A new judgment of the Court of Appeal has made more complex and
subjective the determination of whether a company is insolvent by
reason of the so-called balance sheet test in section 123(2)
Insolvency Act 1986.
Although the case concerned a structured finance, asset-backed,
transaction, the Court's detailed consideration of the balance
sheet test is of considerable general interest.
Definition of insolvency
If a company is insolvent (ie, unable to pay its debts), it not
only runs the risk that it may be wound up by the court under
section 122 Insolvency Act 1986 (the IA), it may also trigger an
event of default in key contracts such as financing agreements.
Typically, such events of default refer to the definitions of
inability to pay debts in section 123 IA, in particular the test of
a company's inability to pay debts as they fall due in section
123(1)(e) and the so-called balance sheet test in section 123(2)
which provides that:
"A company is also deemed unable to pay its debts if it is
proved ... that the value of the company's assets is less than
the amount of its liabilities, taking into account its contingent
and prospective liabilities."
Taken at face value, the balance sheet test might be taken to
mean that a company is deemed to be unable to pay its debts,
whenever it has negative net assets.
For the first time, in BNY Corporate Trustee Services
Limited v Eurosail-UK-2007-3BL plc & others (2011),
the Court of Appeal has considered in detail the meaning of section
In June 2007, Eurosail had acquired a portfolio of sub-prime UK
mortgage-backed loans, funded by the issue of different classes of
interest bearing notes, denominated in sterling, US dollars and
euros. As the mortgages were redeemed, the proceeds were used to
pay off the notes in a stipulated order of priority. The long stop
date of redemption for the outstanding notes was 2045. To hedge its
exposure to interest and exchange rate fluctuations, Eurosail took
out swap contracts with a Lehmans entity, which were terminated
when Lehmans failed.
The sterling received by Eurosail, when mortgages were redeemed,
was only sufficient to repay a smaller quantum of dollar and euro
denominated notes than was originally envisaged. This resulted in a
significant deficiency in Eurosail's net assets. One class of
noteholders argued that an event of default had occurred, because
the company's liabilities exceeded its assets within the
meaning of section 123(2), to which the relevant event of default
Court's interpretation of balance sheet test
The Court rejected outright the proposition that a company can
be balance sheet insolvent, simply because its "liabilities
(however assessed) exceed its assets (however assessed)". So,
if the balance sheet test is not a mechanistic one, how does it
work? The Master of the Rolls said that it "can only be relied
on by a future or contingent creditor of a company which has
reached "the end of the road", or in respect of which the
shutters should be "put up", imprecise, judgment-based
and fact-specific as such a test may be".
In the case of Eurosail, the Court found that it had not reached
the "point of no return". The Court was being asked to
look a long time into the future, the principal under the
outstanding notes was not finally due to be repaid until 2045 and
the weighted average term of the remaining mortgages was 18 years,
with early redemption rates slowing. Eurosail was not "on any
commercial view, insolvent".
Implications of Eurosail
Fact specific as it clearly is, Eurosail nevertheless gives an
important pointer as to how courts are likely to regard attempts to
base insolvency on the balance sheet test in section 123(2). Taking
assets and liabilities at face value as they appear in the accounts
will not be enough. The company must also be shown to be "at
the point of no return". This is not to say that there is no
longer a balance sheet test for insolvency, though it now looks
harder to establish. It is clear that the outcome in Eurosail could
well have been different had the terms of the mortgages been
shorter and/or the redemption date of the notes been sooner.
The degree of uncertainty which Eurosail engenders means that
any party to a contract that contains an event of default by
reference to section 123 IA will need to consider very carefully
before seeking to exercise its rights on the basis of the balance
sheet test of insolvency.
At the time of writing, it is not known whether permission will
be granted for an appeal to the Supreme Court.
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