Past the point of no return? Corporate Rescue and Insolvency (2011) 2 CRI 43 1 April 2011


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The Court of Appeal, in its recent decision in the Eurosail case, has considered for the first time the interpretation of balance sheet test for insolvency.

The court adopted a 'point of no return' approach, which asks whether, looking at the Company's assets and making proper allowance for its prospective and contingent liabilities, it can not reasonably be expected to meet those liabilities.

Whilst the courts' commercial approach to the test is welcome, a significant degree of uncertainty has also been introduced.

You can pretty much always count on the Aussies to have extensive jurisprudence on legal issues when we have none. The exception being, it would seem, the balance sheet test for insolvency. For a change, the recent Court of Appeal decision in BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL PLC and others [2011] EWCA Civ 227, the first serious judicial consideration of the balance sheet test, is not littered with quotes from the Court of Appeal of New South Wales. It is instead festooned with extracts from Professor Roy Goode's 'Principles of Corporate Insolvency Law'. This is no bad thing, for most practitioners will be familiar with the text, and the sections on the cash flow and balance sheet insolvency tests in particular. For the Court of Appeal to have finally been given the opportunity to consider the test in the round, particularly so recently after the decision in In the Matter of Cheyne Finance PLC (in receivership) [2007] EWHC 2402, which refreshed our perspective on the cash flow test, makes this case of enormous relevance.

The balance sheet test

English law does not recognise insolvency per se; instead it looks to the ability of a company to pay its debts. The two primary tests of inability to pay debts are the cash flow test (s 123(1)(e) of the Insolvency Act 1986 ('IA 1986')) and the balance sheet test (s 123(2)). Those sections provide: 'A company is deemed unable to pay its debts … if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due' — the cash flow test. A company is also deemed unable to pay its debts 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' — the balance sheet test.

The relevance of the test

These two tests underpin much of English insolvency law. The jurisdiction of the court to wind up a company or put it into administration is founded on whether the company is unable to pay its debts (s 122(1)(f) and para 11(a) of Sch B1, respectively). A director may be personally liable to make a contribution to a company's assets under the wrongful trading regime if, inter alia, he knew or ought to have known that there was no reasonable prospect of the company avoiding going into insolvent liquidation, which is tested by reference to whether the company's assets were insufficient for the payment of its debts and other liabilities and the expenses of the winding up (s 214(6)). It is a prerequisite of a transaction at an undervalue and a preference, and for the avoidance of floating charges, that a company was at the time of entering into the transaction or giving the preference, unable to pay its debts within the meaning of s 123, or became unable to pay its debts as a consequence of the transaction or preference (ss 240(2) and 245).

The relevance of the tests does not stop there. Insolvency of a contractual counterparty is a common termination event in commercial contracts, and it will be an event of default in most loan agreements. It is not uncommon to see events of default refer to the specific sections of the IA 1986. It has also become standard practice to disapply the requirement that inability to pay debts be proved to the satisfaction of the court.

The occurrence of an event of default can have huge economic implications for the parties involved. This can range from the right to terminate a contract, at a time when the defaulting party may need the income from that contract most (there being no equivalent in English law of the US Bankruptcy Code prohibition on ipso facto clauses — clauses that purport to terminate executor contracts on insolvency or bankruptcy of a counterparty), to enforcement of security, and the right to appoint insolvency officeholders (a qualifying floating chargeholder's right to appoint an administrator is triggered on the floating charge being enforceable, typically following the occurrence of an event of default: para 16 of Sch B1).

For example, in Eurosail, the effect of the occurrence of an event of default, if then certified by the security trustee to be materially prejudicial to noteholders, is to move from a pre-enforcement payment waterfall to a post-enforcement payment waterfall. Under the former, interest is paid when due on quarterly interest payment dates (subject to a mechanism for deferring payments of interest to junior noteholders in the event of an insufficiency of interest), and notes are redeemed in order of seniority within Class A — which is where the value break was anticipated to fall — ie A1 then A2 then A3. Under the latter, the three sub-classes of A Notes would rank pari passu for the repayment of principal, and no interest would be paid to classes of notes junior to Class A until Class A noteholders had been repaid their principal and interest in full. It would therefore be in the interests of holders of A3 notes to move to a post-enforcement waterfall, and in the interests of the holders of A1 notes to resist it.

Past the point of no return

The balance sheet test is, by definition, not a measure of a company's present ability to pay its debts. As a practical test of 'insolvency', its use is therefore rather limited. There are many companies trading successfully which are solvent on a cash flow basis but arguably insolvent on a strict interpretation of the balance sheet test. Should a company with assets of £100,000 today and a liability to repay the bank £101,000 in five years' time be regarded as unable to pay its debts, and so liable to be wound up? What about a company, such as the issuer in Eurosail, whose liabilities are dollar-denominated and due in 20 years, but whose assets are primarily in sterling — what rate of exchange should apply to determine whether its assets are sufficient to meet its liabilities? What level of crystal ball gazing is acceptable?

