BNY Corporate Trustee Services Ltd & Ors v Neuberger [2013] UKSC 28

Holders of junior A3 notes argued that Eurosail, a Lehman-sponsored securitisation vehicle, was balance-sheet insolvent under section 123(2) of the Insolvency Act 1986 (incorporated into the notes' default clause). The Supreme Court dismissed their appeal, rejecting the Court of Appeal's "point of no return" test, and dismissed Eurosail's cross-appeal on the post-enforcement call option.

Facts

Eurosail-UK 2007-3BL plc (“Eurosail”) was a single purpose entity (“SPE”) established by the Lehman Brothers group, off the balance sheet of any group company, shortly before the group’s collapse. In 2007 it acquired a portfolio of mostly “non-conforming” residential mortgage loans of approximately £650m, funded by the issue on 16 July 2007 of loan notes in five classes (A to E, with sub-classes denominated in sterling, US dollars and euros) raising just under £660,000,000. The initial surplus of assets over prospective liabilities, taken at face value, was small.

BNY Corporate Trustee Services Ltd (“the Trustee”) held the notes on trust for the noteholders and adopted a neutral position, not appearing by counsel in the Supreme Court. Condition 9(a)(iii) of the conditions of issue made it an Event of Default if the issuer were “being unable to pay its debts as and when they fall due” or deemed unable to pay its debts within the meaning of section 123(1) or (2) of the Insolvency Act 1986, read as if the words “it is proved to the satisfaction of the court” did not appear in section 123(2). An Event of Default under that sub-paragraph counted only if the Trustee certified that it was, in its sole opinion, materially prejudicial to the noteholders’ interests.

The practical significance lay in the payment waterfalls. Before enforcement, under Condition 2(g) and Condition 5(b), Class A2 noteholders had priority over Class A3 noteholders for repayment of principal out of Actual Redemption Funds. After service of an Enforcement Notice, Condition 2(h) made A2 and A3 notes rank pari passu for principal. The A3 noteholders therefore had a strong commercial interest in establishing an Event of Default.

Following the Chapter 11 filings of Lehman Brothers Holdings Inc and Lehman Brothers Special Financing Inc, the currency and interest-rate swaps were terminated in November 2009, leaving Eurosail with an unadmitted claim of about US$221m in the Lehman estates and unhedged currency exposure. Sterling depreciated against the dollar and euro. Nevertheless, low interest rates produced an “excess spread” enabling Eurosail to pay interest in full on all outstanding notes. Audited accounts to 30 November 2009 showed a net liability of £74.557m. Absent an Event of Default, the outstanding notes were not finally redeemable until 2045.

Sir Andrew Morritt C ([2010] EWHC 2005 (Ch), [2011] 1 WLR 1200) and the Court of Appeal ([2011] EWCA Civ 227, [2011] 1 WLR 2524, Lord Neuberger MR, Toulson and Wilson LJJ) held that Eurosail was not to be treated as unable to pay its debts. The A3 noteholders appealed; Eurosail cross-appealed on the Post-Enforcement Call Option (“PECO”).

Issues

(1) The construction and effect of section 123(1)(e) and (2) of the 1986 Act as incorporated (with modification) into Condition 9(a)(iii), and whether on the evidence Eurosail was deemed unable to pay its debts; in particular whether the Court of Appeal was right to adopt a “point of no return” test derived from Professor Sir Roy Goode.

(2) On the cross-appeal, whether the PECO (under which all noteholders would, on request, sell their notes to OptionCo for a nominal consideration after enforcement where the proceeds proved insufficient) affected the quantification of Eurosail’s liabilities for the purposes of section 123(2) as incorporated.

Arguments

Mr Moss QC for the appellant A3 noteholders argued for a strict construction, emphasising that inability to pay debts is only a precondition to the court’s discretionary jurisdiction to wind up or make an administration order, and that the precondition should be transparent and certain. He contended that the Cork Report passage relied on by the Court of Appeal (reflecting Professor Goode’s view about an honest trader trading out of difficulty) was not in point.

