Eurosail was a limited company that was used to raise finance from investors by issuing loan notes, the proceeds of which were invested in sterling mortgages. The loan notes were denominated in US dollars and Euros as well as Sterling, which created both a currency risk and an interest rate risk that Eurosail eliminated by entering into two interest rate swaps with a Lehman counterparty.
The trust deed allowed the trustee to issue an enforcement notice if an event of default had occurred. This would be in circumstances where Eurosail was deemed insolvent as described in section 123(2) of the Insolvency Act 1986. This would have the consequence of altering the priorities between the different noteholders. When Lehman entered into insolvency the trustee sought directions as to whether an event of default had occurred as defined.
Eurosail’s accounts showed net liabilities of £74,557,000 as of 30 November 2009 a fact that would support a finding of balance sheet insolvency, prior to the Court of Appeal’s judgment in this case.
The Court of Appeal’s judgment (March 2011)
Eurosail was not unable to pay its debts within the meaning of section 123(2).
Lord Neuberger MR said that the relevant question was whether the company “reached the point of no return” and that this is “only when it can be said that the company’s use of its cash or other assets for current purposes amounts to what may be vernacularly characterised as a fraud on the future or contingent creditors.”
Toulson LJ said that the relevant question was “whether it had been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet those liabilities…”
Three key points emerged:
- The court recognised the value of an asset being the claim against the swap counterparty because that debt was listed and traded on a recognised market and had a demonstrable value. This meant that because bonds issued by Lehman were trading in the secondary market at 40 cents in the dollar, the claim against the insolvent estate could be given a value of $220 million and this amount could be taken into account when assessing the solvency of Eurosail;
- The court refused to take into account a large proportion of the total liabilities shown in the financial statements because the exchange rate used was the spot rate and not the rate that would apply in 2045 (when the notes would be redeemed.) This meant that a large proportion of those liabilities could be taken out of consideration when assessing the solvency of Eurosail;
- The reason why both the assets represented by the value of the claim against Lehman and the liabilities determined by the application of the spot rate had been excluded previously was because accounting conventions dictated this treatment. The court was able to depart from these conventions because they considered that the accounts were only the beginning of the enquiry, not the end of it.
This has made balance sheet insolvency very difficult to determine. One of the consequences has been that Office holders seeking to overturn antecedent transactions have been unable to prove insolvency on the part of the company at the relevant time. This has made it impossible to pursue preference claims and transactions at an undervalue in some cases.
The issue for the Supreme Court is whether section 123(2) should be given a meaning that makes balance sheet insolvency harder to prove. Whilst it is true that under the “old” test many companies would be technically insolvent from time to time, insolvency per se is neither a tort nor a crime and it does not of itself have a consequence. That said, the possibility that a vexatious creditor could ask the court to issue a winding up petition notwithstanding, and the attendant problems that this can cause, may suggest that the test does need to be redefined.
The Supreme Court’s judgement
Lord Walker recognised the distinction between the two tests described above and specifically endorsed the test described by Toulson LJ, adding that he considered that the expression “point of no return” should “not pass into common usage as a paraphrase of the effect of section 123(2).”
However, “a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test” and despite the difference in form, no significant change in the law occurred when section 123(1) and (2) of the Insolvency Act 1986 were enacted.
The court recognised that the test was far from an exact one and it would depend on the available evidence and the circumstances of the particular case.
Applying this test, and in light of the available evidence, the Court was not satisfied that Eurosail was unable to pay its debts.
The Supreme Court opened the way for practitioners to distinguish this judgement because it was explicitly recognised that “The circumstances of Eurosail’s business…are quite unlike those of a company engaged in normal trading activities.”
In addition, Lord Walker made it plain that the point of no return test “is not the correct test” and so whilst this expression has entered common usage, it now has no legal basis.
The relevant question is “whether it had been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet those liabilities…”
Whilst proving insolvency is undoubtedly more difficult than it was before March 2011, insolvency practitioners can take some comfort from the fact that very few trading companies will be able to bring themselves within its scope.
Moon Beever Solicitors
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