So Eurosail-UK 2007-3BL plc (Eurosail) is not ‘balance sheet’ insolvent, no event of default has occurred under the RMBS notes it has issued and a post-enforcement call option (PECO) does not make limited recourse any of the notes it relates to.
Those are the conclusions of the Supreme Court (see here) after it substantially re-affirmed the judgments of both the High Court and the Court of Appeal in the case of BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL and others.
For those unfamiliar with the facts, the case concerned an attempt by certain A3 noteholders to have an event of default under the notes declared on the basis that Eurosail was balance sheet insolvent due to, amongst other things, losses incurred as a result of the lack of currency swaps originally provided by Lehman Brothers. The key argument being that the audited balance sheet of Eurosail showed an excess of liabilities over assets and that losses from the loss of the currency swaps could not realistically be recovered. An event of default in respect of the notes would have meant that the transaction would make payments in accordance with the post-enforcement priority of payments thereby allowing the A3 noteholders to rank pari passu in terms of principal repayments with the existing A2 noteholders (who rank senior in the pre-enforcement waterfall).
Eurosail along with certain A2 noteholders disputed the assertions of the A3 noteholders and argued that Eurosail was not insolvent as, amongst other reasons, it was paying all liabilities as they fell due and Eurosail’s statutory audited balance sheet (i) did not take into account the value of Eurosail’s claim against Lehman Brothers arising from the termination of various swaps with Lehman Brothers; and (ii) it valued all future liabilities of Eurosail denominated in dollars and euros as sterling liabilities using the exchange rates at the time the balance sheet was drawn up which does not reflect the actual exchange rates that will apply until the redemption of the notes (which could be in 2045).
Based on the facts, the court agreed with Eurosail and the A2 noteholders and found that Eurosail was not balance sheet insolvent and stated that “Eurosail’s ability or inability to pay all its debts, present or future, may not be finally determined until much closer to 2045, that is more than 30 years from now” and that the “movements of currencies and interest rates in the meantime, if not entirely speculative, are incapable of prediction with any confidence.”
What about the PECO?
As a secondary argument, Eurosail also stated that a balance sheet insolvency could never arise as the existence of a PECO meant that the notes were, for all practical purposes, limited recourse - i.e. Eurosail’s liabilities would ‘shrink to fit’ the assets it had available in the same way as if traditional limited recourse language had been included. Eurosail was seeking to overturn the judgments of the High Court and the Court of Appeal on the issue as both had found that the existence of the PECO did not mean that a ‘balance sheet’ insolvency could never arise. Lord Hope dismissed the appeal as “to limit those liabilities as the Issuer contends would contradict the parties’ clearly expressed commercial intention as found in the contractual documents”. However, he did go on to say that the PECO “can be expected to achieve bankruptcy remoteness as effectively” as traditional limited recourse. In other words, economically the PECO mechanism will work but legally speaking the method is separate from the traditional limited recourse provisions.
So what does it all mean?
The case was of interest not only within the securitisation context but also in the wider context of insolvency law as it considered, really for the first time directly, the application of the ‘balance sheet’ insolvency test (as contained in s.123 (2) of the Insolvency Act 1986). In providing commentary on previous case law, Lord Walker went out of his way to dismiss the ‘point of no return’ test adopted by Lord Neuberger MR in the Court of Appeal insofar as it went “beyond the need for a petitioner to satisfy the court, on the balance of probabilities, that a company has insufficient assets to be able to meet all its liabilities, including prospective and contingent liabilities.” Lord Walker also stated “whether or not the test of balance-sheet insolvency is satisfied must depend on the available evidence as to the circumstances of the particular case”. That is not a particularly clear test and will mean that balance sheet insolvency in UK securitisations with a PECO will be difficult to prove, especially if the maturity of any notes issued will not occur until some time in the future. However, it does mean that a balance sheet event of default can occur, given the right circumstances, in such securitisations. Whether or not that was originally intended is another question altogether, but issuers, trustees and noteholders will need to consider the balance sheet insolvency event of default during the life of any relevant UK securitisation, particularly as it approaches its legal maturity date. However, if there is no point of no return test, when does that point come?