The Supreme Court has delivered a judgment providing welcome clarification on the construction and effect of section 123(2) of the Insolvency Act 1986 (the “balance-sheet” insolvency test) and its interaction with section 123(1)(e) of the Act (the “cash flow” insolvency test).The decision is relevant not just to creditors presenting winding-up petitions in respect of insolvent debtors but also to the wider banking industry, insofar as insolvency related events of default are commonly incorporated in finance documents (either by direct reference to the statutory provisions or by some other means).
- There is no clear indication as to how the two insolvency tests under the Insolvency Act 1986 are intended to interact. Section 123(1)(e) refers to debts “as they fall due” and section 123(2) makes a direct reference to a company’s assets and liabilities.
- The “cash-flow” test is not simply concerned with presently-due debts owed by the company, but also with debts falling due from time to time in the reasonably near future. What constitutes “the reasonably near future” depends on all the circumstances and, particular, the nature of the company’s business. Once the court has to move beyond the reasonably near future, any attempt to apply the cash-flow test becomes speculative and a balance sheet test becomes “the only sensible test“.
- The “balance-sheet” test is not to be taken literally. There is no statutory provision linking section 123(2) of the 1986 Act to the detailed provisions of the Companies Act 2006 as to the form and contents of a company’s financial statements. The “balance-sheet” test concerns a comparison of present assets with present and future liabilities (discounted for contingencies and deferment). This is far from an exact test and will depend on all the circumstances of the company’s business. Crucially, however, the test does not concern a test as to whether the company has “reached the point of no return” as a result of an incurable deficit in its assets. The abandonment of this aspect of the test overturned the decision (but not the ultimate findings) of the Court of Appeal.
- The “point of no return” test goes beyond the need for a petitioner (or any party seeking to assert balance-sheet insolvency) to satisfy the court that, on the balance of probabilities, a company has insufficient assets to be able to meet all of its liabilities, including prospective and contingent liabilities. The academic reference to a company “reaching the point of no return“1 (as cited and relied on by the Court of Appeal) serves only to illustrate the purpose of section 123(2), but it does not purport to paraphrase it. The Supreme Court warned that the phrase should not pass into common usage as a paraphrase for the effect of section 123(2).
The present case concerned the solvency of Eurosail, which was a single purpose entity set up by Lehman Brothers (as part of a securitisation transaction) to issue interest paying notes. The underlying portfolio comprised non-conforming mortgage loans secured on residential property in the United Kingdom.
The Court considered that there were three “imponderable” factors which determined Eurosail’s ability to meet its liabilities, the majority of which could be deferred until the final redemption date of the notes (which was scheduled for 2045). Those factors were currency movements, interest rates and the United Kingdom economy and housing market. These factors were outside the control of the company and, given the redemption date of 2045, were a matter of speculation. Eurosail was not engaged in normal business activities and there were no management decisions to be made as to how the company should be run.
The decision will be welcomed by holders of distressed debt in particular and participants in the financial markets generally. The “point of no return” test adopted by the Court of Appeal set a high hurdle for parties seeking to assert insolvency in complex commercial scenarios.
However, the problem of uncertainty remains. The “balance-sheet” test under section 123(2) is not simply concerned with a review of the company’s financial statements. This will be assessed on a case-by-case basis and the Court gave no general guidance as to which factors will be taken into account. Rather, it will take into account “all the relevant circumstances“. In the present case, the Supreme Court considered there were five salient features of the conditions (and the supporting documentation) to the securitisation transaction which meant that the majority of Eurosail’s payment obligations could be deferred to 2045:
- The obligation to pay interest on certain junior notes was deferred to the redemption date if insufficient funds were available at the time the obligation became due;
- Temporary shortages of income were provided for by a Liquidity Facility;
- The redemption of the notes was not due until 2045;
- If there was surplus income from portfolio’s assets, the ‘excess spread’ could be used to reduce or eliminate any deficiency on whatever was the highest-ranking class of principal notes with a deficiency; and
- The transaction incorporated a post-enforcement call option (a “PECO”). If there were insufficient funds to repay the entire principal in the event of enforcement of the security, a call option was triggered whereby the option holder (a company related to the issuer) had an option in respect of the benefit of all the notes for a nominal purchase price. The purpose of this mechanism was to achieve bankruptcy remoteness for the issuer by limiting, in practical terms, Eurosail’s susceptibility to winding-up proceedings.
Since the majority of the payment obligations would not fall due until 2045, and Eurosail’s performance in the intervening 30 years would depend on the three “imponderable” factors identified above, the Supreme Court was not satisfied, on the balance of probabilities, that Eurosail had insufficent assets to meet all of its liabilities. Eurosail could not therefore be said to be “balance sheet insolvent” at this time.
Although a highly fact-specific case, Eurosail illustrates the type of factors that the Court will take into account when determining balance-sheet insolvency. As is clear, the Court will not be required to assess whether the company can trade its way out of financial difficulty or has met the point of no return. Notwithstanding the Supreme Court’s curtailment of the test, it is apparent from the decision that neither the cash-flow test nor the balance-sheet test can be precisely characterised.
Therefore, in order to give maximum flexibility to contracting parties who may seek to assert insolvency Events of Default, it is prudent for draftsmen to ensure that both tests are incorporated into the contractual documentation (either by direct reference to the statute or by words to that effect). This is already seen in various types of standard form documentation. For example, section 5(a)(vii)(2) of the 2002 version of the ISDA Master Agreement states that Bankruptcy Events of Default will be triggered when a Party “becomes insolvent[the balance-sheet test] or is unable to pay its debts [the cash-flow test]”.
1 Sir Roy Goode, Principles of Corporate Insolvency Law, Third Edition (2005) para 4-06