This corporate update summarises certain decisions in the Court of Appeal and the Supreme Court relating to the balance sheet insolvency test, agreements to agree and the exercise of contractual discretion. The decisions clarify the law in a number of areas of day-to-day relevance.

UK BALANCE SHEET INSOLVENCY TEST: Implications for lenders and borrowers

Background

The balance sheet insolvency test set out in s.123(2) Insolvency Act 1986 ("IA") is an important element of English insolvency law, with a significant impact on matters such as directors' duties, directors' disqualification, and administration and insolvency procedures. The balance sheet test set out in s.123(2) IA is as follows:

"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."

The recent decision of the Supreme Court in BNY Corporate Trustee Services Ltd and others v Eurosail-UK 2007-3BL Plc and others provides guidance on the way the test should be interpreted and rejects the view that the test involves considering whether a company has reached "the point of no return" as suggested by the Court of Appeal.

Eurosail was a special purpose vehicle established in 2007 as part of the Lehman Brothers group to acquire a portfolio of some £650 million mortgage-backed loans relating to UK properties. The acquisition was funded by the issue to investors of various classes of notes, with different priorities and in different currencies, with a final redemption date of 2045 for the lowest priority notes. Eurosail's position in relation to its exposure under the notes was hedged by various currency and interest rate swaps with another entity in the Lehman group, which were terminated following the collapse of Lehman Brothers in 2008. The fall in the value of sterling against the dollar after 2008 meant that a shortfall between Eurosail's assets and liabilities emerged. However, the company did not experience cash flow problems because the interest payments received from the underlying mortgages were greater than the interest payable under the notes.

A class of noteholders (the A3 class) asked the trustee representing the noteholders to serve an enforcement notice on the basis that Eurosail was unable to pay its debts as they fell due in accordance with s.123(2) IA. The effect of this would have been to change the priority of payments and enforcement by bringing all the A class noteholders into one group, ranking equally among themselves for repayment.

Otherwise, the A2 noteholders would have priority to the other A class noteholders in relation to payments of principal from mortgage redemptions in the underlying portfolio.

The transaction documents had also provided for a post-enforcement call option (PECO) the terms of which obliged the noteholders to transfer the notes to the option holder (an associate of the issuer) with the intention that the liabilities under the notes would be forgiven by the option holder. The effect of this was that the issuer would not be regarded as unable to pay its debts.

Decision

The Supreme Court upheld the decision of both the High Court and the Court of Appeal in finding that the balance sheet insolvency test is not simply an accounting exercise, and that Eurosail could not be regarded as balance sheet insolvent under s.123(2) IA.

The judgments of both the High Court and the Court of Appeal emphasised that the balance sheet test should not be applied simply by aggregating a company's assets and liabilities. They were particularly aware of the adverse consequences of applying such a literal approach to a whole range of companies including those, like Eurosail, with non-trading businesses, and others with cyclical businesses. The Supreme Court held that in deciding whether a company is “balance sheet insolvent” the Court must decide whether, on the balance of probabilities, and considering the company's assets, as well as its prospective and contingent liabilities, it cannot reasonably be expected to meet those liabilities. In the case of Eurosail there were too many uncertain factors to say whether or not in 2045, when its final obligations matured, the company would be able to meet them. As a result it could not be considered balance sheet insolvent.

The Court also considered the “cash flow” test for insolvency, even though it was not directly relevant to the case. This is set out in s.123(1)(e) IA, which provides that a company is deemed unable to pay its debts "if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due". It approved a decision of the High Court holding that the cash flow test is not simply a picture of current debts due, but should also take account of debts falling due from time to time in the reasonably near future. What counts as the “reasonably near future” will depend on the company's business.

Finally, it was also decided (although the comments were not central to the decision) that for the purposes of assessing assets and liabilities in order to apply the balance sheet insolvency test, the PECO was not relevant. This is helpful as PECOs are commonly used in securitisations.

Comment

This case provides useful guidance on a number of important issues in relation to the balance sheet and cash flow tests for insolvency. The outcome of applying the test is necessarily fact specific and the case makes it clear that neither test can be characterised precisely. In particular, it becomes more difficult to state that a company fails the “balance sheet test”, as the dates on which the various liabilities to be taken account of become due further into the future.

AGREEMENTS TO AGREE: Guidance from the Court Of Appeal

Background

Under English law “agreements to agree” are unenforceable, but it is also clear that parties may agree to be contractually bound, but defer dealing with significant matters arising under the contract until later.

The important issue is how to distinguish an unenforceable agreement from one which is enforceable, and this issue has recently been considered by the Court of Appeal in MRI Trading AG v Erdenet Mining Corp.

This case involved the sale of copper concentrates by Erdenet to a Swiss company, MRI Trading. A dispute arising about a contract originally entered into in 2005 was referred to arbitration, which resulted in the parties entering into a settlement agreement under which the original contract was terminated and new sale and purchase contracts entered into in 2010. Two of these contracts were performed, but Erdenet failed to supply certain goods as required under the 2010 contract. When the dispute regarding this failure was referred to arbitration, EMC argued that it was not under an enforceable obligation because of the "agreement to agree" provision in the third contract, which provided for the parties to agree on the shipping schedule and on some refinement and treatment charges. An arbitration panel accepted this argument, but MRI’s appeal to the High Court was successful and the Court of Appeal has upheld that decision.

