The guidelines laid down by the English courts for applying the balance sheet test for insolvency affects not only whether a company is technically insolvent, but also the enforceability of clauses in transactional banking documents and the ability of a liquidator to challenge certain antecedent transactions. The Supreme Court’s decision will therefore be welcomed by advisors, bankers and insolvency practitioners as it has overturned the high threshold laid down by the Court of Appeal.

The decision confirms that there are indeed two separate and distinct tests for establishing a debtor’s insolvency under the Insolvency Act 1986 (IA). More particularly, the balance sheet test in section 123(2) is not dependant on whether the debtor has genuinely “reached the point of no return”. Instead, the balance sheet test should be assessed on a balance of probabilities to determine whether the debtor has insufficient assets to be able to meet all its liabilities (including contingent and prospective liabilities).

Eurosail, a subsidiary of Lehman Brothers, had issued a variety of loan notes on the back of UK domestic mortgages. The notes were issued in Sterling, Euros and US dollars, with swaps taken out to hedge the currency risk. Certain currency exchanges became expensive as a result of the decline in Sterling and a shortfall appeared in the difference in value between Eurosail’s assets and its liabilities. Despite this, Eurosail was not suffering from cash flow problems as the interest it received on the mortgages was sufficient to meet its liabilities in the short term.

The “A3 Noteholders” concluded that they would benefit from an event of default occurring as that would result in a new priority of payments whereby excess interest received on the mortgages would go towards paying down the principal debt on their notes, rather than going to the “A2 Noteholders” as would ordinarily be the case. The A3 Noteholders argued that an event of default had occurred since Eurosail was balance sheet insolvent pursuant to section 123(2).

Eurosail and the A2 Noteholders argued that a simple mathematical analysis of Eurosail’s assets and liabilities was not enough to demonstrate that it was insolvent, and a broader analysis would be needed. For example, Eurosail had a valuable claim in Lehman Brothers’ insolvency which did not appear on its balance sheet for accounting purposes. Since Eurosail was able to meet its liabilities going forward, Eurosail argued that it would be unjust to conclude that it was insolvent.

The High Court agreed with Eurosail, as did the Court of Appeal, but on a different analysis of the law. The Court of Appeal concluded that the balance sheet test for insolvency was whether the debtor had “reached the point of no return” so that to continue trading would amount to a fraud on future and contingent creditors.

The Court of Appeal acknowledged that many debtors may technically have fewer assets than their liabilities at any given moment in time. However, these debtors may still be able to pay their debts and meet their liabilities as they fall due. To interpret the balance sheet test in a narrow, mathematical way would result in injustice as many solvent and successful companies falling within the scope of s123(2) would be at risk of a winding-up or an administration order being made. Instead, the court acknowledged that a commercial analysis was needed with an emphasis on fairness.

The Court of Appeal’s analysis was driven by an understanding of the commercial reality faced by companies, but it blurred the balance sheet test and the cash flow test. It also created uncertainty over how to assess whether a company has actually reached the “point of no return” with the result that the bar to meeting the balance sheet test became much higher to reach.

The A3 Noteholders appealed to the Supreme Court. Their appeal was unanimously dismissed by the Supreme Court judges who were not satisfied that ultimately there would be a deficiency in Eurosail’s balance sheet. The Supreme Court also rejected the test proposed by the Court of Appeal in connection with section 123(2), which required the company to have reached “the point of no return”. Instead, the test will be whether, on a balance of probabilities, the company's assets are sufficient to satisfy its liabilities, including contingent and prospective liabilities.

Lord Walker acknowledged the uncertainty that is inherent in the test, commenting that: “it is still very far from an exact test, and the burden of proof must be on the party which asserts balance-sheet insolvency.” It will, therefore, not simply be a matter of looking at a company's statutory balance sheet at a given moment in time as there may be relevant assets and liabilities not contained in that document. However, nor will it involve a rather more complex assessment of whether the debtor has reached the point of no return.

Comment:

The Court of Appeal’s solution to interpreting section 123(2) was based in pragmatism, but it created difficulties and did not sit comfortably with the statutory language of section 123(2). It is of course true that a snapshot of a company’s balance sheet is not conclusive as to its commercial and economic viability, and to make every company in this position vulnerable to a winding-up or administration order would be unfair and uncommercial. However, section 123 draws a clear distinction between the cash flow insolvency test and the balance sheet test, and the Court of Appeal was incorrect to make the balance sheet test effectively another limb of the cash flow test.

The Supreme Court’s decision should therefore be welcomed for clarifying that the two tests are mutually exclusive and both represent different ways of analysing whether a company is insolvent.

The judgment does leave some issues unresolved, for example the correct methodology for discounting future liabilities and the timing of the accrual of future and contingent liabilities. Those questions will need answering another day and in the meantime we should take some comfort that the Supreme Court has re-established the usual bar for the balance sheet test, which will assist liquidators wishing to challenge antecedent transactions (as the point of insolvency determining the claw back period is typically analysed using the balance sheet test). In addition, bankers can take comfort that the financial covenants in their transactional documents are more sensitive than the Court of Appeal’s analysis would have interpreted them and are more aligned to original intentions.

Further reading: BNY Corporate Trustee Services Ltd v Eurosail UK 2007-3BL PLC and Ors [2013] UKSC (09/05/2013); Section 123 Insolvency Act 1986