BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL PLC
On Thursday 9 May, the Supreme Court delivered a hugely significant, conclusive judgment in relation to the widely-reported Eurosail 3BL (Lehman originated) RMBS transaction. The Supreme Court unanimously confirmed the solvency of Eurosail 3BL, and in doing so provided important clarification on the relevant tests for insolvency.
The judgments of the lower courts in this case have had a significant impact on how ratings agencies have approached similar transactions; and so the Supreme Court’s judgment has been eagerly anticipated by structured finance market participants. The judgment also has broader implications in relation to the balance sheet test for insolvency.
Decision in summary
In Lord Walker’s leading judgment, he rejected the appeal of the holders of the appellant Class A3 Notes, and confirmed the solvency of Eurosail 3BL; but rejected the “the point of no return” test for solvency adopted by Lord Neuberger in the Court of Appeal judgment.
Eurosail 3BL had also cross-appealed on the issue of a post enforcement call option, or “PECO”; a tax efficient mechanism commonly used for many UK based securitisations. The Supreme Court rejected this cross-appeal, with Lord Hope providing the judgment on this issue and finding that a PECO does not operate so as to give effective limited recourse (i.e. recourse limited to the assets) to issuer vehicles in securitisations for the purposes of considering the solvency of the vehicle.
Eurosail issued loan notes that provided that a (potential) event of default may occur if the issuer is deemed unable to pay its debts within the meaning of Section 123(2) of the Insolvency Act 1986. Section 123(2) is commonly referred to as the “balance sheet test” and provides that a company is unable to pay its debts if it is proved to the satisfaction of the Court that the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
As a result of the subsequent insolvency of Eurosail 3BL’s swap counterparties (being Lehman entities), the issuer’s currency hedge protection is currently non-performing, leaving it exposed to currency market fluctuations. When filing its last audited accounts, Eurosail 3BL applied the contemporary rates of exchange; based on those rates, Eurosail 3BL recorded liabilities to noteholders substantially in excess of its assets. The Class A3 noteholders relied upon these accounts to contend that Eurosail 3BL had suffered an event of default (which, if correct, would result in more advantageous prioritisation for that class of noteholders).
In opposing this position, Eurosail 3BL relied on two separate arguments. First, within the meaning of Section 123(2), it is not appropriate simply to add up the total liabilities and total assets of the company; it is necessary to “take into account” a number of factors (explained in greater detail below). Second, Eurosail 3BL relied upon the existence of the PECO. The PECO is a mechanism common to a great many UK based issuers in securitisation transactions, under which the liabilities of the issuer, once the assets have been exhausted, may be acquired by the option holder for nominal consideration. Under the structure of the transaction documents, the noteholders are obliged to transfer the liabilities to the option holder in the event that the PECO is exercised and, as the option holder is a company in common ownership with the issuer, the expectation is that the liabilities will be forgiven by the option holder. The PECO structure was developed by market participants to retain a UK based issuer’s tax neutrality in light of prevailing legislation at the time and was accepted by the ratings agencies as a structure which gave effective limited recourse to this type of transaction.
Supreme Court’s decision
The Supreme Court unanimously upheld the decision of the Court of Appeal in finding, on the questions that were posed of it, that Eurosail 3BL was not deemed to be unable to pay its debts within the meaning of section 123(2) of the Insolvency Act 1986 (and that, therefore, no event of default could be considered), but also that the PECO would not have any effect on this question, in circumstances where Eurosail 3BL was deemed unable to pay its debts within the meaning of Section 123(2).
The effect of the judgment is two-fold. First, for Eurosail 3BL, it means that the transaction has not suffered an event of default and the vehicle is solvent. Second the PECO structure, which market participants had been relying upon to give effective limited recourse to this type of transaction, does not operate in the way that had been anticipated.
Significance of this judgment
Berwin Leighton Paisner LLP acted for Eurosail 3BL in these proceedings. In evidence and submissions put before the Chancellor, the Court of Appeal and the Supreme Court, Eurosail 3BL illustrated the importance and impact of the PECO to UK based issuer securitisations. It is believed that there are potentially in excess of 200 UK based issuer transactions which utilise a PECO structure. This judgment has a direct impact on each of those transactions.
The event of default that the Supreme Court was asked to consider is common to almost all of these transactions, and its judgment is of considerable importance to the directors of any UK based issuers with this structure. In considering the application of Section 123(2), Lord Walker stated that the issue of “whether or not the test of balance-sheet solvency is satisfied must depend on the available evidence as to the circumstances of the particular case”. Given the relatively unique (non-trading) nature of Eurosail 3BL, Lord Walker considered that its present assets should be a guide of the company’s ability to meet its long-term liabilities.
However, he also found that there existed “three imponderable factors”. These were: (1) potential currency movements; (2) potential interest rate movements; and (3) the UK economy and housing market. These factors, when combined with a period of more than 30 years to redemption of the notes in 2045, meant that the process of considering them in the context of balance sheet insolvency was “a matter of speculation rather than calculation and prediction on any scientific basis”. In addition, as a result of the non-performance of its currency swap counterparty, Eurosail 3BL has a claim in the estate of that party which, as the Court was shown, has a current market value. As a result, the Court should proceed with the greatest caution in deciding that a company is balance sheet insolvent. In this instance, Lord Walker concluded that Eurosail 3BL’s ability to pay all of its debts (whether present or future) may not be finally determined until much closer to the date for redemption in 2045. He did not say when that point may be reached.
The Supreme Court was also very clear to reject the “point of no return” test, adopted from academia by the Court of Appeal. Lord Walker categorically states that he considers that the phrase “should not pass into common usage as a paraphrase of the effect of section 123(2)”.
Where do we go from here?
The profound and far-reaching effects of the first instance and Court of Appeal decisions for securitisation market participants have now been conclusively upheld; the contention that a PECO structure gives effective limited recourse is now discredited. UK based issuers who operate these structures will not be able to rely on the PECO to effectively discount the value of their liabilities to noteholders back to the level of their assets, at least until the conclusion of the transaction.
The second issue arising out of this judgment concerns insolvency law. Practitioners had been looking to this case to give some guidance on the issue of balance sheet insolvency. Lord Neuberger in the Court of Appeal went some way towards doing this with the adoption of the point of no return test, even if the parameters of the test itself were somewhat difficult to establish. The Supreme Court decision, however, takes us back to where we were at the outset of the Eurosail 3BL litigation, with a petitioner needing to satisfy a court that a company is balance sheet insolvent and that exercise being heavily fact specific. The manner with which the Supreme Court takes into account both the value of the prospective future liabilities and the assets of the company, goes some way to illustrating the latitude that will be afforded to a company when the question is considered.
A team at Berwin Leighton Paisner LLP, led by finance dispute resolution partner Oliver Glynn-Jones acted for Eurosail 3BL in these proceedings. In response to the judgment Oliver Glynn-Jones commented: “The Supreme Court’s judgment puts an end once and for all to the issue of Eurosail 3BL’s solvency and in doing so, the Supreme Court has demonstrated the mix of factors and issues that must be weighed up when considering the concept of balance sheet insolvency. It is not just a question of taking a snapshot at a point in time and relying on that. The ramifications of the case for both securitisation parties and insolvency practitioners are significant.”