Vol 8 (2011) - Issue 3

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Balance Sheet Insolvency: A Commercial Approach

Introduction

In BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL Plc & Ors [2011] EWCA 227 the Court of Appeal was called on to consider for the first time:

i) The test for whether a company is unable to pay its debts set out in section123(2) of the Insolvency Act 1986 ('section 123(2)') (the so-called 'balance sheet insolvency test') and, in particular, the requirement that a company’s contingent and prospective liabilities are taken into account; and

ii) The relevance of a post-enforcement call option ('PECO') to the assessment of balance sheet insolvency under section 123(2).

Upholding the Chancellor’s first instance decision, the Court of Appeal held that, notwithstanding that Eurosail’s audited accounts showed it to have net liabilities, Eurosail was not unable to pay its debts within the meaning of section 123(2); it was not balance sheet insolvent. The Court of Appeal’s decision on this first issue meant that it did need to address the relevance, if any, of the PECO, but it did so in any event, agreeing with the Chancellor that, although the effect of the PECO was to render Eurosail bankruptcy remote, it would not necessarily follow that it was not unable to pay its debts within the meaning of section 123(2).



Background

Notes ('the Notes') were issued to various classes of noteholders by Eurosail, a special purpose vehicle incorporated in England. The Notes provide that an 'Event of Default' occurs in the event of Eurosail being 'unable to pay its debts as they fall due, or within the meaning of Section 123(1) of (2) (as if the words 'it is proved to the satisfaction of the court' did not appear in Section 123(2)) of the Insolvency Act 1986 (as that Section may be amended from time to time), being deemed unable to pay its debts'.

The Notes also featured a PECO which gave a company under common control with Eurosail the option, following the realisation and distribution of Eurosail’s assets, to acquire the remaining Notes for a nominal sum.

The Notes were denominated in sterling, euros and US dollars, with Eurosail hedging its currency exposure through swap agreements with Lehman Brothers Special Financing Inc (‘LBSF’). Following the collapse of Lehman Brothers in 2008, payments ceased to be made by LBSF under the swaps and a dispute arose between various groups of noteholders as to whether Eurosail was unable to pay its debts within the meaning of section 123(2), meaning that an Event of Default had occurred.

If an Event of Default had occurred, and was deemed by the trustee for the noteholders ('the Trustee') to be 'materially prejudicial' to the noteholders’ interests, the consequence would be the service of an Enforcement Notice and, crucially, a change in the order of priority in which the noteholders were to be paid.

In order that this dispute could be resolved, proceedings were issued by the Trustee, with the relevant noteholders being added as parties, and the Trustee taking a neutral position. The key issues between the various groups of noteholders were firstly whether, without regard to the PECO, Eurosail was unable to pay its debts within the meaning of section 123(2) and secondly, whether, if without regard to the PECO Eurosail was unable to pay its debts, the existence of the PECO meant that in fact Eurosail was not unable to pay its debts within the meaning of the same section.

The balance sheet insolvency test under section 123(2)

Section 123(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 the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities’.