The UK’s Insolvency Act 1986 sets out in s.123 various tests to determine whether a company should be deemed unable to pay its debts. The relevance of these tests to distressed companies is obvious: deciding as they do when it is appropriate to seek an administration order or present a winding up petition. They also help determine directors’ duties, antecedent transactions and issues such as wrongful and fraudulent trading. Furthermore, it is also almost standard practice to include the tests in commercial and financial contracts as triggers for termination or events of default.

s.123 was recently considered by the Supreme Court in the case of BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc and others1 (Eurosail). In Eurosail, the Supreme Court clarified in particular what is known as the “balance sheet test” of s.123(2).

The facts

Eurosail acquired a portfolio of sub-prime mortgages which it funded through the issue of various classes of loan notes (the Notes), the majority of which were repayable in 2045. The Notes were issued in several currencies with the associated risk hedged through currency swaps entered into with a Lehman Brothers entity (the Swaps).

The terms of the Notes provided that an event of default would occur were Eurosail to be deemed unable to pay its debts within the meaning s.123(1) or (2) subject to slight amendments. Under s.123(2)(e) a company will be so deemed where “it is proved to the satisfaction of the court that the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities” ie the balance sheet test of solvency.

The insolvency of Lehman Brothers terminated the Swaps leaving Eurosail vulnerable to adverse currency market fluctuations. As a result, Eurosail’s audited balance sheet had liabilities significantly in excess of assets. However, Eurosail was, at all times, cashflow solvent as it was able to pay its debts (the interest on the Notes) as they fell due out of the income from the mortgages.

The Supreme Court was asked to consider whether the net liability position of Eurosail meant that it was balance sheet insolvent for the purposes of s.123(2) and thus whether an event of default had occurred.

Court of Appeal decision

In 2011, the High Court and Court of Appeal held that Eurosail was not balance sheet insolvent under s.123(2). A broad interpretation of s.123(2) was adopted: the balance sheet test could not be reduced into a simple formula. The Court of Appeal stated that the court should determine whether a company had reached the point of no return due to an incurable deficiency in its assets (taking into account future and contingent liabilities) rather than a “mechanistic, even artificial, reason for permitting a creditor to present a petition to wind up a company”.

Supreme Court decision

The Supreme Court upheld the Court of Appeal’s decision, but clarified the approach to be taken to the balance sheet test. It held that the court must consider the facts in each case so as to satisfy itself that, on the balance of probabilities, a company had insufficient assets to meet all its liabilities, including prospective and contingent liabilities. The more distant the liabilities, the harder it would be to establish insolvency. The Supreme Court commented that in the case of Eurosail, the length of time before its liabilities matured (2045) meant that assessing its balance sheet solvency was “a matter of speculation rather than calculation” that could not be done with any accuracy. As a result, the Supreme Court could not find that there was, or would be, a deficiency in Eurosail’s assets capable of satisfying s.123(2).

The Supreme Court also rejected the concept developed by the Court of Appeal of a company having to have “reached the point of no return” before it fails the test in s.123(2) and can be held to be insolvent; stating that it did not reflect the true effect of s.123(2). That concept asserted that a company could not be deemed insolvent simply because its assets exceeded its liabilities but rather s.123(2) should apply only where there is an incurable deficiency in the assets. The Supreme Court rejected this and stated that the concept should not be thought of as a shorthand version of s.123(2).

Comment

The clarification of the balance sheet test has not brought certainty to its application. The Supreme Court has decided that a fact-based approach informed by commercial considerations and the broader position of the company must be used when assessing the balance sheet solvency of a company. This is a move away from a consideration of the black and white numbers of the company’s accounts to a more subjective assessment of the company as a whole.

The rejection of the “point of no return” test will be welcomed by creditors and lenders. It has lowered the threshold for establishing insolvency and accordingly has on one hand made it easier for events of default to be called against distressed entities. However, on the other hand it has created uncertainty by confirming the move away from a simple balance sheet analysis of assets against liabilities.

The effect on petitions for formal insolvency procedures is unlikely to be marked. The majority of creditor petitions and administration applications arise from a debtor’s failure to pay a debt that has fallen due. Eurosail will be of greater relevance to the appointment of administrators by the company or its directors or creditors’ voluntary liquidations. Relevant stakeholders must now take a long term view of the company’s balance sheet and satisfy themselves that the extent of the liabilities held against the company’s assets means it cannot pay its debts. Furthermore, where a company looks to enter into insolvency for the purposes of a reorganisation or pre-pack sale, directors and insolvency practitioners will need to carefully consider whether the test has been satisfied in such circumstances – particularly where the effect is to significantly disadvantage certain creditors.

Commercial contracts may be most affected by this decision. It is common for these to include event of default or termination provisions triggered by a s.123. The uncertainty created by the Eurosail decision means parties ideally should review these clauses and adapt the insolvency tests to include a stricter definition of a company’s defaulting balance sheet position or imposing, for example, a defined net liability position continuing over a specific period.