It was argued for the A3 Committee of noteholders that liabilities should be brought into account at face value under s 123(2). In particular, the full amount of any prospective liabilities should be added in, without any reduction or discount to reflect the futurity of the payment obligation, and the amount of any contingent liabilities, to the extent unascertained, should be valued and added in, again without any discount or reduction. It was accepted that this would trigger the jurisdiction of the court to wind-up a company, even if, as the issuer in Eurosail was, the company was plainly solvent on a cash flow, or 'commercial' basis. It was submitted that the inherent jurisdiction of the court to refuse to make a winding-up order or administration order provided an adequate check and balance: if the balance sheet test produced an uncommercial outcome, the court could simply refuse to make a winding up or administration order in respect of the company.

The Master of the Rolls considered that such a strict interpretation of the balance sheet test was commercially undesirable and overly simplistic: 'I find it hard to discern any conceivable policy reason why a company should be at risk of being wound up simply because the aggregate value (however calculated) of its liabilities exceeds that of its assets'.

The court endorsed Professor Roy Goode's 'point of no return' formulation of the balance sheet test. That is, that the balance sheet test effectively provides a safeguard for future creditors of a company which, in the words of the Master of the Rolls, 'has reached “the end of the road”, or in respect of which the shutters should be “put up”'.

The court accepted that there will always be an element of risk for future or contingent creditors, but concluded that the balance sheet test was not intended to ensnare companies which suffered a momentary or curable shortfall, echoing the sentiments expressed by Mr Justice Briggs in Cheyne when describing the rationale for the cash flow test having an element of futurity under Australian case law. The Master of the Rolls stated that 'it 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 that it can be said that it has “reached the point of no return”'.

Does this leave any substantive difference between the cash flow test and the balance sheet test, as formulated by the Court of Appeal?

The A3 Committee thought not, and it was a ground of their appeal that the approach of the Chancellor at first instance elided s 123(1)(e) and s 123(2). In Cheyne, Briggs J held that the cash flow test permitted a review of the future, and was not solely concerned with immediate liquidity issues. However, he accepted that the cash flow test had its limitations in practice, where uncertainty as to future cash flow projections meant that the test could not easily be satisfied. It was in such circumstances that the balance sheet test filled the gap. The Court of Appeal also dismissed this argument of the A3 Committee, on the basis that the two tests serve different, but complementary, purposes.

How do you know when you're there?

Although the test may be known as the balance sheet test, a company's balance sheet is only a starting point; the valuation of assets and liabilities, especially contingent liabilities, and particularly under present market conditions, can be very difficult. As the Court of Appeal put it, the balance sheet prepared by a company with its auditors may present a true and fair view of the company's position, but it was not the only such view. Factors such as the balance sheet date and the accounting conventions applied in preparing it would affect the weight to be given to it.

The Master of the Rolls took the Issuer's most recent accounts as his starting point, and then made various adjustments. The principle that he appears to have taken in doing so is that the market will generally supply the best evidence of value, and that this can displace accounting conventions contained in the balance sheet. For example, he added back onto the balance sheet a figure representing the likely realisations for the issuer on its litigation against Lehman for the loss of its currency hedge, having a value based on where Lehman's claims were trading in the market. For the same reasons, the present rate of exchange was favoured for converting dollar liabilities into sterling values, as opposed to some alternative measure.

We see that the court therefore had little difficulty in setting aside complex accounting standards and practices, and fettling with the balance sheet to reflect what they considered better reflected a true and fair view of the financial position of the issuer. This is fairly concerning: corporate balance sheets are drawn up by accountants and not lawyers, and accountants are trained experts in doing so, whereas lawyers are most certainly not. This approach lends itself to uncertainty.

The Court of Appeal was reluctant to give any further guidance on the test, save to say that it is to be determined 'with a firm eye both on commercial reality and on commercial fairness', and that (obviously) the closer in time a prospective liability is to mature, and the more likely a contingent liability is to crystallise, and the greater the size of the contingent liability, the more probable it is that the test will apply.

And what is the applicable burden of proof for the test?

The Master of the Rolls noted that the parties agreed that the issue of whether s 123(2) applies — whether it has 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 meet those liabilities' — is to be determined on a balance of probabilities. Interestingly, he does not go on to confirm where he stands on this, but his agreement can perhaps be inferred on the basis that he does not disagree. Though this is presented as a straightforward issue, it is not. In particular, being past the point of no return implies a greater degree of certainty, or irreversibility, than on the balance of probabilities.

What does this mean?

In practice, most practitioners have favoured Professor Goode's formulation of the balance sheet test for years, and so it should come as no surprise that the Court of Appeal did so as well, when presented with the question of what it meant. What is clear is that anyone seeking to rely on balance sheet insolvency as an event of default or termination event should ensure that they have the best evidence they can adduce, if possible taken from the market, on the value of the assets and liabilities of the other party, before acting. Relevant in making that assessment will be the proximity of any future liabilities, and the likelihood of any contingency occurring which would trigger a contingent liability. As these factors can change over time, it will be a matter of reviewing the position regularly to determine if and when the point of no return has been reached.

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