Eurosail’s journey has come to an end: the Supreme Court rejects the “point of no return” test, returns to balance sheet basics.
John Houghton, European Head of Restructuring and Co-Global Chair of Bankruptcy and Restructuring remarks:
“The balance sheet test is an essential foundation of English insolvency law and is a key factor which will drive the dynamics in any out-of-court restructuring negotiations. It is critical not only for the purposes of administration applications, winding-up petitions, the determination of directors’ duties, the disqualification of directors and challenging pre-insolvency transactions, but also plays a key role in determining the ability of creditors to be able to trigger events of default in order to take enforcement action or to commence restructuring negotiations with the company”.
The Eurosail Supreme Court ruling of 9 May 2013 dismissed the appeal but simultaneously rejected the “point of no return” test relied upon by the Court of Appeal. In so doing the Supreme Court has re-affirmed the essence of the balance sheet insolvency test set out in s.123 (2) IA. As the Supreme Court acknowledged, this is still very far from an exact test, but the ruling arguably leaves less room for manoeuvre by a company trying to deny that a balance sheet event of default has been triggered; potentially good news to creditors seeking to force over-leveraged debtors to the negotiating table to commence restructuring discussions. Of course it remains a challenge to put a value on those long-term liabilities, but that is a matter of evidence, which, as per the Supreme Court, cannot purely be “a matter of speculation”.
Definition of Section 123(2) of the Insolvency Act 1986 (“IA”)
“a company is (…) deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.”
Why Worry About the Balance Sheet Insolvency Test?
To take a step back, before delving into the Supreme Court judgment1, an assessment of balance sheet insolvency is a crucial step in many aspects of restructuring negotiations and insolvency processes:
- The balance sheet test is often a specific event of default in loan and bond documentation. As explained further below, the Loan Marketing Association (LMA) standard form includes wording which mirrors the s.123 (2) language. It will determine whether creditors can enforce any security granted in connection with the finance transaction and thus in turn may become the impetus for the commencement of restructuring negotiations between the stakeholders.
- It is a gating item as regards a court-led administration appointment (para 11 Schedule B1 IA), as well as in the case of a directors’ or company’s out-of-court application for administration (paras 22, 27 Schedule B1 IA): if the company “is or is likely to become unable to pay its debts” (and is not in liquidation) and the other requirements are met (prescribed purpose of administration and timely filing of specific notices/documents), then an administrator may be appointed.
- It is one factor in assessing whether a director can be accused of wrongful trading (and be ordered to contribute personally to the company’s assets as a result) as the key is whether the directors knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into an insolvent liquidation, i.e. whether the company’s “assets are insufficient for the payment of its debts and other liabilities (…)” (section 214 (6) IA).
- It is used to ascertain whether there are grounds to disqualify a director (s.6 (2)(a) of the Company Directors Disqualification Act 1986) on the basis of the unfit conduct of such person, provided he was (or still is) the director of a company which has become “insolvent”, i.e. the company has gone “into liquidation at a time its assets are insufficient for the payment of its debts and other liabilities and expenses” (or alternatively it has gone into administration or administrative receivership).
- It will determine the “relevant time” as regards any attempt by a liquidator or administrator to set aside pre-insolvency transaction. This is driven by the question of whether at the time of the relevant transaction the company was, or as a consequence of the transaction concerned was rendered, “unable to pay its debts as they fell due” (ss.238, 239 IA). Such an assessment by a liquidator or administrator is often far more likely in practice to rely on balance sheet insolvency rather than cash flow insolvency.
- If there was continuing uncertainty around the application of the test, it could lead to a proliferation of trustees and special servicers turning to the Court for directions when faced with a demand from noteholders to take enforcement action based on a purported balance sheet insolvency event of default.
Eurosail was a Special Purpose Vehicle (SPV) set up in July 2007 to acquire a portfolio of sub-prime mortgage loans secured on residential property in the United and funded by the issue of £660 million of floating rate loan notes in several classes and currencies. The final redemption date of the lowest priority notes is in 2045. The underlying loans were in English Pounds, while the notes were denominated in English Pounds, Euro and US Dollars; Eurosail hedged its position by entering into various interest rate and currency swaps with a Lehman Brothers entity. Following Lehman’s demise, the swaps were terminated and Eurosail was faced with a growing deficit in principal, as it was no longer able to hedge the notes against the Pound’s post-2008 slide vis-à-vis the US Dollar. However, the excess spread resulting from the difference between the interest payments received from the underlying mortgages and the interest payments paid out under the notes meant that Eurosail was able to continue servicing the notes and therefore was not cash flow insolvent.
