision of the UK Supreme Court
The Court focused on the words "as they fall due" and "present and contingent assets and liabilities" in section 123 of the UK Insolvency Act. The Court determined that, like the phrase "as and when they become due and payable" in the equivalent Australian legislation, the UK Insolvency Act requires the reader to look to the future as well as the present. The Court made the following points in this regard:1
- the cash-flow test is concerned with debts falling due in the reasonably near future, as well as presently due debts. What constitutes the 'reasonably near future' will depend on all the circumstances, and in particular, the nature of the company's business;
- once the court has to move beyond the reasonably near future, the cash-flow test becomes entirely speculative, and a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test – this is not an exact test however, and the burden of proof lies with the party asserting a balance-sheet insolvency test; and
- the issue as to whether the balance-sheet test is satisfied will depend on all the circumstances of the case.
On the facts of this case, there were too many uncontrolled variables to determine whether Eurosail would be in a position to meet its 2045 debt. The Court coined these variables the "imponderables" and they included:
- movements of the US dollar and the Euro relative to the Pound sterling;
- movements of the London Interbank Offered Rate (LIBOR) or equivalent interest rates; and
- the performance of the UK economy in general, and of its residential property market in particular.
As the performance of the property portfolio and the mortgage arrangements depended on these "imponderables", the company's liquidity in a trading environment in the year 2045 could not be determined with certainty. Accordingly, the Court was incapable of predicting with any confidence Eurosail's ability or inability to pay its debts, present or future.
The appeal was unanimously dismissed by the UK Supreme Court.
Implications of the decision
The Eurosail case has removed ambiguity for both the UK securitisation market and companies around the country by clarifying the ambit of the 'balance-sheet' test. That is, the Court held that a company is not balance-sheet insolvent solely because its liabilities exceed the value of its assets at any particular point in time.
The concept of insolvency is to be given a wide ambit and entails a consideration of a company's financial position in its entirety. While prospective and contingent liabilities are to be taken into account, when this exercise becomes one of speculation and conjecture, and where the company is currently paying its debts as they fall due, as Lord Walker warned, "the court should proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency under section 123(2)."2
The implications for creditors in the UK is that they are now restricted in their ability to push a struggling company into liquidation when there are impending factors which could arise that could breathe life into the company's commercial viability. The Eurosail case may not create a novel situation in the Australian legal landscape, however, it is acknowledged as a significant step forward in the UK's development of insolvency law and one which has aligned UK insolvency law with the Australian position.3
Footnotes
1BNY Corporate Trustee Services Ltd &
Ors v Eurosail-UK2007-3BL plc and others [2013] UKSC 28,
[37]-[38].
2BNY Corporate Trustee Services Ltd & Ors v
Eurosail-UK2007-3BL plc and others [2013] UKSC 28, [42].
3Lord David Hope, A light at the end of the tunnel?
– BNY in the UK Supreme Court (Speech delivered at the
Banking and Financial Services Law Association, Gold Coast, 29
August 2013).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
