A new judgment of the Court of Appeal has made more complex and subjective the determination of whether a company is insolvent by reason of the so-called balance sheet test in section 123(2) Insolvency Act 1986.

Although the case concerned a structured finance, asset-backed, transaction, the Court's detailed consideration of the balance sheet test is of considerable general interest.

Definition of insolvency

If a company is insolvent (ie, unable to pay its debts), it not only runs the risk that it may be wound up by the court under section 122 Insolvency Act 1986 (the IA), it may also trigger an event of default in key contracts such as financing agreements.

Typically, such events of default refer to the definitions of inability to pay debts in section 123 IA, in particular the test of a company's inability to pay debts as they fall due in section 123(1)(e) and the so-called balance sheet test in section 123(2) which provides that:

"A company is also deemed unable to pay its debts if it is proved ... that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities."

Taken at face value, the balance sheet test might be taken to mean that a company is deemed to be unable to pay its debts, whenever it has negative net assets.

For the first time, in BNY Corporate Trustee Services Limited v Eurosail-UK-2007-3BL plc & others (2011), the Court of Appeal has considered in detail the meaning of section 123(2).

Eurosail

In June 2007, Eurosail had acquired a portfolio of sub-prime UK mortgage-backed loans, funded by the issue of different classes of interest bearing notes, denominated in sterling, US dollars and euros. As the mortgages were redeemed, the proceeds were used to pay off the notes in a stipulated order of priority. The long stop date of redemption for the outstanding notes was 2045. To hedge its exposure to interest and exchange rate fluctuations, Eurosail took out swap contracts with a Lehmans entity, which were terminated when Lehmans failed.

The sterling received by Eurosail, when mortgages were redeemed, was only sufficient to repay a smaller quantum of dollar and euro denominated notes than was originally envisaged. This resulted in a significant deficiency in Eurosail's net assets. One class of noteholders argued that an event of default had occurred, because the company's liabilities exceeded its assets within the meaning of section 123(2), to which the relevant event of default referred.

Court's interpretation of balance sheet test

The Court rejected outright the proposition that a company can be balance sheet insolvent, simply because its "liabilities (however assessed) exceed its assets (however assessed)". So, if the balance sheet test is not a mechanistic one, how does it work? The Master of the Rolls said that it "can only be relied on by a future or contingent creditor of a company which has reached "the end of the road", or in respect of which the shutters should be "put up", imprecise, judgment-based and fact-specific as such a test may be".

In the case of Eurosail, the Court found that it had not reached the "point of no return". The Court was being asked to look a long time into the future, the principal under the outstanding notes was not finally due to be repaid until 2045 and the weighted average term of the remaining mortgages was 18 years, with early redemption rates slowing. Eurosail was not "on any commercial view, insolvent".

Implications of Eurosail

Fact specific as it clearly is, Eurosail nevertheless gives an important pointer as to how courts are likely to regard attempts to base insolvency on the balance sheet test in section 123(2). Taking assets and liabilities at face value as they appear in the accounts will not be enough. The company must also be shown to be "at the point of no return". This is not to say that there is no longer a balance sheet test for insolvency, though it now looks harder to establish. It is clear that the outcome in Eurosail could well have been different had the terms of the mortgages been shorter and/or the redemption date of the notes been sooner.

The degree of uncertainty which Eurosail engenders means that any party to a contract that contains an event of default by reference to section 123 IA will need to consider very carefully before seeking to exercise its rights on the basis of the balance sheet test of insolvency.

At the time of writing, it is not known whether permission will be granted for an appeal to the Supreme Court.