The insolvency of the borrower is a standard event of default in facility agreements. As well as covering the borrower's cash flow insolvency, these clauses also often cover other, earlier signs of distress. Two recent cases have seen lenders try to exploit these outer reaches of their insolvency event of default clauses. Hayley Çapani and Adam Pierce explain why these cases are significant for parties negotiating new deals, and for lenders considering their enforcement options on existing deals.
Negotiations with creditors for rescheduling
The Grupo Hotelero1 case was about a facility agreement with a Spanish hotel company as borrower. The events of default included the borrower, "by reason of actual or anticipated financial difficulties, begin[ning] any negotiations with any creditor for the rescheduling of any of its indebtedness". The company had several other facilities, and had been in negotiations with some of its other lenders over renewing and amending their facilities. The parties disagreed on whether these negotiations triggered the event of default.
The High Court found that they did. In doing so the court analysed separately the key words and phrases in the clause. It found that "rescheduling" implies a degree of formality and that "financial difficulties" must be of a substantial nature. It also implied that a lender may not be able to cite financial difficulties it was aware of at the point of entering the agreement. But it still found in favour of the lender on the facts, largely because "beginning negotiations with any creditor" covered such wide ground.
Why is this significant?
Even before Grupo Hotelero, this clause had been a common focus of negotiation. In September 2012 the LMA carved out "negotiations with a Finance Party" (i.e. a finance party under the agreement in question) from the clause in its leveraged finance facilities agreement. This reflected a common concession sought by borrowers.
Although Grupo Hotelero creates no new law, seeing a lender successfully enforce this clause may encourage borrowers, particularly those with multiple facilities, to push harder to dilute this clause in other ways. For example, they may seek to carve out negotiations with trade creditors, or argue the negotiations must be with whole "classes" of creditors.
Balance sheet insolvency
Companies' liabilities sometimes exceed their assets, even when they are not insolvent, or even close to insolvent, on a cash flow basis. Can a lender call an event of default if this happens to its borrower? Should it be able to?
In Eurosail2, the Supreme Court had to decide whether an event of default had occurred under some notes issued by a securitisation vehicle. Under the notes, it would be an event of default if the issuer was deemed unable to pay its debts as they fall due "within the meaning of section 123(1) or (2) (as if the words 'it is proved to the satisfaction of the court' did not appear in section 123(2) of the Insolvency Act 1986)".
Under section 123(2), 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 than the amount of its liabilities, taking into account its contingent and prospective liabilities." This is the closest thing to a balance sheet insolvency test under English law.
The issuer's assets were less than its liabilities. The note trustee argued this was an event of default. The Supreme Court disagreed on the basis that section 123(2) is not simply an assets against liabilities test. It is about whether a company has, and will have, sufficient assets to meet it liabilities when they are due. In this case, the issuer's liabilities were all long term. It was therefore a "matter of speculation" whether the issuer's negative net asset position now indicated that it would be unable to meet them.
In its earlier judgment in the same case, the Court of Appeal had found that section 123(2) only applies once a company has reached "the point of no return". The Supreme Court decided this went too far. But it did agree that where a company is not cash flow insolvent, a court "should proceed with the greatest caution in deciding that the company is in a state of balance sheet insolvency".
Why is this significant?
Some insolvency event of default clauses refer expressly to section 123(2). Others refer simply to "insolvency" or "insolvency under applicable law". Eurosail shows that in these situations the lender should not assume it can call a default simply because the borrower's latest accounts show it has negative net assets.
However, lenders should also not assume the Eurosail analysis is relevant to interpreting all insolvency events of default clauses. The LMA's facility agreements include this event of default: "The value of the assets of any member of the Group is less than its liabilities (taking into account contingent and prospective liabilities)." This seems to be a straight balance sheet test. If that is right, this event of default may occur where the relevant company does not pass the test for "balance sheet insolvency" under English insolvency law. On new deals, Eurosail may encourage borrowers to argue that the two tests should be aligned.