Facility agreements almost always contain events of default based on a borrower's insolvency. Defining insolvency is therefore key. In this article published in July 2013 we discussed how, following Eurosail1 , the common law was beginning to move the statutory tests of insolvency towards a more commercial view.

As Hayley Çapani explains, a recent case has advanced this analysis and suggests a move towards viewing insolvency as one test made up of two limbs, rather than two standalone tests. As the common law advances, it is therefore in the interests of both lenders and borrowers to focus again on the drafting of insolvency events of default in loan agreements.

The statutory tests – towards a single "view" of insolvency?

Section 123 of the Insolvency Act 1986 includes both a cash flow and balance sheet test of insolvency. The 2013 Eurosail case stated that, when considering a borrower's potential insolvency, these tests should not be applied either (i) mechanically or (ii) in isolation of one another.

Since Eurosail, and most recently in Evans v. Jones2 , the courts have continued to apply both of these tests together to form a view on whether the borrower is insolvent in "a way that has regard to commercial reality". The court is showing increasing reluctance to find insolvency when the borrower only satisfies one test.

Borrowers with insolvency events of default that rely on the statutory wording (or refer simply to "insolvency") may breathe a sigh of relief since the court is adopting an increasingly commercial view of insolvency. However, for lenders this move towards an overall commercial view of a company's solvency highlights the need for careful drafting to ensure they have certainty over when they can call an event of default.

Divergence from market standard documents?

LMA facility agreements currently contain two separate "insolvency" events of default: a "cash flow" test and a "balance sheet" test. The two tests are drafted as two standalone events of default, meaning that a lender could call an event of default if the borrower meets only one of them. Also, neither of the LMA events of default directly refers to the equivalent statutory insolvency tests under the Insolvency Act 1986. Arguably, therefore, each of these events of default could still be triggered when the relevant company might not pass the test for insolvency under English law.

Following these recent developments in English insolvency law, could lenders start seeing borrowers push back on the drafting of the LMA insolvency events of default? Possibly. It is not inconceivable that strong borrowers could start trying to negotiate amendments to try and benefit from the single (and wider) common law insolvency test.

Treatment of contingent assets and liabilities

When it is coming "down to the wire", borrowers often place a large emphasis on contingent assets and seek to underplay contingent liabilities. It is therefore unsurprising that the courts have ruled on the treatment of contingencies in recent cases. In doing so, the courts have continued to move towards looking at the figures from a commercial perspective.

In Evans v. Jones the court stated that when looking at balance sheet insolvency:

  1. contingent assets are excluded; and
  2. contingent liabilities should only be included if a "reasonable commercial person" would consider that they should be. The courts will only include contingent liabilities if they are a "known unknown": any "unknown unknown" liabilities should be excluded.

The LMA treats contingencies in a stricter way, not least because borrowers usually prepare their accounts based on accounting standards. A balance sheet insolvency event of default occurs under an LMA facility agreement when "the value of [the borrower's] assets is less than its liabilities (taking into account contingent and prospective liabilities)". If based on accounting standards, these contingent liabilities will be recognised for balance sheet purposes when they are "probable". However, following Evans v. Jones English insolvency law will recognise them when a "reasonable commercial person" would.

So, following Evans v. Jones, could borrowers try to amend the contingent liabilities drafting in the LMA balance sheet insolvency event of default? Could they argue contingent liabilities should only be "taken into account" if a reasonable commercial person would say they should? Perhaps. On the flip side, Evans v. Jones has now made it clear that contingent assets should be completely excluded from the statutory balance sheet test for insolvency. However, the LMA balance sheet insolvency event of default says nothing about the treatment of contingent or prospective assets – only contingent liabilities. It is unlikely that a borrower would be able to persuade a lender to take into account contingent assets when insolvency law now says this is not the case. So its best option may be to seek to rebalance the contingent liabilities side of the event of default.

Practical implications

The courts are showing a continued push towards reviewing potential insolvency from the point of view of a "reasonable commercial person". This is a welcome development and arguably mirrors what lenders already do when approached by a borrower in financial difficulty. However, the continued merger of both the cash flow and balance sheet tests in section 123 to one single "review" is moving further away from the two standalone insolvency events of default often seen in market standard facility agreements.

Lenders are likely to want to keep (and draft) separate and alternative cash flow and balance sheet events of default. However, strong borrowers may well start to argue that the existing drafting no longer reflects the reality of how a court will assess a borrower's solvency and push for drafting that better reflects the common law.