Mr Dicker QC for Eurosail went more fully into the transaction documents, relying on contextual and commercial arguments that the incorporated statutory language should be moulded to take account of commercial realities, pointing to five features of the structure tending to defer Eurosail’s obligations: deferral of junior note interest under Condition 6(i) and (j); the Liquidity Facility; deferral of principal until 2045 with redemption limited to Actual Redemption Funds; the Principal Deficiency Ledger; and the PECO. On the cross-appeal he submitted that, although as a matter of contract recourse was unlimited, in commercial substance the PECO was the equivalent of a limited recourse provision, and that “legal form should not triumph over commercial substance”.

Judgment

Lord Walker gave the lead judgment, with which Lord Mance, Lord Sumption and Lord Carnwath agreed. Lord Hope agreed that the appeal should be dismissed for Lord Walker’s reasons and gave fuller reasons for dismissing the cross-appeal.

Section 123: history and effect

Lord Walker noted at the outset that “balance-sheet” insolvency is “a convenient shorthand expression”, and that there is no statutory link between section 123(2) and the Companies Act 2006 provisions on financial statements. He reviewed the legislative history from sections 79 and 80 of the Companies Act 1862 through the Companies (Consolidation) Act 1908 and the Companies Acts 1948 and 1985, and the authorities including In Re European Life Assurance Society (1869) LR 9 Eq 122, In Re Capital Annuities Ltd [1979] 1 WLR 170, In Re a Company (Bond Jewellers) [1986] BCLC 261, Byblos Bank SAL v Al-Khudhairy [1987] BCLC 232 and In Re Cheyne Finance plc (No 2) [2008] Bus LR 1562. He observed that it may be unfortunate that the extempore judgment in European Life Assurance “has come to be regarded as a leading case”, and endorsed Briggs J’s analysis in Cheyne Finance.

Despite the changes of form introduced in 1985, Lord Walker concluded that sections 123(1) and (2) made “little significant change in the law”. As to the cash-flow test:

The changes in form served, in my view, to underline that the “cash-flow” test is concerned, not simply with the petitioner’s own presently-due debt, nor only with other presently-due debt owed by the company, but also with debts falling due from time to time in the reasonably near future.

What is the reasonably near future depends on all the circumstances, especially the nature of the company’s business. Beyond that point, a cash-flow test becomes “completely speculative”, and the comparison of present assets with present and future liabilities (discounted for contingencies and deferment) “becomes the only sensible test”. But, Lord Walker added, “it is still very far from an exact test, and the burden of proof must be on the party which asserts balance-sheet insolvency”. Importantly, the deletion from Condition 9(a)(iii) of the words “it is proved to the satisfaction of the court” could not alter that allocation of the burden.

Rejection of the “point of no return” test

Lord Walker approved the more guarded formulation of Toulson LJ in the Court of Appeal, who had said (at para 119) that section 123(2) “requires the court to make a judgment 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 be able to meet those liabilities”, and that “[t]he more distant the liabilities, the harder this will be to establish”. Lord Walker said:

I agree with what Toulson LJ said here, and with great respect to Lord Neuberger MR I consider that “the point of no return” should not pass into common usage as a paraphrase of the effect of section 123(2).

Where liabilities can be deferred for over 30 years and the company is paying its debts as they fall due without any permanent increase in borrowings, “the court should proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency”.

Application to Eurosail

Lord Walker questioned aspects of the reasoning below: he noted that counsel for the A2 noteholders had not fully supported the Chancellor’s second point (conversion of future foreign currency liabilities at spot rates), and respectfully doubted the third point, since the Principal Deficiency Ledger under clause 8 of the Cash/Bond Administration Agreement involved “no more than an accountancy exercise, not … a permanent extinction of liabilities”; Condition 2(h) preserved full recourse post-enforcement.

Nevertheless, the Court of Appeal would have reached the same conclusion without the “point of no return” test, and Lord Walker reached the same result himself. Eurosail operated in a “closed system”, its position depending on three imponderables outside its control: currency movements, interest rates, and the performance of the UK economy and housing market. The documentation contained several mechanisms deferring principal liabilities to 2045. Accordingly:

The movements of currencies and interest rates in the meantime, if not entirely speculative, are incapable of prediction with any confidence. The court cannot be satisfied that there will eventually be a deficiency.

