We reported on the Court of Appeal case of BNY Corporate Trustee Services Limited v Eurosail in March 2011. Yesterday’s Supreme Court decision dismissing the appeal unanimously provides further guidance on how the balance sheet test of insolvency is to be interpreted.

The Facts

The fact pattern is complex and, in the words of Lord Walker the legal documents relating to the securitisation "regrettably and forbiddingly voluminous". In short, Eurosail-UK 2007-3BL Plc (the Issuer) acquired a portfolio of about £650 million of mortgage–backed loans in 2007, relating to UK residential properties. To fund the acquisition, the Issuer sold investors various interest bearing multi currency notes divided in to five classes (A to E) (the Notes). BNY Corporate Trustee Services Ltd (the Trustee) was appointed as the noteholder trustee. The final maturity date for the lowest priority Notes was 2045.

The Issuer had entered into currency and interest rate hedges with a Lehman Brothers entity, LBSF, whose obligations were guaranteed by another Lehman entity, LBHI. LBHI and LBSF entered bankruptcy proceedings on 15 September and 3 October 2008 respectively and the hedging contracts were terminated soon after. The loss of the currency swap in particular resulted in a significant deficiency in the Issuer’s net position.

The order of payments was in consequential order with class A notes being repaid first. At the time of the application all class A1 noteholders had been repaid in full. Absent an enforcement event A2 noteholders would be repaid next, followed by A3 notes etc. Class A2 noteholders wished to retain this payment structure.

The terms of the Notes provided that in the event of an Event of Default, the Trustee is empowered to serve an Enforcement Notice. One Event of Default was if the Issuer becomes "unable to pay its debts" under the terms of section 123(2) of the Insolvency Act 1986 (the Act) – a test often referred to as the "balance sheet test of insolvency". An Enforcement Notice would bring all the Class A noteholders into one class and they would accordingly rank pari passu in any distribution made. The A3 therefore noteholders requested the Trustee to serve an Enforcement Notice so that principal amounts of money would be paid equally to the A2 noteholders rather than the A3 noteholders having to wait and risk not being paid when due. The Trustee applied to the court for directions.

The transaction included a post enforcement call option (PECO). This gave an associate of the Issuer (OptionCo) an option to acquire all the Notes if the Trustee determined that the Issuer is unable to pay its debts under section 123. If OptionCo then exercised the PECO, all the noteholders’ claims would be sold to OptionCo with the intended effect that the Issuer would not be regarded as being unable to pay its debts.

The Supreme Court judgment

The Supreme Court unanimously dismissed the appeal. The Supreme Court considered the balance sheet test: 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 that the amount of its liabilities, taking into account its contingent and prospective liabilities" (section 123(2)). The Supreme Court also considered (even though this was not directly relevant to the case itself) the cash flow test: a company is deemed to be 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" (section 123(1)(e)).

The Supreme Court acknowledged that the two sections stand side by side with no indication of how they are to interact.

Cash flow test

The cash flow test was most recently interpreted by Briggs J in Re Cheyne Finance Plc (No 2) [2007] EWHC 2402 (Ch) where the High Court held that the cash flow test is not a snapshot of debts due here and now but requires an element of futurity. In Eurosail, the Supreme Court approved this decision. The cash flow test is concerned not simply with the petitioner’s own presently-due debt but also with debts falling due from time to time in the reasonably near future. What is the reasonably near future will depend on all the circumstances, but especially on the nature of the company’s business. Where it is necessary to move on from the reasonably near future it becomes necessary to look to the balance sheet test with its express reference to assets and liabilities, which in the court’s view is "a practical 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 (…) becomes the only sensible test."

Balance sheet test

The balance sheet test requires the court to decide whether, on the balance of probabilities, it has been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet those liabilities. The burden of proof rests with the party which asserts balance sheet insolvency. The Supreme Court confirmed that the test developed by the Court of Appeal that the balance sheet test of insolvency is only engaged where it can be said that the company has "reached the point of no return" is not the correct test. However, the Supreme Court held that the Court of Appeal would have reached the same conclusions without any reference to the point of no return test and indeed, Lord Walker reached the same conclusion as the Court of Appeal: Eurosail could not, on the available facts, be deemed to be balance sheet insolvent. There were simply too many "imponderable factors", such as currency movements, interest rates and the UK economy and housing market which are outside Eurosail’s control and which will ultimately determine whether on the final maturity date in 2045 Eurosail will be able to meet its obligations in full.

Where, as in the current case, liabilities could be deferred for over 30 years (until the final maturity date in 2045) and where the company is paying its debts as they fall due "the court should proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency under section 123(2)." The Court concluded that it could not be satisfied that there will eventually be a deficiency.


The decision on the effects of the PECO is, just as in the High Court and Court of Appeal obiter only. However, as the Court acknowledges, PECOs are widely used in securitisations and it is appropriate that the Court addresses the effects of a PECO. The Supreme Court (Lord Hope giving the judgment on this part) held that for the exercise of assessing the Issuers’ assets and liabilities to determine whether it is balance sheet insolvent (and whether there is an event of default) a PECO is irrelevant. It was not possible to distinguish the intended commercial effect of the provision form the legal effect and the PECO was of no relevance as regards the interpretation of the quantification of the liabilities.


So where does this judgment leave us? The judgment is helpful in that it clarifies a number of points which were left open or unconfirmed before: First, there is clear endorsement by the highest court in England that the cash flow test includes an element of futurity but only with regard to the reasonably near future. Second, balance sheet insolvency is more complex than the point of no return test and includes a proper assessment of assets and liabilities. Third – and endorsing the Court of Appeal, a company’s statutory balance sheet is different from the balance sheet test of insolvency and as such can only be a starting point for the court’s analysis, not the be all and end all.

However, the judgment also leaves vital questions unanswered. What is the "reasonably near future"? The Court acknowledged that Eurosail’s essentially "closed" business is quite unlike the business of an ordinary company engaged in normal trading activities. Equally, how does one apply the balance sheet test, taking into account prospective and contingent liabilities? The application will be fact specific, but the analysis will be very different dependent on whether prospective and contingent liabilities fall due in one year’s time as opposed to 30 years. It is notable that the balance sheet test becomes increasingly difficult to apply as the liabilities falling due become more distant. More ‘imponderable facts’ beyond the control of the company inevitably accumulate over time, particularly in the case of a complex trading company where both assets and liabilities continually fluctuate. On the present facts, no decisions as to the running of the businesses, suppliers etc need be made, as the Trustee is only engaged in collecting in realisations and distributing these in accordance with the documentation. The only important management decision that could arise is if it were decided to purchase a replacement hedge. The Court acknowledges that in these specific facts, Eurosail’s present assets "should be a better guide to its ability to meet its long-term liabilities than would be the case with a company actively engaged in trading". However, even so the Court was not satisfied that the balance sheet insolvency test was met.

While the case itself focuses on the interpretation of section 123(2) which was incorporated by reference into the documentation, the case will be of relevant not only where contracts specifically incorporate the section but also where contracts made reference to the balance sheet without explicit incorporation of the statute. What is clear is that a company’s own assessment as to when it is balance sheet insolvent remains difficult – and for a counterparty to enforce a balance sheet based event of default will be virtually impossible the longer the date that the contingent and prospective liabilities fall due.