Odd as it may seem, you have to plough through 122 sections of
the UK Insolvency Act 1986 (the "Act") before you finally
reach the section that sets out the criteria for establishing
insolvency. Section 123 of the Act lists a series of circumstances
under which a company may be deemed insolvent. Some of these
circumstances are factual—for example, owing a debt of more
than £750 for more than 21 days after a demand for
payment—but two rely on a legal test of company insolvency.
These two tests are colloquially known as the "cash-flow
test" and the "balance-sheet test." Direct or
indirect reference to these tests is prevalent throughout
English-law finance documents, including those based on Loan Market
Association standard forms, as a way of determining whether an
event of default has occurred and/or termination clauses have been
triggered.
The UK Supreme Court has now unanimously confirmed the test for
balance-sheet insolvency under section 123 of the Act in its
decision in BNY Corporate Trustee Services Limited v Eurosail and
others [2013] UKSC 28. In particular, the court declined to follow
the intermediate court of appeal's suggestion that a debtor can
be insolvent only after it has reached the "point of no
return." The three court rulings in this matter concluding
with the recent Supreme Court judgment are the first reported cases
to interpret the balance-sheet test of insolvency—namely, are
the liabilities of a company greater than its assets?
Cash Flow v Balance Sheet
The circumstances under which a company is to be "deemed unable to pay its debts" (i.e., insolvent) under section 123 of the Act include:
- if "the company is unable to pay its debts as they fall due"; or
- if "the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities."
Even a casual observer can see that many companies are
balance-sheet insolvent, while still being able to comfortably meet
current debts. Following a line of cases, the accepted position was
that the cash-flow test took precedence over the balance-sheet
test. However, courts would sometimes accept that a company,
despite meeting day-to-day debts, was balance-sheet insolvent,
since its long-term liabilities (very often pension deficits) were
such that there was no chance that they would be repaid, however
long one waited.
In the Beginning . . .
The first hearing in the long-running Eurosail case was in 2010,
although the event under scrutiny occurred before that. Eurosail
(as issuer) purchased a portfolio of high-risk mortgages for
securitisation and issued notes. (The ones subject to the hearing
were due to mature in 2045.) Although the underlying mortgage
payers paid only in pounds sterling, Eurosail issued notes in
various currencies, entering into swap arrangements with two Lehman
Brothers entities to reduce its exposure to currency-rate
fluctuations. These swap arrangements ceased in 2008 with the
collapse of Lehman Brothers. Without the protection of the hedging
arrangements, Eurosail's net-asset position weakened
substantially, but it was still able to pay its debts as they
arose.
The security trustee was entitled to declare an event of default
under the notes and enforce the security if, among other
conditions, Eurosail could be deemed unable to pay its debts under
the balance-sheet test of section 123(2) of the Act. A notification
of an event of default would also alter the priorities between
noteholders such that subordinated "A3" noteholders would
then rank equally with, rather than behind, "A2"
noteholders. Naturally, this would also reduce the distribution for
A2 noteholders. Additionally, a post-enforcement call option
("PECO") had been granted under the securitisation. The
PECO provided that in the event the security for the notes was
enforced and found to be insufficient to pay all amounts due in
respect of them, an affiliate of Eurosail had a call option for the
notes for nominal consideration. PECO provisions are a common
feature of securitisations with a UK-incorporated issuer as a means
of satisfying rating-agency requirements for insolvency remoteness.
The expectation is that an affiliate would release the issuer from
further liabilities rather than allow the issuer to enter into an
insolvent liquidation.
The court was asked to decide whether Eurosail was unable to pay
its debts under the section 123(2) balance-sheet test and whether
the PECO would have any effect on that decision.
First-Instance Decision: Assets v Liabilities
The first-instance court decided that Eurosail was able to pay
its debts within the meaning of section 123(2); the key point was
the interpretation of "taking into account contingent and
prospective liabilities." It decided that the assets to be
valued were the present assets of the company. According to the
court, the nature of Eurosail's business meant that it was not
necessary to consider whether valuation was on a going-concern or
breakup basis, but the court did explicitly include the as-yet
unallowed claims against the Lehman Brothers estate as an asset of
Eurosail.
In contrast, the court narrowed which liabilities needed to be
counted and how much weight to give them. The court rejected the
idea of comparing liabilities on their face value to assets on
their face value, deeming it "commercially illogical" not
to give weight to the maturity date of the obligations. The judge
also noted that section 123(2) refers to "taking into
account" liabilities, not "includ[ing]" liabilities.
Thus, the court reasoned, a straight aggregation of present and
prospective liabilities was not what Parliament intended when it
enacted the provision.
The court also rejected the company's financial statements as
a means of establishing insolvency, concluding that such records
considered elements which were deemed to go "beyond what
[section] 123(2) requires," while also excluding assets which
the court held ought to be counted.
The court also took into account the fact that: (i) the notes in
question were not due to mature until 2045; (ii) any valuation of
liabilities relating to currency fluctuations was "entirely
speculative"; and (iii) the notes were actually fully funded,
as any losses in the underlying asset pool would also reduce the
liabilities due to the noteholders through the operation of the
"principal deficiency ledger" governing the notes (a
mechanism for distributing the risk of principal losses among
noteholders in reverse order of seniority).
