On 7 March 2011, the Court of Appeal delivered judgment1 on an appeal and a cross-appeal from a decision of the Chancellor of the High Court2 in the case of BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL PLC & Ors [2010] EWHC 2005.

Both the appeal and cross-appeal concerned questions of interpretation with respect to the terms of interest bearing notes, due 2027 and 2045 (the "Notes") issued by Eurosail-UK 2007-3BL plc (the "Issuer"), and more specifically, the effect a post enforcement call option agreement ("PECO") has on the determination of a securitisation issuer's solvency.

Appeal and Cross-Appeal

The Court of Appeal was asked to consider:

  1. whether, without regard to the PECO, the Issuer should be "deemed unable to pay its debts" within the meaning of section 123 (2) of the Insolvency Act 1986 (the "Act") (which is a balance sheet test) for the purposes of the terms and conditions of the Notes (the "Conditions"); and
  2. if the answer to question 1 was positive, whether the existence of the PECO had the effect that the Issuer was not unable to pay its debts within the meaning of section 123 (2) of the Act for the purposes of the Conditions.

Judgment

The Court of Appeal's judgment was supportive of the judgment of the Chancellor of the High Court, who had previously determined that (i) on the facts in question, the Issuer should not be deemed unable to pay its debts, and (ii) even if the Issuer had been deemed unable to pay its debts, the PECO would not have altered this conclusion.

In relation to the first question the Court of Appeal was asked to consider, the court concluded that:

  • Any analysis of a company's inability to pay its debts under section 123 (2) of the Act should not be limited to whether the liabilities of a company exceed its assets. Rather, given the historical background for section 123 (2) of the Act, it is more appropriate to consider whether the relevant company has "reached the point of no return because of an incurable deficiency in its assets". Accordingly, in practical terms, even though a company is currently able to pay its debts as they fall due, for the purposes of section 123 (2) of the Act, it is necessary to consider whether, on the basis of the facts provided, the relevant company will be able to meet all of its liabilities, including those that are future or contingent.
  • The decision as to whether a company has reached the "point of no return" will be based on "commercial reality and on commercial fairness". Consequently, the "closer in time a future liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123 (2) of the Act will apply".
  • When assessing section 123 (2) of the Act, it is proper to consider the assets and liabilities revealed by the company's most recent audited accounts. However, in many, if not most, cases it may be necessary to depart from the figures contained in the audited accounts to take into account the relevant circumstances of the company, as well as its contingent and future liabilities.
  • As a result, having regard to the "substantial assets of the Issuer, the relatively long period over which the Issuer's liabilities have to be met and the potential for significant change in the differences between the value of the Issuer's assets and liabilities", the Court of Appeal found (dismissing the appeal) that the Issuer had not yet passed the "point of no return" and thus was not capable of being wound up pursuant to section 123 (2) of the Act.

With respect to the second question the Court of Appeal was asked to consider, the court found that:

  • The PECO was not exercisable until after enforcement of all of the available security, and arguably, not effective until exercised and the transfer of the outstanding amount of the securitisation notes to the option company was completed. Consequently, on the basis of, among other things, the wording contained in the transaction documentation, the court considered that the PECO did not have the same effect as limited recourse.
  • Accordingly, as the purpose of the PECO was to render the Issuer "bankruptcy remote", the Court of Appeal concluded (dismissing the cross-appeal) that there was nothing "commercially insensible" in the noteholders' rights against the Issuer being treated as full recourse, notwithstanding the PECO.
  • Further, the court asserted that as a result of the noteholders' rights against the Issuer being treated as full recourse, the noteholders (and the trustee) would be given the opportunity to make a winding up petition and thus justify the service of the enforcement notice the parties had anticipated would be served in circumstances where the Issuer's liabilities were not met.

Conclusion

Unless leave to appeal to the Supreme Court is granted and the judgment is overruled, the Court of Appeal's decision will have far-reaching effects on participants in the securitisation market. In particular, it is likely that the use of the "point of no return" concept may add additional complexity for directors of special purpose vehicles, servicers, accountants and trustees who need to make decisions with regards to a securitisation issuer's solvency.

However, given the continuing decline in asset values, parties to other securitisation transactions may take comfort from the court's ruling that solvency is not a simple matter of accounting. Nevertheless, many of the factors the court took into account when determining that the Issuer was not insolvent will not be present in other transactions. As such, parties to many other securitisation transactions will need to exercise their own judgement as to their issuer's solvency. Consequently, it remains to be seen how many market participants will seek direction from the court as to whether their issuer has reached "the point of no return".

In addition, the Court of Appeal's judgment in connection with the PECO structure deprives a large number of asset backed securitisation transactions that incorporated a PECO structure of one of their principal benefits, limited recourse. As the Court of Appeal's decision pointed out, unless and until a loss has crystallised and the PECO option is exercised, recourse to the issuer is not limited to the ringfenced assets from which the payment stream is generated to amortise the related notes.

Accordingly, it is possible that this judgment may cause an increasing number of noteholders to question the solvency of an issuer and seek to force a declaration of an event of default and, consequently, an acceleration of the related notes in situations where the relevant issuer may be insolvent (taking into account, among other things, future and contingent liabilities).

Furthermore, although the Court of Appeal has determined that the Issuer was not unable to pay its debts within the meaning of Section 123(2) of the Act, it has yet to be seen how the rating agencies will react in relation to the court's findings on the PECO structure. In this regard, we note that Moody's have previously indicated that in the absence of traditional limited recourse, the agency will need to take into account the possibility that an issuer can become balance sheet insolvent before final maturity. Accordingly, it may be expected that several securitisation transactions will be downgraded as a result of this decision.

In addition, it is possible that non-securitisation debtors may be impacted by the introduction of the "point of no return" concept. However, as the level of contingency is often greater in trading companies (vis-à-vis special purpose vehicles) it is questionable whether the Court of Appeal's decision to impose a fact-based test will have any practical impact on these companies' ability to stave-off a winding up petition, particularly if such contingent liabilities need to be ascribed a realistic value.

Moreover, it seems apparent that directors of issuers of near-term maturing notes (with high loan to value ratios) will need/want to explore, among other things, (i) maturity extensions, (ii) equity infusions from sponsors/originators, (iii) debt for equity swaps, (iv) amending the terms of PECO's to render them more automatically exercisable by issuers, so they equate more readily to limited recourse, or a combination of such strategies, in order to avoid being regarded as irretrievably beyond the "point of no return" and thus predisposed to an insolvent liquidation.

Notably, although this judgment will obviously be authoritative in England and Wales, it will also have persuasive effect in other commonwealth jurisdictions where such special purpose vehicle issuers are often established.

Footnotes

1 BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL PLC & Ors [2011] EWCA Civ 227

2 "New Guidance from the English Courts on the Solvency of Securitisation Issuers" by Conor Downey, Charles Roberts, Karl Clowry & Diego Shin, dated August 2010

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.