The concept of insolvency is at the core of every insolvency regime. It is commonly employed as a trigger for different sorts of rules, such as those that discipline the conditions for filing winding up petitions, as well transaction avoidance claims. Thus, certainty and predictability are particularly important in this field, as doubts regarding whether or not a particular firm is insolvent can potentially have significant impacts both on the availability and cost of credit. This is due to the fact that creditors1 facing relevant uncertainties can be expected to extend less credit and/or do it at a higher cost.
The Supreme Court of the United Kingdom (the “Supreme Court”) has recently handed down an important judgment in the so-called Eurosail case,2 which involved important discussions concerning the concept of insolvency. I suggest that such judgment illustrates some of the difficulties in setting and applying precise and predictable tests for determining whether firms are insolvent. Particularly, in the Eurosail case the Supreme Court has made important assessments regarding the two main tests set forth under English law for determining whether companies are unable to pay their debts, namely the cash flow3 and the balance sheet4 tests.
Among other important issues, in the Eurosail case the Supreme Court was faced with the difficult task of determining whether Eurosail-UK 2007-3BL plc (“Eurosail”), a single purpose investment vehicle, was balance-sheet insolvent for the purposes of the Insolvency Act 1986 (“IA 1986”) section 123(2).
In 2007, Eurosail acquired a portfolio of mortgage-backed loans related to real estate properties located in the United Kingdom. Said company issued and sold interest-bearing notes of different classes (the “Notes”), some of which were repayable in 2027 and the remaining in 2045 at latest. BNY Corporate Trustee Services Ltd (the “Trustee”), was designatedas the trustee of the rights of the noteholders.
Due to the characteristics of the Notes issuance, Eurosail was exposed to currency and interest risks. For such reason, the company entered into hedging agreements with a Lehman Brothers company, LBSF, whose liabilities were guaranteed by another company pertaining to the same group, LBHI.
The terms and conditions of the Notes provided that on the occurrence of certain events classified as ‘Events of Default’, the Trustee had to serve a written enforcement notice to Eurosail declaring the Notes immediately due and repayable. The list of Events of Default included the case of Eurosail being unable to pay its debts as and when they fall due or within the meaning of IA 1986 section 123(1) or (2).
As per the terms of the Notes, the service of an enforcement notice by the Trustee had the effect of changing the regime of priorities of payment among the noteholders. Accordingly, since the pre-enforcement priority regime was different from the one taking place post-enforcement, the service of the referred notice had significant impacts on the rights of the different classes of Notes.
In 2008, due to the collapse of the Lehman Brothers group and the consequent termination of the hedging agreements, Eurosail became exposed to adverse changes in interest and currency rates. The poor performance of mortgage markets also negatively affected the company. As a consequence, in such year Eurosail’s accounts began to evidence a substantia lnet asset deficiency.
In such context, some noteholders benefiting from the service of the enforcement notice contended that an “Event of Default” had arisen, alleging that Eurosail supposedly became ‘unable to pay its debts’ within the meaning of the IA 1986 s.123(2).
In addressing such issue, the Court of Appeal rejected the view that the test set forth in section 123(2) consisted in a mere exercise of verifying whether liabilities of a company exceed its assets.5 In fact, Lord Neuberger MR concluded that a company should be considered to be unable to pay its debts for the purposes of the referred provision when it reaches the point of no return.6 Such test became know as the ‘point of no return test’.
III. Supreme Court Judgment
The Supreme Court dismissed the appeal, however for different reasons as were given by the Court of Appeal. The Supreme Court affirmed the decision that the ability of a company to meet its liabilities was to be determined on the balance of probabilities with the burden of proof on the party asserting ‘balance-sheet insolvency’. Based on such understanding, the Supreme Court held that it was not possible to reach the conclusion that Eurosail was indeed unable to pay its debts within the meaning of IA 1986 s.123(2).
Regarding the balance sheet insolvency test, the Supreme Court concluded that the ‘point of no return test’, as employed by the Court of Appeal, was incorrect and, therefore, should not pass into common usage as a paraphrase of the effect of section 123(2).7
Nonetheless, the Supreme Court asserted that the Court of Appeal would have reached the same conclusion without reference to any ‘point of no return test’.8 Particularly, the Supreme Court concluded that Eurosail’s ability or inability to pay its debts could not be finally determined until much closer to 2045. One of the main drivers for such conclusion was the premise that the movements of currencies and interest rates before the maturity of the Notes, if not entirely speculative, are incapable of prediction with confidence.
In what concerns the cash flow test, the Supreme Court concluded that such test is not exclusively concerned with presently-due debts, but also with debts falling due in the reasonably near future. According to the decision in question, what is the ‘reasonably near future’, will depend on case-specific circumstances, but especially on the nature of the debtor’s business. Hence, according to the conclusion reached by the Supreme Court, once it is necessaryto assess the reasonably near future, any attempt to apply a cash-flow test will become completely speculative. As a consequence, the comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test.9
As mentioned, the Supreme Court judgment in Eurosail illustrates how difficult it is to set and apply precise and predictable tests for determining whether firms are insolvent. The lack of certainty and predictability are particular problematic from a policy perspective, as such factors contribute to increasing the cost of capital and/or decreasing the availability of credit.
