The recent decision in BNY Corporate Trustee Services Limited v Eurosail - UK 2007 - 3BL PLC (Eurosail) has provided helpful guidance on the interpretation of the insolvency tests set out in section 123 of the Insolvency Act 1986. This guidance is not only relevant to companies with financial problems. The common practice of drafting contractual events of default by reference to section 123 means that it has significance to anyone who is creating or is party to contracts (whether finance documents or other commercial contracts) containing this type of provision.

In particular, when drafting or reviewing insolvency events of default:

  • Be aware that cross referring to an insolvency event as determined by s123 Insolvency Act 1986 will not give rise to an exact test.
  • Simply deleting the requirement drafted into the act for a test to be satisfied "to the satisfaction of the court" may not be sufficient by itself to avoid the need for litigation to determine the outcome of the test.

Section 123

The tests for insolvency considered in Eurosail were the cash-flow test from section 123(1)(e) and the balance sheet test from section 123(2) of the Insolvency Act 1986, as set out below:

  1. A company is deemed unable to pay its debts -

e.if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.

  1. A company is also 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.

Eurosail had issued loan notes to various classes of Noteholders. The loan notes included an event of default described by reference to section 123, albeit that the words "it is proved to the satisfaction of the court" were deemed to be deleted from s123(2). The occurrence of an event of default could result in the service of an enforcement notice and a change in the order of priority of capital payments to certain classes of Noteholders. The financial impact of this would be significant.

The cash-flow test

The guidance given in the judgment for the application of the cash-flow test is that it is concerned "not simply with the petitioner's own presently-due debt, nor only with other presently-due debts owed by the company, but also with debts falling due from time to time in the reasonably near future".

What constitutes "reasonably near" will depend on the circumstances, not least on the nature of the company's business. This does not significantly change the current interpretation of this section.

The balance sheet test

The evolution of the more complex balance sheet test was considered in detail. The judgment states that the express reference in section 123(2) to assets and liabilities is recognition that "once the court has to move beyond the reasonably near future...any attempt to apply a cash-flow test will become completely speculative, and a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test".

Although this is not an exact test, it does re-introduce some certainty in stating that the relevant assets will be the assets of the company which exist at the point of calculation. The relevant liabilities will be those currently existing or arising out of the existing commitments of the company.

Beyond this, the view of the Court of Appeal (and supported in the Supreme Court) was that section 123(2) goes beyond the scope of a mathematical calculation. It also requires a court to make a judgment about whether the company will be able to meet its future and contingent liabilities at the appropriate time. If this were not the case then there is a risk that the section could be used to the detriment of successful companies. They may have assets worth less than their liabilities at certain stages of their development but at all times are able to repay their debts as they fall due.

The court went on to note that the burden of proof must be on the party which alleges balance-sheet insolvency and that the "omission from [the event of default] of the reference to proof 'to the satisfaction of the court' could not alter that". This amendment is frequently encountered in practice, but parties should be aware that simply deleting the words which require the balance sheet test to be proven to "the satisfaction of the courts" will not necessarily prevent the need for a court to determine whether the test has been satisfied.

In some cases, it may not be possible to satisfy the burden of proof and demonstrate whether a company will be in a position to pay long term future debts until much closer to the relevant payment date. It is worth noting that Eurosail had a relatively simple business structure. It had specified long term liabilities to repay loan notes in 2045 and few management decisions required (and for that matter other commercial uncertainties) in the intervening period. Despite this simplicity, it was considered impossible to determine whether or not Eurosail was unable to pay its future debts and so it could not be deemed to be insolvent at this time.