Monday 05 August 2013 by Katie Harding
Section 123 of the Insolvency Act 1986 provides that a company is deemed to be unable to pay its debts if: 'the company is unable to pay its debts as and when they fall due'; and 'the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities'. The former limb being the so-called 'cashflow test', the latter limb the 'balance sheet test'.
The Supreme Court decision in BNY Corporate Trustee Services Ltd & Others v Eurosail-UK  UKSC 28 concerned the interpretation of what constitutes balance sheet insolvency, and in this context the treatment of contingent and prospective liabilities.
Eurosail was a company set up in 2007 by the Lehman Brothers group which purchased a portfolio involving sub-prime mortgage loans secured on UK residential property. The cost was approximately £650m to Eurosail and was funded by Eurosail issuing various classes of loan notes to a value of just under £660m (the notes were issued in sterling, US dollars and euros). BNY was trustee for the holders of these loan notes. The terms of these loan notes were that some were repayable by 2027 and the remainder by 2045, in the absence of any event of default.
Eurosail entered into various currency and interest-rate swaps with another Lehman Brothers entity in an effort to reduce its exposure to changes in interest rates and currency rates over time. This entity became insolvent following the collapse of the Lehman Brothers group in 2008. As a result of this, and the fact that Eurosail could not get replacement swaps, some noteholders considered that an event of default had occurred, on the basis that when the loans did fall to be repaid there could be a discrepancy between the amount Eurosail had received and its foreign currency liabilities.
This would mean that Eurosail was not able to pay its debts, and certain noteholders argued that on this basis an enforcement notice should be issued rendering the full amounts due and repayable immediately. It should be noted that as a result of the collapse of the swap agreements with Lehmans and the accounting standards to which Eurosail's accounts were prepared, there was a deficit shown on its balance sheet. However, the question was whether this balance sheet in fact reflected the commercial outcome for creditors.
BNY applied to the court for a ruling as to whether Eurosail could be considered to be unable to pay its debts (and therefore whether it could be placed into liquidation), notwithstanding that the principal amounts under the loan were not yet due and payable, and any shortfall in the amount redeemed under the mortgages (and therefore leaving Eurosail unable to repay the full amount of the loan notes) was at this stage unknown and hypothetical.
At first instance, Sir Andrew Morritt said that a company's balance sheet should be considered in the 'context of the overall question posed by the subsection' (paragraph 32 of the judgment). Far from simply taking the values on the balance sheet as read, it must involve 'consideration of the relevant facts of the case, including when the prospective liability falls due, whether it is payable in sterling or some other currency, what assets will be available to meet it and what if any provision is made for the allocation of losses' (paragraph 32). He accordingly did not consider that Eurosail could be considered to be insolvent.
The Court of Appeal upheld this decision.
Master of the rolls Lord Neuberger considered that it would be extraordinary if 'section 123(2) was satisfied every time a company's liabilities exceeded the value of its assets' (paragraph 44 of the judgment). Of great interest to legal commentators, Lord Neuberger went on to refer to Sir Roy Goode's book Principles of Corporate Insolvency Law and his principles of 'the point of no return' and 'incurable deficiency in its assets' (paragraph 119 of the judgment), saying that they illuminated 'the purpose of the subsection' (paragraph 119) but were not a paraphrase of it.
While the Supreme Court upheld the Court of Appeal's decision, reservations were expressed about the possible introduction of a 'point of no return' test alluded to by Neuberger, and which many commentators had dwelt upon. Lord Walker considered that this phrase 'should not pass into common usage' (paragraph 42 of the judgment), stating that the court was required to take a pragmatic and balanced approach, looking at the reasonable expectation of whether (in all the circumstances) the company will be able to meet its liabilities. In relation to Eurosail, Lord Walker urged 'the greatest caution' (paragraph 42) given the fact that the company could have up to 30 years to repay the loan notes. He did conclude that the issue 'may not be finally determined until much closer to 2045' (paragraph 49). He referred to the fact that the reason for any shortfall (for example, fluctuations in the currency and interest rate markets) were 'incapable of prediction with any confidence' (paragraph 49). As such, the court 'could not be satisfied that there will eventually be a deficiency' (paragraph 49).
This case therefore shows the importance of the commercial context and reality of a company's financial position in making an assessment as to whether a company is 'balance sheet' insolvent. The court has a wide discretion to make a winding-up order or to place a company into administration, but may not do so unless the court is satisfied that the company is insolvent. An assessment as to whether a company is insolvent thus is likely to require a detailed and realistic assessment of the entire financial picture of the company.
Eurosail also demonstrates that the interests of shorter-term creditors should not be prejudiced by longer-term creditors applying pressure in respect of debts which are not due to be repaid for some years. Contingent and future liabilities should be considered in all the commercial circumstances of the case. Thought should be given to the size of the contingent claim, the timescale for that contingency and the likelihood of that contingency occurring. One can conclude that the larger, closer and more likely the contingency the more likely it is that the company will be deemed insolvent, however such assessment will always be dependent on all the circumstances of the case.
Katie Harding is a solicitor at HowardKennedyFSI