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Clarification at last for the ‘Balance Sheet Insolvency Test’

May 15 2013

The recent case of BNY Corporate Trustee Services Limited v Eurosail UK 2007-3BL PLC [2013] UKSC 28 (“Eurosail”) is of significant importance as it was the first time the Court of Appeal and the Supreme Court have had to analyse the meaning of the “balance sheet insolvency test” as outlined under s123(2) of the Insolvency Act 1986. Therefore, the decision will have serious ramifications not only for the securitisation industry but also for businesses that face a challenge to their solvency.

Section 123 (2) of the Insolvency Act 1986 provides that a company is deemed insolvent if it is proved to the satisfaction of the court that the “value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities”.

Eurosail was an issuer of residential mortgage backed securities and the debtor’s recently audited balance sheets showed a net liability of £75 million and accordingly, one of its creditors within the Class A3, was of the opinion that Eurosail will have breached s123(2). This would have meant that Eurosail would have gone into an Event of Default  and thus would have elevated the Class A3 creditors to a Class A2 priority rank.

Eurosail argued that it was entirely “premature and inappropriate” to determine that its assets are less than its liabilities given that a key counter-party to Eurosails’ transactions, Lehman Brothers Special Financing Inc. had become insolvent. Furthermore, Eurosail maintained that they had been paying their debts as they fell due and accordingly they were “cash-flow” solvent.

The Supreme Court decided that Eurosail was not insolvent, noting that an audited balance sheet is not decisive for the purposes of s123(2). The Court suggested that in order to determine whether a company is insolvent requires a factual enquiry based on “all the available evidence and the circumstances of a particular case”.

In summarising, the court rejected the reasoning of the Court of Appeal decision of 2007 i.e. the question was whether the company had reached the point of no return. The Supreme Court stated that it must be satisfied, on a balance of probabilities, that a company has insufficient assets to be able to meet all its liabilities (including its prospective and contingent liabilities).

The Supreme Court stated that “where a company is paying its debts as they fall due, the court shall proceed with the greatest caution in deciding that a company is in a state of balance-sheet insolvency under s123(2)”. So long as the company continues to meet its liabilities, they will not fall foul of the balance sheet test under s123(2).

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