A class of Noteholders (A3) requested the Trustee to call an event of default on the basis that Eurosail was unable to pay its debts as they fell due since the audited accounts showed net liabilities in the range of £74 million to £130 million. The effect of calling a note event of default would have been to switch the priority of payments and enforcement would cause the excess spread to be used to repay the A2 and A3 Noteholders pari passu, as opposed to continuing to adhere to the pre-enforcement payment regime which gave the A2 Noteholders priority in receiving repayments of principal from mortgage redemption in the underlying portfolio. The loan notes documentation included a direct reference to section 123(2) IA. Lastly, the documentation contained a post enforcement call option (PECO), a tax-driven provision whereby noteholders are obliged to transfer the notes to an ‘option holder’ in the event the PECO is exercised (the expectation being that the liabilities under the notes will be forgiven by the connected option holder).
The Supreme Court Ruling
No “Point of No Return”
The judge at first instance and the Court of Appeal ruled that the balance sheet test is not simply a matter of aggregating a company’s assets and liabilities at their face value. They were trying to avoid a too literal reading of the balance sheet test which would mean a vast number of solvent companies, especially those prone to cyclical ups and downs, would be vulnerable to a winding-up order. Lord Neuberger went further and stated that a company would, before it could be wound-up, have to have reached a “point of no return” such that the directors should have to “put up the shutters”.
The Supreme Court expressly rejected this approach and noted the “point of no return” test “should not pass into common usage as a paraphrase of the effect of section 123(2)”. Instead, Walker J said it was imperative to “proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency”, putting the onus firmly on the party asserting balance-sheet insolvency. The court then undertook a very fact-specific assessment of Eurosail’s financial position and considered the following factors in concluding the hurdle had not been overcome:
- Given its SPV status (as opposed to that of a normal trading company), Eurosail’s present assets were the best place to start in assessing its ability to meet its long-term liabilities.
- Against that, however, Walker J considered “three imponderable factors” as having a bearing on Eurosail’s financial position and future prospects, being: (1) potential currency movements, (2) potential interest rate movements and (3) the UK economy and housing market, all of which were clearly out of Eurosail’s control.
- There were more than 30 years left to redemption of the notes in 2045.
- The potential movements in currencies and interest rates over this period were adjudged to be “incapable of prediction with any confidence”.
A Matter of Speculation?
All of these factors led the court to conclude that there simply was no way to decide whether or not Eurosail was balance sheet insolvent, it being: “a matter of speculation rather than calculation and prediction on any scientific basis”. Unfortunately the Supreme Court did not take the opportunity to elaborate further on the “difficult” task of quantifying contingent and prospective liabilities, for example discussing the applicability of the hindsight principle (as was done in Deuilemar2, a case which followed the Eurosail Court of Appeal ruling).
Of course, guidance does exist on such quantification from accounting standards and from principles set out in the Insolvency Rules (e.g. Rule 4.86 IR), which allow for a present value to be put on a future or contingent liability. In turn, those rules have been put to the test before the UK courts and as recently as earlier this year the Ricoh3 ruling made clear that a liquidator does not need to concern him/herself with the benefit of foresight, nor is (s)he obliged to delay a distribution and/or set up a retention fund to ensure the creditor’s claim is maximised.
What is clear is that it is going to be especially difficult to establish balance sheet insolvency where there are long-dated liabilities (as is often the case in mortgage-backed securitisation deals) – “The more distant the liabilities, the harder this (meeting prospective and contingent liabilities) will be to establish”4, as per Court of Appeal judge Toulson LJ, with which the Supreme Court agreed. But to come back to the point made above, and as a leading academic in an article on s.123 IA and its legislative history pointed out5, those liabilities “will still be capable of a present valuation”. Once the petitioner has shown the company to be insolvent on a balance sheet basis, the requirements are met. Of course the courts retain a discretion not to make a winding-up order if they consider it unjust in the circumstances to do so, but that is an extremely fact-driven assessment, and one which is arguably not helped by reference to a “point of no return” test, which inherently introduces further uncertainty.
