iona_millership_phAt the end of February, Lords Hope, Walker, Mance, Sumption and Carnworth heard an appeal against the Court of Appeal’s judgment in BNY Corporate Trustees Services Ltd & Ors v Neuberger Berman Europe Ltd & Ors; BNY Corporate Trustees Services Ltd & Ors v Eurosail-IK 2007-3BL plc [2011] EWCA Civ 227.


The following issues were considered over the course of a two-day hearing:

  1. the proper interpretation of the Insolvency Act 1986, s 123(2) as incorporated into a securitisation agreement, in particular whether a company is to be deemed “unable to pay its debts” by reason of the fact that on an examination of its balance sheet its liabilities exceed its assets; or whether some further test is involved; and
  2. whether s 123(2) of the 1986 Act is satisfied on the facts.


In 2007, Eurosail 2007-3BL plc, a special purpose vehicle (the “Issuer“), issued a series of loan notes in different currencies (sterling, euros and US dollars) with an aggregate value of £660m to enable it to buy a portfolio of sub-prime loans secured by mortgages over UK residential properties.  The loan notes are of five different classes, A to E, subdivided into subclasses one to three, and all outstanding loan notes mature in 2045 (the A1 loan notes were due to mature in 2027 but have already been repaid in full).  The underlying mortgages are denominated exclusively in sterling and payments made on them are closely linked to how the Issuer pays interest and principal under the loan notes.

The terms and conditions of the loan notes include a post-enforcement call option (“PECO“) so that, in the event that security for the notes is enforced, an associate company of the Issuer will have a call option in respect of all of the loan notes for a nominal price.  The commercial expectation of a PECO is that the associated company will release the Issuer from its liabilities and ratings agencies can therefore consider the Issuer to be “insolvency remote“.

In order to protect itself against currency fluctuations vis-à-vis the euro and US dollar loan notes, the Issuer entered into currency swap agreements with entities within the Lehman Brothers group. Those entities became insolvent in 2008 and the swap agreements were subsequently terminated, leaving the Issuer with losses in its financial statements and unprotected against currency (and interest rate) fluctuations.  However, it did have substantial claims against the Lehman entities in excess of $221m, which it could sell for approximately £60m.

The Issuer continued to meet all payments due on the loan notes and expected to be able to meet all repayments on principal ahead of schedule.  However, the A3 noteholders asked the trustee of the noteholders (the “Trustee“) to declare an event of default under condition 9 of the terms and conditions of the loan notes on the basis that the Issuer should be deemed unable to pay its debts under s 123(2) of the 1986 Act.  The effect of an event of default would trigger an early redemption of the notes and mean that the A3 noteholders would rank pari passu with holders of all A loan notes, whereas in the pre-enforcement regime the A1 and A2 loan noteholders have priority of payment.

High Court judgment

The Trustee brought proceedings in the High Court before the then Chancellor, Sir Andrew Morritt, to determine:

  1. whether an event of default had occurred; and
  2. if so, whether the PECO would have an effect on whether there was an event of default.

In relation to the first issue, s 123(2) of the 1986 Act states that:

a company is also 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.

This is often referred to as the “balance sheet test” of insolvency.

The A3 noteholders argued that, as a result of losses due to the swap termination, the Issuer’s audited accounts showed net liabilities and it was therefore unable to pay it debts as they fell due.  It also argued that although the Issuer was able to continue to pay interest on the loan notes, if it was asked to repay the principal amount back immediately, there would be a significant shortfall due to currency fluctuations since the notes were issued.