The cross-appeal: the PECO

Although the cross-appeal only arose if the appeal succeeded, both Lord Walker and Lord Hope addressed it because, as Lord Hope noted, PECOs are widely used and the issue was said to be of importance to the securitisation market. Lord Hope held that the PECO had no effect on the quantification of Eurosail’s liabilities. Eurosail accepted that as a matter of contract the liabilities were unlimited in recourse but relied on commercial substance. Lord Hope rejected the distinction:

I do not think that it is possible to distinguish the intended commercial effect of these provisions from their legal effect in this way.

He agreed with the Chancellor’s analysis that, unless and until the option holder released the issuer, its liability was unaffected, and with Lord Neuberger MR’s fuller reasons based on the Prospectus, clause 6.7 of the Deed of Charge, Condition 2(h)’s express full recourse provision, and Condition 9(a)(iii) itself. Applying Rainy Sky SA v Kookmin Bank [2011] UKSC 50, [2011] 1 WLR 2900, commercial good sense has a role where provisions are open to different interpretations, but here the meaning “is not open to doubt”; its role is “to find out what the parties meant when they entered into the arrangement, not to replace it with something which is not to be found in the language of the documents at all”.

Lord Walker, dismissing the cross-appeal for the reasons given below, also observed (obiter) that Mr Dicker’s contextual arguments “would have encountered serious difficulties” in the light of Enviroco Ltd v Farstad Supply A/S [2011] UKSC 16, [2011] 1 WLR 921, and that where documents are of such complexity the court might conclude that the draftsman had failed to grasp all the implications, “and that it was not for the court to rewrite the documents for the parties”.

Implications

The decision is the leading modern authority on section 123 of the 1986 Act. It establishes that section 123(1)(e) looks not only to presently due debts but to debts falling due in the “reasonably near future”, the length of which is fact-sensitive, and that section 123(2) takes over where cash-flow analysis becomes speculative. Crucially, the Supreme Court disapproved the “point of no return” formulation as a paraphrase of section 123(2), treating it as useful only as illuminating the subsection’s purpose, and endorsed Toulson LJ’s reasonable expectation formulation. The burden lies on the party asserting balance-sheet insolvency, on the balance of probabilities, and contractual removal of the words “proved to the satisfaction of the court” does not shift it.

For structured finance practitioners, two points matter. First, where long-dated liabilities are deferred by the transaction documents and the issuer is meeting its obligations, courts will be very cautious before finding balance-sheet insolvency; a snapshot deficiency in audited accounts, or an adverse spot exchange rate applied to liabilities decades away, will rarely suffice. Second, a PECO does not operate as a limited recourse clause: for the purpose of a default provision incorporating section 123(2), liabilities are quantified on a full recourse basis notwithstanding the option’s economic effect. Drafters who wish to limit liabilities must do so expressly in the contractual language.

The decision is fact-sensitive and does not lay down an exact test. Lord Walker emphasised that whether balance-sheet insolvency is established “must depend on the available evidence as to the circumstances of the particular case”, and that Eurosail’s “closed system” was quite unlike a normal trading company. The court expressly did not determine whether Eurosail would ultimately prove solvent, noting that the question might not be finally determined until much nearer 2045. Nor did the court decide how the Trustee should exercise its discretion in the event of a conflict between A2 and A3 noteholders, no evidence or submissions having been presented on whether the thresholds for compelling service of an Enforcement Notice could be met.

Verdict: The appeal by the A3 Noteholders was dismissed, the Supreme Court holding that it could not be satisfied that Eurosail was unable to pay its debts within the meaning of section 123(1) or (2) of the Insolvency Act 1986 as incorporated into Condition 9(a)(iii), although the Court of Appeal’s “point of no return” test was disapproved. Eurosail’s cross-appeal on the Post-Enforcement Call Option was also dismissed, the PECO having no effect on the quantification of the issuer’s liabilities.

Source: BNY Corporate Trustee Services Ltd & Ors v Neuberger [2013] UKSC 28