'Balance sheet' insolvency after Eurosail

What is the key feature of the judgment?

In a unanimous judgment handed down last Thursday (9th May 2013), the Supreme Court confirmed the ‘balance sheet’ test insolvency of the IA 1986, s 123 is not a mechanical exercise of comparing the value of a company’s assets against the value of its liabilities, but a more sophisticated test requiring a judgment as to whether the present assets of a company will reasonably enable the company’s present and future liabilities to be met. In so doing, their Lordships rejected the ‘point of no return’ test formulated by Lord Neuberger MR in the Court the Appeal.

Why is the balance sheet test important?

A clear definition of inability to pay debts is often said to be ‘fundamental’ to any system of insolvency law. An insolvent company may be compulsorily wound-up by the court on the ground that it is ‘unable to pay its debts’. Insolvency is a necessary condition for setting aside a preference or a transaction at an undervalue. A company’s inability to pay its debts is a commonly found ‘event of default’ in commercial contracts. As the Eurosail case shows, the determination of this question may be pivotal to the outcome for creditors.

The circumstances in which a company is to be ‘deemed unable to pay its debts’ under the IA 1986, s 123 include:

1. if ‘the company is unable to pay its debts as they fall due’,
2. if ‘the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’

The former is commonly referred to as ‘cash-flow’ insolvency and the latter as ‘balance sheet’ insolvency. As the Supreme Court has, however, now made clear, these expressions are not to be taken literally. The decision emphasises that the IA 1986, s 123 has to be applied to different companies in a range of different circumstances.

How did the problem arise in Eurosail?

Eurosail was formed to acquire a portfolio of ‘non-performing’ UK mortgage loans funded by an issue of five classes of loan-note denominated in three currencies. In order to protect against interest rate and currency risks, Eurosail entered into certain ‘swap’ agreements with Lehmans but, when that firm collapsed, the swap agreements defaulted leaving Eurosail with a claim of uncertain value in Lehmans’ insolvency. As a result of that, and accounting standards, Eurosail had a deficit on the face of its audited balance sheet.

Eurosail’s inability to pay its debts was an ‘event of default’ under the terms of its loan notes. If considered to be prejudicial, the claimant trustee, BNY, was required to serve an enforcement notice. The effect of serving that notice would be to alter the priorities between note-holders, so that ‘A3’ class note-holders ranked parri passu with the otherwise prior ranking ‘A2’ class note-holders. BNY sought a determination as to whether an event of default had taken place.

It was submitted on behalf of the A3 class of note-holders that the IA 1986, s 123(2) should be interpreted in a way that was certain and transparent, leaving scope for the exercise of discretion by a judge or trustee. Since Eurosail’s audited accounts demonstrated a clear deficiency of liabilities over assets, an event of default had occurred. The A2 note-holders countered that the IA 1986, s 123(2) should be interpreted broadly and commercially. Accounts which were prepared on a conservative basis did not necessarily reflect the outcome for creditors.

What happened in the lower courts?

The Chancellor, Sir Andrew Morritt, sitting at first instance, rejected the argument that the IA 1986, s 123(2)required the court to take the assets and liabilities of Eurosail UK at their balance sheet values unless good reason was shown. In his judgment, the words ‘taking account of’ in the IA 1986, s 123(2) ‘must be recognised in the context of the overall question posed by the subsection...This will involve consideration of the relevant facts of the case, including when the prospective liability falls due, whether it is payable in sterling or some other currency, what assets will be available to meet it and what if any provision is made for the allocation of losses.’

The Court of Appeal agreed, with Lord Neuberger observing that ‘in practical terms, it would be extraordinary if s 123(2) was satisfied every time a company’s liabilities exceeded the value of its assets’. In Lord Neuberger’s judgment, ‘both the purpose and the applicable test of s 123(2) are accurately encapsulated’ in Sir Roy Goode’s book, Principles of Corporate Insolvency Law:

If the cash flow test were the only relevant test then current and short-term creditors would in effect be paid at the expense of creditors to whom liabilities were incurred after the company had reached the point of no return because of an incurable deficiency in its assets.

Toulson LJ agreed the passage ‘illuminates the purpose of the section’, but noted that it ‘does not purport to be a paraphrase of it’.

How did the Supreme Court approach the case?

Lord Walker, giving the only judgment of the court on the issue, agreed with the result but not with all of the reasons expressed below. He considered that ‘the point of no return’ should not pass into common usage as a paraphrase of the effect of the IA 1986, s 123(2). However, he did agree with Toulson LJ’s alternative formulation, namely that:

Essentially, s 123(2) requires the court to make a judgment whether it has been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet those liabilities.

Applying this to a case where Eurosail was cash-flow solvent and might have up to 30-years to repay the notes, Lord Walker considered that ‘the court should proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency’. He concluded:

Eurosail’s ability or inability to pay all its debts, present or future, may not be finally determined until much closer to 2045...The movements of currencies and interest rates in the meantime, if not entirely speculative, are incapable of prediction with any confidence. The court cannot be satisfied that there will eventually be a deficiency.

What are the practical consequences of the judgment and what should practitioners do now?

This is the first time the Supreme Court has provided guidance on the meaning of the IA 1986, s 123 and the judgment pays careful reading. The ‘future-looking’ test of ‘cash-flow’ insolvency set out by Briggs J in ReCheyne Finance Plc [2008] 2 All ER 987 and the ‘reasonable expectation’ test of ‘balance-sheet’ insolvency set out by Toulson LJ in the Court of Appeal have both been approved. The decision will be welcomed by directors for its commercial-mindedness—but less by creditors and liquidators upon whom the burden of proving insolvency often falls. In a finely balanced case, it will be hard to establish that a company is unable to pay its debts without access to up-to-date financial information and outsiders may find the burden difficult to discharge. The other deeming provisions of the IA 1986, s 123 come to the fore.