The Irrelevance of PECO
In an obiter dictum, Lord Hope sided with the earlier courts’ decisions on the potential impact of the PECO on the question of Eurosail’s balance sheet insolvency under s.123(2), by confirming that a PECO is irrelevant for the purpose of assessing whether there is a deficiency as per s.123(2) and that its purpose was to achieve bankruptcy remoteness for Eurosail.
How the Balance Sheet Insolvency Test Impacts the Drafting of LMA Finance Documents
As mentioned above, the LMA standard form loan agreement contains a variety of separate insolvency defaults, some of which mirrors the s.123 (2) language, but others which distinguish it. For example:
- “A member of the Group is unable or admits inability to pay its debts as they fall due”
- “A member of the Group is deemed to, or is declared to, be unable to pay its debts under applicable law”
- “The value of the assets of any member of the Group is less than its liabilities (taking into account contingent and prospective liabilities)”
Whilst it is common to see the first two defaults in leveraged loan agreements (which are more akin to the cash flow test) accepted by borrowers, they remain open to negotiation and stronger borrowers may look to add wording such that it is clear that a default is not triggered under such test as a result of its balance sheet liabilities exceeding its balance sheet assets unless one of the other specific insolvency events of default is also triggered, thereby looking to ensure that the particular defaults have a later trigger.
In addition, borrowers are also often resistant to the final formulation of asset/liabilities default set out above, (akin to the balance sheet test), particularly in a scenario which involves multiple companies in the group providing guarantees for the entire debt. If it is not possible through negotiation to remove the concept entirely, then in that case the LMA language can be qualified to say that you have to take into account the likelihood of the contingent liabilities becoming actual (in other words you cannot use the existence of the contingent liability under a guarantee by itself to call a default).
What Can We Take Away?
It has to be emphasised first and foremost that this was a factual ruling involving a cash flow solvent, non-trading securitisation SPV with extremely long-dated maturities. That being said, and especially given the dearth of judicial guidance on the balance sheet insolvency test, it is a very welcome and long-awaited judgment.
- This ruling leaves less room for manoeuvre by a company trying to argue that events of default etc. have not been triggered because it has not yet reached the moment it has to “put up the shutters” or “reached the point of no return”. This is potentially good news to creditors seeking to force over-leveraged debtors to the negotiating table to commence restructuring discussions, where the likely alternative is insolvent liquidation. It would certainly seem to be a step in the right direction in unravelling the multitude of ‘zombie companies’ operating in the UK which have covenant-lite packages where the only real way for creditors to trigger restructuring negotiations is based on potential enforcement remedies and directors’ duties issues falling off the back of actual or potential balance sheet insolvency.
- As explained, many loan agreements include in the insolvency events of default direct references to all or various parts of the s.123 (2) test or, at a minimum, do so indirectly as per the LMA standard documentation. If the “point of no return” concept had remained part of the balance sheet insolvency test, one would have expected going forward to see lenders trying to avoid the uncertainty around the ‘contingent and prospective’ element of s.123 (2) by drafting specific insolvency event of default triggers which avoid these direct (or indirect) references to the balance sheet insolvency test and result in an earlier trigger than the “point of no return”. The Supreme Court decision has made this less likely but nevertheless emphasises the importance for lenders to have access to detailed financial information if they wish to be able to argue balance sheet insolvency – so whilst referring directly or indirectly to the s.123 (2) test no longer opens up the can of worms which the “point of no return test” brought, it does still bring into play the difficulty of overcoming the burden of proof in establishing balance sheet insolvency “taking into account contingent and prospective liabilities”. It is finally worth noting that for borrowers the risk that the event of default referring to balance sheet insolvency could mean a pure negative net asset calculation as sufficient to create a default trigger has been firmly eliminated.
- Finally, the judgment is welcome in that it avoids the speculation and uncertainty that the “point of no return” test had undoubtedly brought to many aspects of restructuring negotiations and insolvency procedures.