Vol 10 (2013) - Issue 4

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Balance Sheet Insolvency: Supreme Court Dismisses the Appeal in Eurosail

On 9 May 2013, the Supreme Court delivered its judgment in BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL PLC, upholding the decision of the Court of Appeal in relation to the 'balance sheet' test for insolvency as incorporated into the events of defaults under various issuances of loan notes. The Supreme Court’s judgment is important in establishing how such a test should be interpreted and has implications for the securitisation market in particular, and the wider finance market more generally where the test is incorporated into default provisions in finance documentation.

Background
The focus of the Supreme Court’s decision was on the interpretation of section 123(2) of the Insolvency Act 1986 which was incorporated by reference into the events of default applicable to certain loan notes issued by Eurosail-UK 2007-3BL ('Eurosail'), an entity set up by Lehman Brothers as part of a securitisation of non-conforming mortgage loans secured on residential property in the UK. Eurosail had issued various classes of notes (in different currencies) to fund the purchase of the mortgage loans.
Section 123(2) is referred to as the 'balance sheet' test for insolvency and refers to a company being deemed unable to pay its debts 'if … the value of the company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities'. Eurosail had suffered in a deterioration of its level of assets relative to its liabilities largely as a result of the collapse of the Lehman Brothers entities (some of which had acted as swap counterparties) and adverse movements in currencies. Eurosail was, however, continuing to pay interest on all of the notes.

Enforcement Notice and post-enforcement waterfall
In order for an event of default to be triggered under the 'balance sheet' insolvency provision, as incorporated into the terms of the notes, BNY Corporate Trustee Services Ltd, in its capacity as trustee for the holders of the notes (the 'Trustee') would also have to certify that in its sole opinion, the event in question is materially prejudicial to the interests of noteholders. The occurrence of an event of default would allow the Trustee to serve on Eurosail a written notice ('Enforcement Notice') declaring the notes to be due and payable and in certain situations, the Trustee would be contractually obliged to serve such an Enforcement Notice.
The service of an Enforcement Notice would trigger an important shift in the payment priority of various classes of notes from the 'pre-enforcement' regime to the 'post-enforcement' regime. The practical importance of this is that, post-enforcement, certain 'A3' noteholders would rank pari passu with 'A2' noteholders for repayment of principal, whereas pre-enforcement, they would rank pari passu in respect of interest payments but A2 noteholders would have priority over A3 noteholders in receiving payments of principal. In light of this, the A3 noteholders therefore argued that an event of default under the ‘balance sheet insolvency’ provision had in fact been triggered.
Given the consequences of the service of an Enforcement Notice for the payment 'waterfall', it was therefore of crucial importance to determine the correct interpretation of the 'balance sheet insolvency' event of default.