UK Supreme Court: Case Preview: Securitisation and the Balance Sheet Test

23 02 2013

BNY Corporate Trustee Services Limited and others (Respondents) v Neuberger Berman Europe Ltd (on behalf of Sealink Funding Ltd) and others (Appellants) UKSC 2011/0086 and BNY Corporate Trustee Services Limited and others (Respondents) v Eurosail-UK 2007-3BL PLC (Appellant) UKSC 2011/0199 shall be heard by the UK Supreme Court on 25 and 26 February 2013. Lord Hope of Craighead DPSC and Lord Walker of Gestingthorpe, Lord Mance of Frognal, Lord Sumption and Lord Carnwath of Notting Hill JJSC will hear these appeals. This hearing can be viewed online during Court hours here.


Interest-bearing Notes were issued by a special purpose vehicle, Eurosail-UK 2007-3BL PLC (“the Issuer”), formed to hold income-producing assets, namely mortgage loans. Due to the insolvency of Lehman Brothers (see the earlier case decided by the UK Supreme Court involving Lehman Brothers here), with whom the Issuer had entered into swap agreements, the Issuer suffered a significant deficiency in its net asset position. The terms governing the issue of the notes provided that on specified Events of Default an enforcement notice could be served, the effects of which included altering the respective priorities of the Noteholders for repayment of capital and interest. One such Event of Default involved the issuer being unable to pay its debts within the meaning of section 123(2) – definition of inability to pay debts; “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” – of the Insolvency Act 1986. The trustee of the Noteholders’ rights, BNY Corporate Trustee Services Ltd, commenced the current proceedings seeking a determination of whether that event of default had occurred.

The Event of Default in play in these proceedings is that Condition 9(a)(iii) (“Condition 9(a)(iii)”), is expressed in the following terms:

The Issuer … ceasing … to carry on business … or being unable to pay its debts as and when they fall due or, within the meaning of Section 123(1) or (2) (as if the words ‘it is proved to the satisfaction of the court’ did not appear in Section 123(2)) of the Insolvency Act 1986 (as that Section may be amended from time to time), being unable to pay its debts.

To expand upon the facts a bit more, on 16th July 2007 Eurosail issued notes to an aggregate value of £660m as part of a securitisation transaction in relation to a portfolio of UK Residential Non-Conforming Mortgage loans with a face value of £650m. The notes were of five classes, A to E, divided into subclasses 1 to 3, variously denominated in and classified as Euros, $US and £ Sterling. The A1 notes mature in 2027, all the rest in 2045. The rate of interest payable varies according to the class, currency denomination and maturity of the note. The Issuer’s risk in relation to changes in interest and exchange rates was “hedged” by means of interest and currency rate swaps with Lehman Brothers Special Financing Inc whose obligations thereunder were guaranteed by Lehman Brothers Holdings Inc. The securitisation transaction also included a Post Enforcement Call Option Agreement (“PECO”) which provided that in the event that the security for the notes is enforced and found to be insufficient to pay all amounts due in respect of them then an associate company of the Issuer is to have a call option in respect of the benefit of all the notes at a nominal price. On 7th May 2010 the Trustee issued a Part 8 claim.


(1) The proper interpretation of section 123(2) of the Insolvency Act 1986 as incorporated into a securitisation agreement, in particular whether a company is to be deemed “unable to pay its debts” by reason of the fact that on an examination of its balance sheet its liabilities exceed its assets, or whether some further test is involved.

(2) Whether section 123(2) is satisfied on the facts.

Court of Appeal: BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc & Ors [2011] EWCA Civ 22 (07 March 2011)

In BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL PLC and others [2011] EWCA Civ 227, read judgment, the Court of Appeal (Lord Neuberger of Abbotsbury MR [as he then was], and Wilson and Toulson LJJ) affirmed Chancellor Sir Andrew Morritt’s High Court [2010] EWHC 2005 (Ch) decision and held that a company should only fail the so-called balance sheet test for whether it is unable to pay its debts (section 123(2) of the Insolvency Act 1986) if the company has genuinely reached the point of no return.

The Court of Appeal, held the “balance sheet test”, for whether a company is deemed unable to pay its debts within the meaning of section 123(2) of the Insolvency Act 1986 was not reducible to a single formula or set of principles that apply to all companies. Rather, judgement needed to be exercised by the Court whether the company “has reached the point of no return” and that this point is arrived at when allowing the company to continue to operate and pay its short-term liabilities is simply likely to reduce the overall pool of assets available to pay the company’s future and contingent creditors.

The Court allowed that, in this case, the company’s most recent audited accounts formed a suitable starting point when applying the test under section 123(2). However, such an approach was not always appropriate, and the characteristic limitations of a company’s accounts ought to be acknowledged.

The Court also ruled that, even where the holders of notes issued by a company granted a post-enforcement call option (PECO) to a third party, the company was still, technically, susceptible to direct action by the noteholders on a full recourse basis until the PECO was exercised. In the same way, the PECO in this case did not prevent the relevant notes from being treated as liabilities of the company when assessing whether it should be deemed unable to pay its debts under section 123(2). However, a distinction was drawn between whether a company was “bankruptcy remote”, meaning it was unlikely to be the subject of formal insolvency proceedings, and “insolvency remote”, meaning the company would not be deemed unable to pay its debts.

Moreover, the Court held that a PECO assisted in preserving a company’s bankruptcy-remote status (as the noteholders had no commercial interest in placing the company in insolvency proceedings where there was a PECO), but did not make it insolvency remote. Furthermore, there was nothing “commercially insensible” in finding that, despite the PECO, the noteholders’ rights against the company were full recourse until very late in the transaction.

