Insolvency: have you reached the point of no return?

18/07/2011 in Corporate, Banking & Finance, Mergers & Acquisitions

The Court of Appeal recently held that, simply because a company’s liabilities exceed its assets, this is not, on its own, enough to deem the company unable to pay its debts and therefore liable to be wound up by the court. If a company with negative net assets can nonetheless continue to service its current liabilities, it is not “unable to pay its debts” unless it has “reached the point of no return because of an incurable deficiency in its assets”.

The facts of this case

The company in question had issued various classes of interest bearing loan notes to investors to fund the acquisition of mortgage loans. Any interest the company received from the mortgages was used to pay the interest to the note-holders and, as the mortgages were paid off, the proceeds of redemption would be used by the company to pay off the principal of the notes. The majority of the notes were issued in euros or US dollars so that while the company’s assets (the mortgages) were in pounds sterling, most of its liabilities were in euros and US dollars. To protect against fluctuations in interest rates and adverse movements in sterling, the company entered into hedging arrangements with a Lehman Brothers company. These fell apart when Lehman Brothers collapsed. Later, as sterling depreciated against both the US dollar and the euro, the value of the company’s liabilities exceeded the value of its assets.

The appellant noteholders claimed that this situation rendered the company unable to pay its debts under the balance sheet test, described below, thus triggering an event of default in the contractual documents.

The insolvency tests

Under the Insolvency Act 1986 the court may wind up a company if it is unable to pay its debts. And 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); or
• 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").

This statutory definition is often used in commercial agreements (as in this case) to define an event of default, but omitting the words “it is proved to the satisfaction of the court that”.

Here the company had kept up with its interest payments. So it was able to pay its debts as they fell due. But the appellants claimed that the company failed the balance sheet test because the liabilities of the company were more than its assets.

The point of no return

The court disagreed with the appellants’ interpretation of the balance sheet test. It said that “many companies in that position [with negative net assets] are successful and creditworthy, and cannot in any way be characterised as “unable to pay [their] debts”.

The balance sheet test should only be concerned with a company which, although able to pay its current creditors, in practical terms, clearly will not be able to pay its future or contingent creditors; in other words, it had reached “the point of no return”.

In reviewing whether a company had reached this point, the audited accounts were a good starting point. However, the court warned, those figures will inevitably be historic, normally conservative, based on accounting conventions and rarely represent the only true and fair view.

Because ultimately it will be for the court to decide whether the company has reached “the end of the road”, or the point at which “the shutters should be put up”, the court acknowledged the test’s limitations as being “imprecise, judgement-based and fact-specific”. It had to determine the question with a firm eye both on commercial reality and commercial fairness.

Had this company reached “the end of the road”?

In this case, the company had substantial assets, the liabilities were likely to be met over a long period of time and there was potential for significant changes in the difference in the value of the assets and liabilities (for example as a result of future fluctuations in the exchange rates). This company would likely find itself with a net negative asset position from time to time, but the court decided that this did not mean that it had reached the point of no return or had an incurable deficiency in its assets.

What does this mean for companies today?

On a literal reading, the balance sheet test seems to capture a swathe of companies which, although trading normally, have liabilities exceeding their assets. In today’s environment, there would be many such companies, and it would be an unduly harsh (and unworkable) position if those companies were said to be insolvent and therefore liable to be wound up.

This case introduces a commercially sensible compromise that seems to protect both businesses and future and contingent creditors. If a company can currently meet its debts, and has not reached the point where future or contingent creditors cannot reasonably be expected to be paid, then merely having a balance sheet showing negative net assets is not in itself a ground for insolvency.

Click here to read the full Court of Appeal judgment of BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL PLC and others [2011] EWCA Civ 227

For more information on these issues please contact Stephen O'Mahony or your usual Lewis Silkin contact.