Background

Section 123 of the Insolvency Act 1986 provides two main tests of when a company is insolvent:

  • The “commercial” test, defined as it being proved to the satisfaction of the court that the company is unable to pay its debts as they fall due; and
  • The “balance sheet” test, defined as the value of the company’s assets being less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

Section 123 is concerned with the grounds on which a creditor can present a winding up petition against a company, but its terms are frequently incorporated into financial and commercial contracts. Many agreements make insolvency within the meaning of section 123 an event of default which allows the other party to a commercial contract to terminate it, or which allows a lender to withdraw facilities and sometimes even to demand immediate repayment of outstanding loans.

BNY Corporate Trustee Services Limited v Eurosail UK plc

The recent decision of the Court of Appeal in BNY Corporate Trustee Services Limited v Eurosail UK plc (7 March 2011) has clarified the effect of referring to the balance sheet test in a financial contract, and has made the test much more difficult to satisfy than many commentators had previously suggested.

The problem with the balance sheet test is that many successful companies are insolvent if it is given too literal a meaning. For example, a relatively new company which is financed by loan capital from its bank and its shareholders could easily find itself in a situation where the market value of its depreciating assets is less than the loans and interest which are outstanding.

BNY v Eurosail concerned the events of default in a complex financial instrument involving sub-prime mortgages. Lord Neuberger, the Master of the Rolls, described the documentation as “regrettably and forbiddingly voluminous”, and fortunately the details of the transaction are not important to the wider issues. In short, the question was whether changes in the financial market meant that a bond issuer was insolvent on the balance sheet test, despite having sufficient liquidity to pay its debts.

The Court of Appeal was faced with two competing interpretations of section 123:

  • An objective test, where one takes the assets and liabilities at their respective face values, which are those in the company’s balance sheet unless good reason is shown to the contrary; and
  • A more restrictive test, where the court looks at whether the company has “reached the point of no return”.

The Court decided in favour of the second option. A company is only insolvent on the balance sheet test if, looking at its assets and liabilities, including future and contingent liabilities, it can be said that the company is paying current and short term creditors at the expense of creditors whose claims will be payable at some time in the future. A company is insolvent on the balance sheet test if its liabilities are such that it cannot continue.

The Court of Appeal recognised that this is an imprecise, judgment-based and fact specific test, and concluded by saying that, “It is not really possible, indeed it would be positively dangerous, to give much further general guidance as to the approach to be adopted by the court when deciding whether section 123(2) applies.”

The Implications of the Decision

  • Winding Up Petitions

The decision is likely to be least significant in relation to winding up petitions, which are the main subject of section 123. In reality, creditors’ petitions are almost always based on a failure to pay the debt due to the creditor on the due date, and significant disputes as to the company’s balance sheet are rare, and will continue to be rare.

  • Administrations

Again, the decision is likely to make no difference to the vast majority of administrations, where the company is undoubtedly insolvent. It should be taken into account in cases where a proposed pre-pack sale or management buy-out is likely to attract hostile criticism from a creditor. If there is any likelihood of an allegation that a company could in fact have survived, and the administration procedure is being used to get rid of particular creditors (such as HMRC, a pension fund shortfall, or the other party to litigation), the proposed administrator and the company’s advisors both need to ensure that there is evidence to demonstrate that the company really has reached the “point of no return”, rather than a short term liquidity problem.

  • Commercial and Financial Contracts

Incorporating section 123 of the Insolvency Act 1986 into commercial contracts is widespread and often beneficial to one of the parties, but it has always created uncertainty because the grounds on which the court may make a winding up order against a company are not always the same as those which should give rise to the right to terminate a contract. Lord Neuberger MR commented that “I find it hard to discern any conceivable policy reason why a company should be at risk of being wound up simply because the aggregate value (however calculated) of its liabilities exceeds that of its assets.”

The practical implication of this decision is that it will now be harder for a party to a contract to exercise a right to terminate based on the balance sheet test. The “objective” approach rejected by the court would have allowed the party wishing to terminate to form a reasonably clear view of whether or not it is entitled to do so. An imprecise test which asks whether a company is paying current creditors at the expense of future creditors is going to be harder to rely upon in a commercial dispute, where termination without justification is likely to lead to a substantial counterclaim for breach of contract.

Greater thought is likely to be necessary in future contracts in deciding exactly when one party can terminate based on the financial status of the other.