Since the court concluded that Eurosail was solvent, there was no
need to consider the PECO, although the judge made side comments
that in his opinion the PECO had no effect on the liabilities
because, until the option holder should decide to release the
issuer from liability, the issuer's liabilities would
remain.
Court of Appeal: "The Point of No Return"
The court of appeal agreed with the lower court that Eurosail
was solvent and able to meet its debts. In its reasoning, the court
agreed with the lower court that examining only a balance sheet or
a company's financial statements was not the test. Many solvent
and successful companies, the court noted, had greater liabilities
than assets, especially early in their history, yet it would be
"mechanistic, even artificial" to deem such a company
insolvent. However, the court of appeal went on to state that a
company would be found balance-sheet insolvent only if the company
"had reached the point of no return." It stated that
future or contingent creditors face an inherent risk that the
company's assets might be used to pay current creditors or for
other purposes, but they are not prejudiced by that risk until
those payments, in the judge's colourful phrase, "may be
vernacularly characterised as a fraud on the future or contingent
creditors." According to the court, only at that point may a
company be deemed to have reached the point of no return. Even so,
the court acknowledged that that test would be "imprecise,
judgement-based and fact-specific."
A supporting judgment drew back from endorsing the "point of
no return" idea, suggesting that it illuminated rather than
paraphrased the legislation. Instead, the concurring judge focused
on the idea that a court would make proper allowance for contingent
and prospective liabilities but that the more distant the
liabilities, the harder it would be to establish that such
liabilities would not be satisfied.
The Supreme Court: The Imponderable Factors
The Supreme Court backed the view that insolvency may occur
before the point of no return and that this phrase should not
"pass into common usage." According to the court, the
true test should be whether on a balance of probabilities the
debtor has insufficient assets to be able to meet all of its
liabilities, applying a discount for contingencies and future
liabilities. This test would come into play once any attempt to
apply a cash-flow test became too speculative as the time frame
lengthened beyond the reasonably near future. That said, the court
acknowledged that it was "still very far from an exact
test" and that the burden of proof would be on the party
trying to prove balance-sheet insolvency.
Given that it is an inexact test, the Supreme Court concluded that
the available evidence in the circumstances was the critical
factor. Eurosail's business, the court explained, was quite
unlike a normal trading business. In fact, the only important
management decision to be made in this context would have been to
attempt to find alternative hedging cover in light of Lehman
Brothers' demise. Although it might then be quite easy to list
Eurosail's assets against its liabilities, the court held that
there were three "imponderable factors" which prevented
it from finding Eurosail insolvent. Those factors were: (i)
fluctuation of the US dollar against the pound sterling for hedging
arrangements; (ii) movement in the London interbank offered rate
(LIBOR) affecting the interest rates of the loans; and (iii)
changes in the UK real estate market, which affected the value of
the underlying pool of assets.
Because maturities on some obligations could be deferred for more
than 30 years and Eurosail was paying its debts as they fell due,
the Supreme Court expressed the greatest reluctance to make a
finding of insolvency. Generally, the Court wrote, any court should
proceed with "the greatest caution in deciding that a company
is in a state of balance-sheet insolvency under [section]
123(2)."
Like the first-instance court, the Supreme Court concluded that it
was not necessary to make a finding on the status of the PECO, but
given the frequency with which PECOs are used, the court did
consider it useful to make some passing comments. It held that
PECOs were irrelevant in the exercise of balancing assets and
liabilities to establish balance-sheet insolvency. According to the
court, it is not possible to distinguish the intended commercial
effect of these provisions from their legal effect, so PECOs have
no role to play when assessing a company's liabilities.
Where to Next?
In some ways, the Supreme Court judgment in Eurosail does not
tell us anything new. Crucially, it pushed back on the court of
appeal's "point of no return" concept, keeping to a
fairly common-sense view of proving insolvency via a balancing of
potential assets and liabilities based on evidence and allowing for
judicial discretion. The court also allowed market practice to
prevail regarding securitisations and PECOs, while noting that it
had not been persuaded purely on that basis.
Nonetheless, the series of Eurosail rulings has brought some
judicial interpretation to a previously unconsidered section of
legislation. The judgment has also helped clarify some points that
were previously open or unclear. This is especially important as
the statutory language has been utilised, sometimes with
modifications, in a range of contracts and market-standard
documents. Thus, securitisations and PECOs can continue to operate
as they did before Eurosail.
Points of clarification provided by the Eurosail rulings include
the following:
- The cash-flow test should look only to what is the reasonably near future in the relevant circumstances. How far ahead the test should look will vary depending on the facts, but some forward-looking analysis should be included.
- Although a court should be wary of finding a company's balance sheet insolvent, it need not establish that the company has reached the point of no return to conclude that it is balance-sheet insolvent. The party trying to claim insolvency bears the burden of proof.
- A company's financial statements are only a starting point for an analysis of balance-sheet insolvency. Full consideration of all evidence of assets and liabilities should be taken into account.
- There can be different weighting and discounting of liabilities. For example, the longer the maturity of the obligation, the lower the value that may be attributed to it (since it is more likely that the company will be able to satisfy it, resulting in a relative decline in the value of the liability). In the same way, an assessment should be made as to the likelihood that a contingent liability will become an actual one; the more likely the event, the greater the value that should be attributed to the claim.
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.