Turnaround, Restructuring & Insolvency Briefing Notes

The Supreme Court has recently provided clarification of the balance sheet test of corporate insolvency contained in section 123(2) of the Insolvency Act in a long- running case related to the collapse of the Lehman Brothers Group in October 2008. The case involves a “special purpose entity” (Eurosail) set up to purchase a portfolio of mortgages on UK residential property by the issue of loan notes. The underlying portfolio comprised various currencies and a currency swap agreement was therefore crucial to Eurosail, which was intended to be “insolvency remote”. The loss of the swap agreement on the collapse of the Lehman Group led some of the noteholders to perceive that Eurosail was insolvent although some notes had already been repaid and the majority are not due for repayment until 2045.

The Supreme Court held that the balance sheet test in section 123(2) of the Act requires the court to be satisfied that, on the balance of probabilities, a company has insufficient assets to be able to meet all of its liabilities, including prospective and contingent liabilities. The Supreme Court also held that the assessment of “balance sheet” insolvency for the purpose of Section 123(2) may differ from a company’s statutory balance sheet prepared in accordance with the requirements of the Companies Act 2006, in that it may need to take into account contingent assets or contingent liabilities which are not reflected in the statutory balance sheet. The Court held that the assessment of balance sheet insolvency in section 123(2) is not concerned with “the point of no return” and held that phrase should not be used as a paraphrase for the effect of Section 123(2).

Another part of the decision was concerned with the effect of the post enforcement call option (PECO) on the solvency of Eurosail. The PECO is the mechanism to ensure the “insolvency remoteness” and is crucial in enabling the special purpose entity to achieve the best credit rating. The Supreme Court held that the existence of the PECO (enabling a trustee to buy in the issuer’s outstanding notes at a nominal price) did not affect the assessment of the balance sheet solvency of Eurosail. Although the facts of the case are esoteric, this is an important decision to the banking and finance sector as the insolvency of a corporate borrower is the key event of default in loan documents and other finance contracts.

The terms of section 123(2) are almost invariably incorporated into event of default clauses in loan documents and the current economic climate means that it is crucial to have a clear meaning attributed to the definition of the balance sheet test of corporate insolvency. BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL PLC appeal [2013] UKSC 28. For further information please contact Richard Baines, Partner and Head of Druces LLP’s Restructuring & Turnaround Group.

This note is not intended to be treated as legal advice. It is intended as general guidance only. It is based on the law in force in May 2013