The Supreme Court handed down an important judgement last week in the case of BNY Corporate Trustee Services Limited v Eurosail - UK 2007 - 3BL PLC ("the Eurosail Case"), which needs to be considered by anyone who is a party to a contract which contains events of default relating to the insolvency of a party to that contract.

Background

Many contracts, in all areas of the law, contain provisions which entitle a party either to terminate that contract or to take other action if the counter-party is a company or other similar legal entity which becomes insolvent. Generally, the insolvency event of default will be defined by reference to Section 123 of the Insolvency Act 1986 ("S123").

Sub-section (1) of S123 defines insolvency of a company as that company being unable to meet its debts as they fall due. This is referred to as cash-flow insolvency. The Eurosail Case does not change this.

Sub-section (2) of s.123 defines insolvency of a company as occurring where the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities. Such a company is referred to as balance sheet insolvent. Prior to the Supreme Court's decision, there was no further guidance on what contingent or prospective liabilities meant - were those liabilities open-ended? The Eurosail case now makes it clear how contingent and prospective liabilities should be approached.

The case

The Eurosail case revolved around a company - Eurosail - which had issued debt by way of a variety of loan notes of different classes with different rights. Whether or not the issuer was insolvent within the meaning of s.123 sub-para (2) affected the point in time at which the rights of the holders of the loan notes would receive repayment of the principal element of their debt and the order - between the different holders - in which such principal was required to be repaid.

Eurosail had entered into swap agreements with two of Lehman Brothers' companies, and when Lehman became insolvent Eurosail's net asset position worsened significantly. The holders of one series of loan notes argued that this worsening of the net asset position had resulted in Eurosail becoming balance sheet insolvent - particularly when the contingent and prospective liabilities to repay the loan notes in full were taken into account.

Eurosail and the other loan note holders argued to the contrary: primarily on two grounds. Firstly, Eurosail was able to meet its debts as they fell due (including interest on the loan notes), so was not cash-flow insolvent. Secondly, the liability to repay the principal sum of the loan notes would not - absent an event of default - arise until 2045, thus should not be taken into account as a contingent or prospective liability for the purpose of determining whether or not Eurosail was balance sheet insolvent now.

The Supreme Court held that Eurosail's ability to pay all its debts, present or future, may not be finally determined until much closer to the date of maturity of the loan notes. It also noted that the events which had brought about the worsening of Eurosail's financial position were beyond the company's control and were events which affected the entire market. Accordingly, much could change between now and 2045 and therefore the court could not be satisfied that there would eventually be an inability on the part of Eurosail to pay its debts. It therefore held that no event of default had occurred.

The practical consequences

Contracts which contain event of default provisions are numerous and varied. They include property contracts, commercial contracts, joint venture agreements, agency and distribution agreements, franchise agreements, leases, banking documents and insurance contracts. Classically, they will refer to s.123. The balance sheet test under s.123 may have changed as a result of the Eurosail Case. In consequence, circumstances which, pre-Eurosail, could have resulted in balance sheet insolvency, triggering an event of default, may no longer have that effect. If there is a need to construe the occurrence of an event of default as widely as possible then the standard s.123 wording found in many contracts may not be sufficient as there is at least an argument now that only contingent and prospective liabilities which are likely to come home to roost in the foreseeable future should be taken into account.

We recommend that you carefully consider your key contracts to ensure that they continue to provide the protection intended. If they do not and the point is critical then you should seek to agree a change to the contract wording. Standard form contracts should also be revisited if they have default provisions which are triggered by insolvency events.