The Chancellor disagreed with the conclusion that the Issuer should be deemed unable to pay its debts under s 123(2) of the 1986 Act.  He analysed the Balance Sheet Test and his key observations can be summarised as follows:

  • Assets should be valued at their present value and not take into account “any contingent or prospective” assets.
  • The requirement to take into account “contingent and prospective liabilities” did not entail aggregating those liabilities at face value alongside debts presently due. The Chancellor held this approach would be “commercially illogical [as] an obligation to pay £100 today has a higher present value than an obligation to pay £100 in five years“.  Instead the requirement involves considering all the 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 if made for the allocation of losses in relation to the assets“.
  • In the premises, the potential long-term liabilities created by the termination of the currency swap agreements could not be taken into account under the s 123(2) of the 1986 Act test as currency rates continuously fluctuate and the future liability is “entirely speculative” – that is to say, the liability was not prospective and it was only contingent in the sense that it may or may not occur. For instance, the Chancellor mentioned there may be the possibility of entering into further hedging currency swap agreements in the future or benefiting from the currency fluctuations in the long term.
  • Overall net liabilities in the accounts will not automatically mean a company is deemed unable to pay its debts.
  • The Balance Sheet Test is different from principles underpinning the preparation of a company’s accounts. For instance, the Court did take into account the value of the claims against the Lehman Brothers group as an existing asset although it is normal accounting practice not to recognise sums that may be recovered from ongoing litigation in an annual balance sheet.

Because of the Court’s findings on the first question, the second question did not arise.  However, the Chancellor expressed his views obiter as he deemed the question to be of some importance to the structured finance industry.  He decided that:

  • The PECO would have the effect of making the Issuer effectively “insolvency remote” as the existence of a PECO would make a winding up petition less likely, and, any petition would be subject to the call option.
  • However, the PECO “can have no effect” on whether the Balance Sheet Test is met as the noteholders have full recourse against the Issuer until the call option has been exercised, and, although “it is assumed the option company will release the issuer from all further liability, it us under no obligation to do so and, until it does, the liability of the issuer is unaffected“.

Court of Appeal judgment

There followed an appeal to the Court of Appeal on the construction of s 123(2) of the 1986 Act and a cross-appeal against the finding that the PECO would not have prevented the Issuer from being deemed unable to pay its debts under s 123(2).  Both appeals were dismissed by the Court of Appeal, although below we focus only on the first of these two issues as the second issue has not been appealed to the Supreme Court. The Court of Appeal decided the thrust of the Balance Sheet Test is to determine whether a company had “reached the ‘end of the road’” through an endemic shortage of working capital, not simply whether a company’s liabilities outweighed its assets.  The Court pointed out that the latter would “in practical terms . . . be rather extraordinary“, as companies often have a temporary shortage of capital.

The Court’s reasoning regarding whether the Issuer would be deemed to meet the Balance Sheet Test under s 123(2) of the 1986 Act was broadly similar to that of the High Court. The following points are of note:

  • The appropriate starting point for the test was the company’s most recently audited set of accounts.  However, “the figures will inevitably be historic, they will normally be conservative, they will be based on accounting conventions, and they will rarely represent the only true and fair view“. The court therefore also needs to consider other factors and form its own opinion on whether the test is met.
  • Although prima facie, future liabilities in a foreign currency should be valued at the present exchange rate, the court also has to carry out a “valuation exercise … supported. by commercial common sense” and treat future liabilities differently from “immediate liabilities“. In this case, the Court emphasized 2the long period over which the liabilities had to be met and the potential for significant change in the difference between the company’s assets and liabilities.
  • Even if the financial circumstances of a company (the Issuer) meant that there is a real possibility that a creditor (the A3 noteholders) would be at an “eventual disadvantage” if the company did not go into insolvency, this cannot of itself justify the creditor seeking to wind up the company.

Supreme Court appeal

The High Court and Court of Appeal were both reluctant to lay down specific guidelines to determine when a company will be deemed unable to pay its debts for the purposes of s 123(2) of the 1986 Act.  In the Court of Appeal judgment, Lord Neuberger stated, “It is not really possible, indeed it would be positively dangerous, to give much further general guidance as to the approach to be adopted by the court when deciding whether section 123(2) applies“. Given the significant consequences of a company being deemed unable to pay its debts, it is perhaps unsurprising that the courts are worried about creating a “checklist” approach which would be clearly inappropriate.

However, the securitisation market and investors would like some more certainty regarding the Court’s approach to the construction of s 123(2) of the 1986 Act and it will be interesting to see if the Supreme Court feels it can use the specific fact pattern set out above to provide that certainty.