BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc & Ors>

Under section 123(2) of the Insolvency Act 1986, a company is not deemed unable to pay its debts merely because its liabilities exceed its assets. The court must make a fact-sensitive judgment about whether, after proper allowance for prospective and contingent liabilities, the company cannot reasonably be expected to meet them.

Future liabilities require valuation rather than treatment at their face amount. Their timing, magnitude and likelihood, together with commercial reality and fairness, are material. A distant and potentially fluctuating deficiency may therefore fall short of establishing balance-sheet insolvency.

Where contractual documents incorporate statutory provisions, those provisions ordinarily bear their statutory meaning, subject to any express contractual modification.

The issuer was a special purpose vehicle which financed a portfolio of sterling residential mortgages by issuing interest-bearing notes in sterling, euros and US dollars. The failure of its Lehman Brothers swap counterparties removed currency and interest-rate hedges. Sterling depreciation then produced a substantial accounting deficit, although the issuer continued to pay its debts as they fell due.

Certain Class A3 noteholders contended that the issuer was unable to pay its debts within section 123(2) of the Insolvency Act 1986, as incorporated into an event-of-default condition. The Chancellor rejected that contention in [2010] EWHC 2005 (Ch); [2010] Bus LR 1731. He also held that a post-enforcement call option agreement would not alter the result if statutory inability to pay debts were otherwise established.

The Class A3 noteholders appealed on insolvency. The issuer and Class A2 noteholders cross-appealed on the effect of the call option. The central questions were the meaning and application of section 123(2), and whether the option made the notes limited-recourse liabilities for the contractual event of default.

1. Appeal and cross-appeal dismissed. Lord Neuberger MR gave the principal judgment. Toulson LJ agreed and supplied additional reasoning on section 123(2) of the Insolvency Act 1986. Wilson LJ agreed with both judgments.

2. Incorporation of section 123 into the contractual event-of-default condition imported its statutory meaning and effect, subject only to the modification expressly stated in the contract. The parties had additionally adopted amendments made to that section from time to time.

3. Section 123(2) does not create a mechanical test under which every company having liabilities greater than its assets is deemed unable to pay its debts. Its purpose is to protect prospective and contingent creditors where a company, although currently paying its debts, has reached the point at which it cannot reasonably be expected to meet those liabilities. The court must make a fact-sensitive judgment with a firm eye on commercial reality and fairness.

4. Prospective and contingent liabilities are not invariably taken at face amount. Their value and significance depend on matters including when they mature, the likelihood of the contingency and the likely amount. Audited accounts ordinarily have real weight, but they are only a starting point. They may be historic, conservative and dependent on accounting conventions. The court must form its own judgment.

5. The issuer had a current asset deficit of about £70 million after appropriate adjustments. Nevertheless, it had substantial assets, liabilities extending over a long period, exposure to volatile exchange rates and a position capable of significant change. The appellants had therefore failed to establish that it could not reasonably be expected to meet its prospective liabilities or had reached the point of no return. No event of default under section 123(2), as incorporated into the notes, was established.

6. On the cross-appeal, considered on an assumed basis, the post-enforcement call option could make the issuer bankruptcy remote in practical winding-up proceedings. It did not, however, convert the noteholders’ rights into limited-recourse rights for the contractual event of default. The prospectus, deed of charge, note conditions and function of the event-of-default clause treated those rights as full recourse until enforcement and arguably until exercise of the option.

7. A neutral trustee should not normally incur the expense of representation at a hearing between other parties unless its conduct may be criticised, its assistance is required or some other special reason exists.

1. Court of Appeal (Civil Division): In [2011] EWCA Civ 227, unanimously dismissed both the Class A3 noteholders’ appeal and the respondents’ cross-appeal.
2. High Court, Chancery Division: The Chancellor held that the issuer was not unable to pay its debts under section 123(2) of the Insolvency Act 1986. He further held that the post-enforcement call option would not have altered the answer if statutory inability had otherwise been established: [2010] EWHC 2005 (Ch); [2010] Bus LR 1731.