Decision

The Court of Appeal (applying existing case law) held that where a contract is incomplete or uncertain, it may nevertheless be capable of being enforced by looking at the wider context of the relationship between the parties. In these particular circumstances the court could imply a term to the effect that, in default of an express agreement on the relevant matters, the parties would adopt reasonable terms allowing the contract to be performed.

The key question was whether the parties intended that the contract would continue to be enforceable even if agreement on the outstanding points was not achieved. In this instance, the Court found that was the case, and that interpretation of the relevant provisions showed that the parties’ intention had been that the matters to be agreed upon in the future were to be determined by the imposition of objective terms of fairness or reasonableness (in default of agreement on specific terms). The 2010 contact was an integral part of an overall deal under which both parties had derived benefits, a deal which they had worked through together for over a year without any suggestion that the final part “fell in to a different and unenforceable category of obligation”.

The language used by the parties in both the settlement agreement and the 2010 contract reflected this. This led to the conclusion that it was “almost implausible” to attribute to the parties an intention not to conclude a binding agreement, particularly since the agreement was part of an overall transaction settling the earlier dispute.

Comment

Although this case follows existing law and does not establish new principles in this area, it is a useful reminder that the courts are reluctant to hold agreements unenforceable where it appears from the agreement itself that the parties intended to create a legally enforceable relationship at the time they entered into it. Two matters were particular pointers to enforceability in this case. The first was that there had already been part performance of the arrangements between the parties, and the second was that the parties had stipulated for the arbitration of disputes by a market tribunal. Accordingly, in these circumstances, the court was willing to imply such terms as were required to enable the contract to be enforceable.

Despite this case, parties requiring flexible (but legally enforceable) future arrangements should still set out as clearly as possible the machinery for settling such outstanding matters.

INTERPRETATION OF CONTRACTS: Exercise of contractual discretion and other contractual interpretation

Background

In a recent case, Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd, the Court of Appeal considered some difficult issues of contractual interpretation.

The case concerned a catering contract entered into between the Trust and Compass in 2008. The contract allowed the Trust to award itself deductions from the payments due under the contract and to award itself points for failure in service which were relevant to its rights to terminate the contract. In July 2009, the Trust purported to terminate the contract on the basis of a provision which allowed termination in the event that the relevant number of points for service failure had been exceeded. Compass responded by asking the Trust to repay certain deductions it had made under the contract, and to correct some of the data that the Trust had used in making the deductions.

In September 2009, Compass also purported to bring the contract to an end on the basis that the Trust had committed a material breach of the contract in failing to correct the data used by it in making some of the payment deductions. The following month, the Trust withdrew the notice of termination which it had given in July, and issued a new one relying on the same provision. The parties agreed that the contract should end, but both argued that they had terminated it on valid grounds.

In the subsequent High Court action Compass claimed damages for breach of contract and the Trust also claimed for damages (on the basis that its own termination of the contract was the valid one).

Decision

In the High Court, the judge found that, since both parties had a valid right to bring the contract to an end, neither of them could succeed in a claim for damages.

The Trust appealed to the Court of Appeal, which considered a number of issues relating to interpretation of the contract. There were three particular issues which are worthy of note.

Exercise of discretion: The contract gave the Trust discretion to make payment deductions where Compass’ performance did not meet the required standard. The Court of Appeal decided that there was not an implied term that the Trust would not exercise its discretion in an “arbitrary, capricious or irrational” way: the cases where such a term had been implied were ones where the discretion involved choosing from a range of options, rather than a simple decision whether or not to exercise a contractual right.

Duty to co-operate in good faith: Under the contract, the parties were obliged to co-operate with each other in good faith, and to take all reasonable action required for the efficient transmission of information and instructions, to allow the Trust to derive the full benefit of the contract. The Court of Appeal rejected Compass’ argument that this duty was a general one applying to all the obligations of the parties where they interacted under the contract. It held instead that the obligation was limited to the relevant clause, and only applied for the two purposes stated in that clause.

The Court underlined that no general duty of good faith exists under English law, and that where such a duty is imposed by contract its scope is a matter of interpretation and is defined by its contractual context. In this case the Trust’s behaviour in awarding itself (excessive) service failure points and payment deductions did not breach the obligation to co-operate in good faith because the “good faith” clause related solely to the provision of information etc. (and because the Trust was not acting dishonestly).

Material breach of contract: Although the Trust’s behaviour in relation to its excessive payment deductions and service point failures did not breach the good faith clause, it did breach other provisions of the contract. However, the Trust had cured the breaches relating to the payment deductions by repaying the sums involved before Compass gave notice of termination. The Court held that the remaining breach, relating to excessive service point failures, was not a material one. As a matter of interpretation of the contract, the Court found that a breach did not have to be so serious as to amount to a repudiatory breach in order to be “material”, although it did have to be a serious matter, not one that was trivial. It followed that since the Trust was not in material breach of the contract, Compass’ termination alleging material breach was wrongful. By contrast, the Trust's termination of the contract when Compass had exceeded its termination points threshold was something it was entitled to do, and was a valid termination.

Comment

While the findings on material breach and good faith are of interest, the most important aspect of the case is arguably the guidance on when and whether a court will imply a term not to act arbitrarily, capriciously or irrationally, and it now seems that such a term will not normally be implied where a contract party has a simple discretion as to whether to exercise a right or not (as opposed to a situation where it has the right to exercise its discretion in a variety of ways).