This case has implications for any financial transaction which includes an insolvency event of default referencing s.123(2) of the IA, but will be of particular interest to those involved with asset-backed transactions.
Eurosail was a special purpose vehicle incorporated in England and Wales for the purpose of issuing various classes of notes funding the purchase of a portfolio of loans secured by mortgages over UK residential properties. The transaction was structured and documented in a way which was standard at the time, including the use of a PECO which was intended to achieve the bankruptcy remote status required by rating agencies for a high credit rating, without incurring an adverse tax treatment in the UK. This tax issue is no longer relevant, so there is no longer any requirement to use a PECO in current transactions.
The underlying loans were in sterling, while the notes were denominated in sterling, euro and dollars, so Eurosail hedged its position by entering into various interest rate and currency swaps with a Lehman entity. After that entity became insolvent, Eurosail had to arrange various expensive ad hoc forex transactions, but was nonetheless able to meet its ongoing interest payments. However, it will not be able to meet the growing principal shortfall caused by the depreciation of sterling in recent years, which is no longer hedged by the failed currency swaps.
One group of noteholders, having calculated that this shortfall would affect repayments of principal to them, called on BNY Corporate Trustee Services Limited as trustee of the noteholders’ rights against Eurosail (the Trustee) to declare an event of default on the basis that Eurosail was balance sheet insolvent. The test in the conditions to the notes mirrored the wording of s.123(2) of the IA, and if met, allowed the Trustee to enforce its security. Such an enforcement would improve the position of the noteholders calling for the default.
Eurosail argued that it was able to pay its debts as they fell due and that the court should take account of all its financial circumstances. It further argued that the effect of the PECO was to make the notes effectively limited recourse.
The questions considered by the High Court and Court of Appeal:
1. Was Eurosail unable to pay its debts within the meaning of s.123(2) of the IA, the balance sheet test? This required the courts to consider how to interpret the requirement to take account of prospective and contingent liabilities; and
2. If the answer to question 1 was that Eurosail was insolvent, did the existence of the PECO change the position (ie have the effect that Eurosail was not balance sheet insolvent)?
The Court of Appeal (consisting of Lord Neuberger MR, the Master of the Rolls, who gave the leading judgment, and Lord Justices Toulson and Wilson) reached the same conclusion as the High Court but gave more guidance on the application of the balance sheet test.
The court found that the balance sheet test requires more than a simple calculation of the assets and liabilities of a company at their face amounts. Many solvent and successful companies would be vulnerable to a winding-up order if this were the correct basis and this would be “extraordinary”. The balance sheet test is designed to be invoked in a situation where it is clear that a company will not be able to meet its future or contingent liabilities, even if it is able to meet its current liabilities as they fall due. The Master of the Rolls referred to a company reaching this “point of no return” once its use of assets for current purposes can be characterised as a “fraud” on future or contingent creditors.
The court was keen to avoid providing any specific rules for applying the balance sheet test and stressed that the “imprecise, judgement-based and fact-specific” test which must be applied is whether the company “has reached the end of the road”, or that “the shutters should be put up”. However, it did say that, “the closer a future liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123(2) would apply”.
In order to achieve a high credit rating, issuers of structured debt securities need to be bankruptcy remote. To protect the issuer from insolvency proceedings, the noteholders’ claims against the issuer are generally limited to proceeds of enforcement of the relevant security. In addition, parties agree that apart from enforcement of the security, they will not proceed against the issuer. In the past, there were concerns that such limited recourse arrangements might have adverse tax consequences for UK issuers, so a PECO was used to give equivalent protection to the limited recourse provisions.
Because the court found that Eurosail was not deemed insolvent under the balance sheet test, the question of the effect of the PECO became irrelevant. Nevertheless, the Master of the Rolls gave comments on the point on the basis that it would be relevant to other transactions. As it was not necessary for the court to decide this point, the comments are “obiter dicta” and therefore persuasive rather than binding in relation to future cases.
Lord Neuberger MR characterised the effect of the PECO as “bankruptcy remoteness” ie the avoidance of winding-up proceedings, rather than “insolvency remoteness” ie the avoidance of insolvency itself. He felt that a court would look at the commercial reality of Eurosail’s position and would conclude that the PECO was effective to achieve bankruptcy remoteness as, due to the PECO, the noteholders would have no economic interest in winding up Eurosail.
However, the question at issue was whether the PECO prevented enforcement of security rather than winding up. The transaction documents contained provisions which described the notes as full recourse prior to enforcement and therefore the PECO was found to be ineffective to prevent insolvency and a consequential event of default leading to enforcement. Thus, unless a loss has crystallised and the PECO has been exercised, there is no limited recourse and the noteholders have recourse to the issuer as well as the secured assets.
This judgment makes the task of successfully showing that a balance sheet insolvency event has occurred much more difficult (although the court commented that this was the first reported case on the interpretation of this provision in the 25 years since the IA came into force). As a result it may deter unhappy groups of noteholders from alleging balance sheet insolvency in cases where it is not very clear that an issuer would be unable to pay its future and contingent liabilities. It certainly seems unlikely that a securitisation trustee will be willing to determine that a balance sheet insolvency event of default has occurred without obtaining directions from a court.
Many insolvency event of default provisions either cross-refer to, or mirror the wording of, the insolvency tests in the IA, and the addition of the “point of no return” concept to the balance sheet test of insolvency may lead lenders or noteholders to draft insolvency events of default with specific insolvency triggers.
An interesting point is that although it is the cashflow insolvency test which is more commonly used in winding up petitions, the balance sheet test is used by administrators or liquidators seeking to overturn voidable transactions prior to the onset of the relevant insolvency procedure. This decision may therefore make it harder for insolvency practitioners to challenge transactions as being at an undervalue or constituting a preference.
The obiter comments in relation to the PECO’s failure to achieve limited recourse may have an impact on securitisation transactions which use this structure. The ratings agencies may downgrade the credit ratings of such transactions because of the possibility that an issuer may become insolvent.
The full judgment can be read here.
This publication is only a general outline. It is not legal advice. You should seek professional advice before taking any action based on its contents.