The English Supreme Court’s eagerly awaited decision on the Eurosail litigation, concerning how the “balance sheet” test for insolvency should be applied, was released today. The decision clarifies how courts should apply the balance sheet test, and what circumstances and facts must be taken into account in doing so.

Balance sheet test must take into account commercial context of company

The Supreme Court has upheld the Court of Appeal’s previous ruling that the “balance sheet” definition of insolvency – namely, that a company will be deemed to be unable to pay its debts if the value of its assets is less than its liabilities, taking into account its contingent and prospective liabilities – must take into account the wider commercial context of the company in question.

Accordingly, for a company to be found balance sheet insolvent, a fact-based approach taking into account the wider circumstances of the company’s situation must be conducted. The test is therefore not a narrow “mathematical” analysis of the ratio between a company’s assets and its liabilities at a given time – as might be the case if only a company’s accounts and financial statements were looked to as evidence of insolvency. Instead, the court must also have regard to contingent assets and liabilities that may well not be reflected on the company’s books.

Eurosail ruling: too many uncertain factors in play

The case concerned a special purpose entity called Eurosail, part of the collapsed Lehman Brothers group, which had issued mortgage-backed securities in various classes of notes. A group of noteholders had sought to trigger an event of default under the note documentation which cross-referred to section 123(2) of the Insolvency Act 1986 (the section of the Insolvency Act which contains the balance sheet test described above). The result of the event of default being triggered on the basis of balance sheet insolvency would be that, under the terms of the note documentation, the post-enforcement ‘waterfall’ governing the priority of payments of principal to noteholders would take effect. The consequence of this would be to give the appellant noteholders pari passu ranking with a group of Eurosail noteholders who, under the pre-enforcement waterfall, rank senior to them.

In dismissing the noteholders’ appeal, the Supreme Court held that the balance sheet test was not satisfied in relation to Eurosail, as although the company’s previous audited accounts had consistently shown its balance sheet to be negative, the court had to take account of the wider circumstances of the company. In this case, long-term factors, including fluctuations of currency exchange rates, interest rates and the health of the UK economy and housing market, all had a fundamental bearing on Eurosail’s future ability to meet its liabilities to noteholders (which, in the case of the litigating noteholders in question, did not fall due until several years in the future).

These long-term variables could move in Eurosail’s favour over the years, meaning that by the time Eurosail was required to redeem the notes Eurosail might be able to pay its debts to the noteholders. Therefore, the uncertainty of the company’s future circumstances made it impossible for a court to rule that, on the balance of probabilities, Eurosail was at the present time balance sheet insolvent.

“The point of no return”: not a new test

Although the Supreme Court upheld the Court of Appeal’s 2011 decision, it did disagree on one point of the Court of Appeal’s analysis. The Court of Appeal suggested that the court should consider, in testing for insolvency on the basis of section 123(2), whether a company has “reached the point of no return.”

The Supreme Court held that this term should not be taken as a new test for insolvency, or a reinterpretation of the section 123(2) balance sheet test; instead, the Supreme Court confirmed that courts should test for balance sheet insolvency on the existing terms of section 123(2); namely, taking into account a company’s actual and contingent assets and liabilities.