The ability of limited recourse provisions to protect borrowers and financiers against insolvency risks may be weaker due to a recent English court case.
Limited recourse clauses are often used in project and structured finance transactions. Borrowers want to avoid the risk of their directors being liable for trading while insolvent; and financiers may want to avoid the possibility of insolvency clawback actions if they seek to enforce their security documents.
This form of limited recourse lending is based solely on the strength of an underlying revenue or cash flow stream. It limits security to the assets of the particular project or asset pool, rather than all the borrower’s assets and undertaking.
The security for a limited recourse arrangement may be structured to ensure that assets and management are outside jurisdictions where a company may be wound up or liquidated, and liabilities can be increased without exceeding the value of assets.
This is all very sensible from a commercial perspective. However, a risk for financiers is that a borrower becomes insolvent and the assets gripped by the security do not, by virtue of the limited recourse provisions, cover the borrower’s liabilities.
The recent case of ARM Asset Backed Securities S.A.  EWHC 3351(the ARM ABS Case) casts doubt on whether contractual mechanisms put in place to achieve “insolvency remoteness” actually work in practice. This English decision is important as it may influence how limited recourse provisions are interpreted by Australian courts.
The Luxembourg-incorporated company, ARM Asset Backed Securities S.A., issued limited recourse bonds that were governed by Luxembourg law. The proceeds were invested to purchase a portfolio of life insurance policies. However ARM applied for the appointment of provisional liquidators after it failed to obtain the licences needed to conduct its business.
The judge in the ARM ABS Case focused on:
- whether a company registered in Luxembourg fell within the court’s English jurisdiction, and had not made itself “insolvency remote” in a jurisdictional sense; and
- whether a company, which has issued debt on a limited recourse basis, could be liquidated because of insolvency even when contractual recourse limits appeared to maintain the company’s liabilities above the value of its assets.
When ruling on the jurisdictional issue, the court accepted that an insolvency process could be opened in England even though ARM was registered in Luxembourg. This is because EU regulations allow a company to file for insolvency in the jurisdiction covering the location of its centre of main interest (COMI).
ARM’s COMI was in England because, the court held, “the decisions which govern the administration and management of the company [were] taken in London with the director based in London being primarily involved in the affairs of the company”.
On the second (insolvency) question, there are three main grounds on which an English court could wind up a company that is not registered in England, namely:
- if the company is dissolved, or has ceased to carry on business, or is carrying on business only for the purpose of winding up its affairs;
- if the company is unable to pay its debts when they fell due; or
- if the court ruled it just and equitable for the company to be wound up.
The court decided that ARM could be wound up under the second limb, on the basis that it was deemed insolvent because it could not pay its debts when they fell due.
The court said:
“… if a company has liabilities of a certain amount on bonds or other obligations which exceed the assets available to it to meet those obligations, the company is insolvent, even though the rights of the creditors to recover payment will be, as a matter of legal right as well as a practical reality, restricted to the available assets, and even though, as the bonds in this case provide, the obligations will be extinguished after the distribution of available funds.”
The court concluded that ARM’s cash flow and balance sheet both showed the company could not pay its debts. The court noted that a useful way of testing this was to consider whether ARM’s bondholders could prove in ARM’s liquidation for the face value and the interest owing on their bonds. When calculated, these liabilities far exceeded ARM’s remaining assets.
POTENTIAL APPLICATION IN AUSTRALIA
The case raises the jurisdictional dangers stemming from a company’s COMI being located outside its place of incorporation and a liquidator being appointed in unanticipated circumstances.
Investors may now introduce mechanisms that prevent a company having total control over the location of its COMI. For instance, financiers or investors may insist upon documented representations and undertakings to try and ensure that an issuer’s administrative activity, management and directors remain within its jurisdiction of incorporation and therefore outside jurisdictions where it is easier to start insolvency proceedings. The position is made considerably clearer in Australia due to Part 5.7 of theCorporations Act 2001 (Cth) setting out how to wind up bodies other than companies (which would include foreign companies).
Australian courts are yet to consider how the solvency issues raised in the ARM ABS case will affect limited recourse clauses. An Australian court may not accept the English Court’s approach and instead find that limited recourse provisions do prevent insolvency.
However, there are other avenues related to limited recourse clauses that could operate independently of the principles set out in the ARM ABS Case to undermine the intended commercial effect of a limited recourse financing. These include:
- financiers who may exercise their rights of set-off and combination of accounts across all bank accounts if they hold both project and non-project accounts and there is no account bank deed;
- sponsors, who exert sufficient control over a project company, being construed as "shadow directors" that make them liable to a liquidator for the loss or damage suffered by creditors if the project company has traded while insolvent;
- a default under limited recourse project financing arrangements may cross-default into the borrower’s other financial accommodation (if any); and
- if third-party guarantees and collateral support are not appropriately limited, and claims are made by financiers under them, the project company may be liable to counter-indemnify those third parties up to the amount claimed.
If the essence of the ARM ABS Case is applied in Australia, alongside existing legal principles, then financiers may have to live with an increased likelihood of insolvency when assets supporting a revenue stream do not meet or exceed the face value of the liabilities.
The reality is that “insolvency remote” does not necessarily mean “insolvency proof”.