Court of Appeal (Neuberger MR et al)

The Court of Appeal interpreted Condition 9(a)(iii) of the Notes, which incorporated section 123(1) and (2) of the Insolvency Act 1986, and held that section 123(2) is not a purely mechanical "assets versus liabilities" test. Instead it requires a judgment whether a company has reached the "point of no return" such that it cannot reasonably be expected to meet its contingent and prospective liabilities. Applying that test to the Issuer, and after adjusting the audited accounts for (i) a realistically valued claim against the failed swap counterparty and (ii) the true full-recourse character of the Notes for present purposes, the court concluded the Issuer had not reached that point. The appeal by holders of A3 Notes was therefore dismissed. The court also considered the effect of the Post Enforcement Call Option Agreement (PECO) and concluded that, for the purposes of Condition 9(a)(iii), the transaction documents treated the Noteholders' rights as full recourse until enforcement; accordingly the cross-appeal on the PECO issue was also dismissed.

Background and parties: The Issuer, Eurosail-UK 2007-3BL PLC, a special purpose vehicle holding a portfolio of sterling-denominated non-conforming residential mortgage loans, issued multi‑class, multi‑currency notes. The Trustee was BNY Corporate Trustee Services Ltd. Appellants (holders of Class A3 Notes) contended that an Event of Default under Condition 9(a)(iii) (incorporating section 123(1) or (2) of the Insolvency Act 1986) had arisen, entitling the Trustee to serve an Enforcement Notice. Respondents included the Issuer and holders of Class A2 Notes who opposed the contention.

Nature of the claim / relief sought: The appellants sought a finding that the Issuer was "unable to pay its debts" within the meaning of Condition 9(a)(iii) (derived from section 123(2) of the Insolvency Act 1986), which would permit enforcement action. The respondents cross-appealed on the question whether the PECO meant that the Issuer should not be treated as within the ambit of section 123(2).

Issues framed:

1. Whether, ignoring the PECO, the Issuer was "unable to pay its debts" within section 123(2) of the Insolvency Act 1986 when contingent and prospective liabilities were taken into account;
2. If the Issuer would otherwise fall within section 123(2), whether the PECO meant that, in commercial reality and for the purpose of Condition 9(a)(iii), the Issuer should not be so treated (because Noteholders would, in practice, have no recourse beyond the assets).

Court’s reasoning and holdings: The court held that:

• Section 123(2) is not a simple mechanical balance-sheet test. It supplements the cash-flow test in section 123(1)(e) and is intended for the comparatively rare case where a company’s contingent and prospective liabilities are such that it has reached a point of no return (an "incurable deficiency"), making future repayment unrealistic. The inquiry is judgement-based and fact-specific, taking commercial reality into account (including appropriate valuation of future and foreign-currency liabilities).
• Account had to be taken of the Issuer’s audited accounts but also of realistic adjustments: a claim against the failed swap counterparty (LBSF/LBHI), valuated by reference to market trading of LBSF debt, and an adjustment to reflect that, for the purposes of the Condition, the Notes must be treated as full-recourse (the audited accounts had treated them as limited recourse). Those two adjustments largely offset each other, leaving a modest net asset deficiency.
• Viewed in context — substantial remaining mortgage assets, long weighted average maturity, the volatility of foreign exchange and the fact that only a part of the apparent deficiency represented an actual realised shortfall — the appellants had not shown the Issuer had reached the "point of no return". The Issuer was therefore not deemed unable to pay its debts under section 123(2).
• On the PECO point the court concluded that, for the purposes of Condition 9(a)(iii), the transaction documents (Prospectus, Deed of Charge clause 6.7 and Condition 2(h)) treated Noteholders’ rights as full recourse until enforcement; accordingly the PECO did not have the effect of removing the Issuer from the ambit of section 123(2) in the context of that Condition.

Conclusion: The Court dismissed the appellants’ appeal and the respondents’ cross-appeal. The judgment also contains observations about the Trustee’s attendance at the hearing and the recoverability of attendant costs.

Appeal dismissed and cross-appeal dismissed. The court held that section 123(2) of the Insolvency Act 1986 is not a purely mechanical balance-sheet test but requires a judgment whether the company has reached the "point of no return" such that it cannot reasonably be expected to meet contingent and prospective liabilities. Applying that test, the Issuer had not been shown to be unable to pay its debts. The court further held that, for the purposes of Condition 9(a)(iii), the Transaction Documents treated Noteholders' rights as full recourse until enforcement, so the PECO did not prevent Condition 9(a)(iii) operating as drafted.

Appeal from the Chancellor of the High Court (Chancery Division), [2010] Bus LR 1731 ; [2010] EWHC 2005 (Ch). Determination by the Court of Appeal [2011] EWCA Civ 227.