Eurosail Supreme Court Judgment: Delineating The Boundaries Of Insolvency 'To Be Solvent Or Not To Be Solvent, That Is The Question'

Odd as it may seem, you have to plough through 122 sections of the UK Insolvency Act 1986 (the "Act") before you finally reach the section that sets out the criteria for establishing insolvency. Section 123 of the Act lists a series of circumstances under which a company may be deemed insolvent. Some of these circumstances are factual—for example, owing a debt of more than £750 for more than 21 days after a demand for payment—but two rely on a legal test of company insolvency. These two tests are colloquially known as the "cash-flow test" and the "balance-sheet test." Direct or indirect reference to these tests is prevalent throughout English-law finance documents, including those based on Loan Market Association standard forms, as a way of determining whether an event of default has occurred and/or termination clauses have been triggered. The UK Supreme Court has now unanimously confirmed the test for balance-sheet insolvency under section 123 of the Act in its decision in BNY Corporate Trustee Services Limited v Eurosail and others [2013] UKSC 28. In particular, the court declined to follow the intermediate court of appeal's suggestion that a debtor can be insolvent only after it has reached the "point of no return." The three court rulings in this matter concluding with the recent Supreme Court judgment are the first reported cases to interpret the balance-sheet test of insolvency—namely, are the liabilities of a company greater than its assets?

Cash Flow v Balance Sheet

The circumstances under which a company is to be "deemed unable to pay its debts" (i.e., insolvent) under section 123 of the Act include:

if "the company is unable to pay its debts as they fall due"; or if "the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities." Even a casual observer can see that many companies are balance-sheet insolvent, while still being able to comfortably meet current debts. Following a line of cases, the accepted position was that the cash-flow test took precedence over the balance-sheet test. However, courts would sometimes accept that a company, despite meeting day-to-day debts, was balance-sheet insolvent, since its long-term liabilities (very often pension deficits) were such that there was no chance that they would be repaid, however long one waited.

In the Beginning . . .

The first hearing in the long-running Eurosail case was in 2010, although the event under scrutiny occurred before that. Eurosail (as issuer) purchased a portfolio of high-risk mortgages for securitisation and issued notes. (The ones subject to the hearing were due to mature in 2045.) Although the underlying mortgage payers paid only in pounds sterling, Eurosail issued notes in various currencies, entering into swap arrangements with two Lehman Brothers entities to reduce its exposure to currency-rate fluctuations. These swap arrangements ceased in 2008...