Dismissing the appeal and cross-appeal, Lord Neuberger (Wilson and Toulson LJJ concurring) held:

Para 44: In the first place, I do not consider that the question whether section 123(2) applies simply turns on the question whether the liabilities of a company (however they are assessed) exceed its assets (however they are assessed). In practical terms, it would be rather extraordinary if section 123(2) was satisfied every time a company’s liabilities exceeded the value of its assets. Many companies which are solvent and successful, and many companies early on in their lives, would be deemed unable to pay their debts if this was the meaning of section 123(2). Indeed, the Issuer is a good example of this: its assets only just exceeded its liabilities when it was formed, and it was more than possible that, even if things went well, it would fall from time to time within the ambit of section 123(2) if the appellants are right as to the meaning of that provision.

Para 49: In my judgment, both the purpose and the applicable test of section 123(2) are accurately encapsulated in that brief passage. Subsection (2) was, in my view, included in section 123 to cover a case where, although it could not be said that a company “is [currently] unable to pay its debts as they fall due” (either because it has no debts which are currently payable, or because it has, or can achieve, the cash flow to pay such debts), it is, in practical terms, clear that it will not be able to meet its future or contingent liabilities. A future or contingent creditor of a company can often claim to be prejudiced by the company using its cash or other assets to pay current creditors or even for some other purpose, but, within bounds, that is an inherent risk in the futurity or contingency of the liability. 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”.

Para 50:This is not dissimilar from the point made in relation to section 123(1)(e) by Briggs J in Re Cheyne Finance plc [2008] 2 All ER 987, para 51, when he contrasted “a momentary inability to pay … as a result of temporary liquidity soon to be remedied” with “an endemic shortage of working capital” which renders “a company … on any commercial view insolvent, even though it may be able to pay its debts for the next few days, weeks or months before an inevitable failure.” Mr Sheldon suggested that, if the last part of the passage, with its reference to future inability to pay debts, was correct, then section 123(2), as Professor Goode suggests it should be interpreted, would add nothing to section 123(1)(e). I do not agree. The point that I think Briggs J was making is that section 123(1)(e) does not require slavish adherence to the immediate present. It is unnecessary to decide whether that is correct, although it is only right to say that, as at present advised, I am inclined to think that it is. However, that does not call into question the conclusion that section 123(2) applies to a company whose assets and liabilities (including contingent and future liabilities) are such that it has reached the point of no return.

Para 51: This conclusion reflects the fact that section 123(2) is concerned with a case of a company not being able to pay its debts, not with an exercise of simply assessing its net assets or liabilities: it is true that the subsection provides that assets and liabilities should be taken into account, but that is for the purpose of addressing the ultimate question of whether the company “is deemed unable to pay its debts”. It is also true that the position described in section 123(2) is merely “deemed” to amount to inability to pay debts, but the same expression is used in section 123(1), and all its paragraphs are concerned with actual inability (or refusal) to pay debts. The fact that the state of affairs described in section 123(2) is deemed to amount to inability to pay debts can properly be taken into account when interpreting what it means.

Para 61: The appellants are on somewhat stronger ground in their contention that the figures in the company’s balance sheet, and audited and signed off annual accounts, should be accorded weight in the exercise envisaged by section 123(2). I do not think that it is possible or helpful to describe in general terms the weight to be given to such figures in such an exercise. Clearly, the fact that the figures have been audited and are said to convey a “true and fair” view of the company’s position in the opinion of its directors should normally have real force. However, the figures will inevitably be historic, they will normally be conservative, they will be based on accounting conventions, and they will rarely represent the only true and fair view. The court will ultimately have to form its own view as to whether the company in question has reached what Professor Goode described as “the point of no return”.

Para 65: When considering if section 123(2) applies, I am content to take the starting point adopted by Mr Sheldon, namely the asset and liability position revealed by the company’s most recent accounts. However, that may well not be appropriate by any means in all cases. Further, in many, I suspect most, cases, in order to answer the question posed by section 123(2), it will be necessary to consider whether to depart from those figures, and whether to take into account other, sometimes more important, factors.

Para 80: Bearing in mind the substantial assets of the Issuer, the relatively long period over which the Issuer’s liabilities have to be met, and the potential for significant change in the differences between the value of the Issuer’s assets and liabilities, I agree with the Chancellor that the appellants have not established that the Issuer has reached what Professor Goode called the point of no return, or the Cork Report’s point at which the shutters should be put up. The financial situation of the Issuer, bearing in mind its assets and liabilities, in particular its liabilities to the Class A3 and junior Noteholders, has not been shown to be such that, to use Briggs J’s language, the Issuer is on any commercial view insolvent.

th-12Para 100: There is nothing commercially insensible in the conclusion that, for the purpose of Condition 9(a)(iii), the Noteholders’ rights against the Issuer are treated as full recourse, notwithstanding the PECO. The purpose of the PECO was to render the Issuer bankruptcy remote, in the sense of ensuring that it could not be wound up. But this conclusion does not cut across that purpose: it merely entitles the Noteholders and Trustee to invoke a ground which would support a winding up petition to justify the service of an Enforcement Notice. Further, whatever else may be in doubt, it is hard to argue against the view that the parties envisaged an Enforcement Notice being served if the Issuer’s liabilities were not met, as Condition 9(a)(i) provides.

Para 105: It appears to me that, unless a trustee has good reason to think that its actions will be subject to criticism or there is some other special reason, it should normally be unnecessary for it to make representations or to be represented at a hearing (save for instructing a note-taker), where, as here, its stance on the issues dividing the warring parties, is neutral. Directions can be sought at a relatively early stage to enable the trustee to make submissions (possibly in writing) if a point arises on which its assistance is required or on which it desires to have a say.



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11 08 2013

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