Readers unfamiliar with the English Insolvency Act 1986 (“IA 86”) may be surprised to learn that “insolvency” is not a defined term in the legislation. Effectively “insolvency” is shorthand for the alternative tests to be applied to determine if a debtor is “unable to pay its debts” within the meaning of S123 IA 86, known colloquially as the cash flow and the balance sheet tests. In England, the inability of a debtor to pay its debts is a trigger relevant in a range of statutory contexts. For example:
- A debtor cannot open administration proceedings (albeit that these proceedings are aimed at rescue) unless it has reached the point at which it “is or is likely to be unable to pay its debts”;
- The court has jurisdiction to wind up a debtor (i.e. to initiate an involuntary liquidation) if the debtor is “unable to pay its debts”; and
- Statutory voidable transaction provisions (preferences and transactions at an undervalue) can only bite where the transaction had taken place within specified time frames and also where at the time of the transaction the debtor is or has as a consequence of the transaction become “unable to pay its debts”.
The cash flow and balance sheet tests are also often incorporated into commercial contracts (sometimes in modified form), and, unless a clause falls within the narrow scope of the common law “anti–deprivation principle,” contractual termination clauses triggered by insolvency events are enforceable. Unlike the Bankruptcy Code, English law (indeed, most of European law) contains no direct equivalent to the prohibition on “ipso facto” clauses. It is perhaps surprising to note then, in view of the scope of its relevance, that the recent case of BNY Corporate Trustee Services Ltd v Eurosail UK EWCA Civ 227 involved the English Court of Appeal interpreting the balance sheet test for insolvency for the first time.
The balance sheet test at S123(2) provides that “a company is deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of a company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities.”
For completeness, it might be noted that the cash flow test at S123(1)(e) provides that “A company is unable to pay its debts … if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.”
The Eurosail Appeal
The principal issue in this case was whether an event of default had occurred under the terms of certain loan notes that Eurosail had issued to finance its acquisition of a portfolio of non-conforming mortgages. The loan documentation permitted noteholders to serve an enforcement notice if an event of default occurred, and the documentation went on to provide that an event of default would arise if the issuer were unable to pay its debts within the meaning of S123(2) IA 86 as if the words “it is proved to the satisfaction of the court”did not appear. The triggering of an enforcement notice was of some commercial significance as the payment priority waterfall was varied following the service of a notice, and a pool of noteholders who would otherwise have enjoyed a priority entitlement to repayment would instead rank alongside a greater pool of noteholders. In consequence, opposing arguments were put forward by different classes of noteholders as to whether the issuer was balance sheet insolvent.
By way of further background, Eurosail had entered into currency hedges as its assets (the mortgages) were all sterling denominated, but most of its liabilities were denominated in euros or dollars. The swap counterparties were Lehman entities that had filed for chapter 11, and Eurosail had been unable to purchase substitute hedges in the marketplace, but had lodged claims in the Lehman estates. Sterling had depreciated significantly against both the euro and the dollar, and the result was a significant deficiency in Eurosail’s net asset position. All the notes had a final maturity date in 2045, although it was anticipated that the principal of the notes would be repaid much earlier as the underlying mortgages were redeemed.
The English Appeal Court rejected the submission that the balance sheet test could simply be applied by identifying the bottom line net liability figure in the balance sheet. If such an approach were taken, many companies, particularly in start up, would fall foul of the test, and parties would be deterred from making investments. Bearing in mind that the focus of the test was on the inability of a company to pay its debts, it was also necessary to consider whether the company had “reached the point of no return” taking into account its contingent and future liabilities and with a “firm eye on commercial reality and commercial fairness.” Although a company’s balance sheet and audited financial statements might be an appropriate starting point, those figures would inevitably be historic, conservative, and based on accounting conventions and would rarely represent the only true and fair view. Ultimately, the court had to decide itself whether the company had “reached the point of no return.”
Applying the test to the facts of this case, the court found that Eurosail was not balance sheet insolvent, taking into account a number of factors, including that (1) the accounts excluded a substantial contingent claim as an asset from the balance sheet due to accounting conventions, (2) It was impossible accurately to predict likely fluctuations in currency before the loan notes had all matured, and (3) the notes were due to be repaid over a long period.
The effect of the decision is that it will be more difficult for creditors to try to wind up a company on a balance sheet basis or for the other trigger points mentioned above to be invoked based on the balance sheet test of insolvency. Greater reliance is likely to continue to be placed on the cash-flow test.