In Eurosail, the Supreme Court appears to have relied on a two-tier exercise while applying the balance sheet insolvency test set forth in IA 1986 s.123(2). Firstly, it considered whether or not there was a net asset deficiency. Subsequently, it assessed whether such deficiency would exist at the time of the future payments. Accordingly, it could be said that the Supreme Court rejected to apply the balance sheet test on a snap-shot basis, according to which assets would be compared against liabilities at a particular date.
The Supreme Court appears to have concluded that it was too early to tell if the balance sheet test was satisfied or not by Eurosail. In this sense, the Court seems to have concluded that it was not demonstrated that Eurosail was not going to be able to pay its debts in the future, closer to the date of maturity of the Notes.
To assess whether such approach is desirable, it is worth taking into account the rationales underlying the balance sheet test. According to a first line of thought, it should not be sufficient for the company to be able to meet its current obligations in case its assets are insufficient to cover its liabilities. Under such perspective, if the cash flow test were the only relevant insolvency test, then current and short-term creditors would in effect be paid first, thus at the expense of contingent and prospective creditors.10
Nonetheless, there are compelling arguments against such rationale. It could be argued that voluntary contingent and prospective creditors are able to adjust the terms and conditions of their claims in order not to be subject to exploitation. As an example, said creditors can often obtain protection by means of (i) contractual provisions (e.g. covenants and acceleration provisions) that enable earlier enforcement of claims (i.e. concomitantly with present creditors), (ii) diversification, as well as (iii) by adjusting prices.
At first blush, assuming that adjusting creditors are able to protect themselves effectively, it could be argued that the first rationale would be more compelling in what regards involuntary contingent and prospective creditors, which cannot adjust the terms of their credits. However, there are two counter arguments that make such argument less appealing. Firstly, involuntary creditors can free ride on monitoring efforts by voluntary creditors, as well in most (although not all) benefits related to the contractual provisions bargained for by said creditors.11 Secondly, there might be relatively less intrusive and more efficient mechanisms to protect involuntary creditors, such as mandatory insurance schemes and priorities rules regarding the ranking of claims in insolvency.
There is a second theoretical rationale for the balance sheet test, which seems to be more compelling than the first one. Under such approach, it would be sensible to consider a company to be insolvent when liabilities exceed assets, as in such case creditors (rather than shareholders) would, from an economic perspective, have the residual interest in the firm’s success.12 The reason for it is that, in principle, in case a company with negative net assets is liquidated, shareholders would not be entitled to receive any amounts, whereas creditors would receive liquidation proceeds up to the amount of their claims. Thus, in economic terms, where a company has negative net assets, creditors become the residual claimants, and, for such reason, in theory face correct incentives to maximise firm value.13 Accordingly, in theory it would be sensible to shift control rights of companies with negative net assets from shareholders to creditors, which would face adequate incentives to make value maximising decisions.14
Nonetheless, although the balance sheet test is sound in theory, the Eurosail case indicates that it is very difficult to demonstrate the satisfaction of such test in practice. One of the key reasons for such practical difficulty is that applying such test in concrete cases frequently requires complex and intricate valuation exercises, which courts are not often in a good position to perform. Such complexities generate uncertainties and hinder predictability of decisions, which could be seen as detrimental from a policy perspective if one assumes that the role of corporate insolvency law is to decrease the cost of credit.
Accordingly, it could be argued that the Supreme Court decision may provide an example of how the balance sheet test is not a practicable trigger for initiating winding up proceedings. There are other evidences that reinforce such conclusion. Particularly, it can be suggested that the fact that very few winding up petitions are filed under IA 1986 s.123(2) (i.e. the balance sheet test) might be considered as another evidence that such test is almost unworkable in practice.
The implications of the Supreme Court’s decision in Eurosail are not circumscribed to cases involving the establishment of jurisdiction for winding up petitions. In fact, the judgement in question has particular relevance for the application of rules governing avoidance of transactions, such astransactions at an undervalue (IA 1986 s.238) and preference claims (IA 1986 s.239), as the application of both rules require the company to be unable to pay its debts at the relevant time, within meaning of IA 1986 s.123.15 Although this matter was raised in Eurosail, the Supreme Court did not seen to have addressed it.
It could be argued that it is relatively easier to apply the balance sheet test retrospectively on a snap shot basis, as opposed to the two-tier test adopted by the Supreme Court. Hence, an apparent shift away from the snap shot approach by the Supreme Court in Eurosail contributes to make it even more difficult to demonstrate that a particular company was unable to pay its debts at the time that the transaction occurred. As a result, it is plausible to say that such decision makes it more difficult for legal advisors to advise liquidators about whether or not they should file transaction avoidance claims. Another undesirable consequenceis that the Eurosail decision may have the effect of rendering it more difficult for directors of distressed companies to anticipate the consequences of decisions made in times of financial difficulties, as well as for counterparties to assess the risk of the transactions being set aside.
Moreover, it could be said that the Supreme Court decision in Eurosail has the potential to shrink the so-called ‘twilight period’, which is the period between the factual insolvency and the initiation of formal insolvency proceedings. As a consequence, this may hinder the application of transaction avoidance provisions, as it reduces the range of time during which transactions may be set aside. Therefore, the decision has a negative impact on the liquidators’ ability to set aside pre-insolvency transactions. If one believes that transaction avoidance provisions are sound, then the Eurosail decision might have a negative impact form a policy perspective.
In conclusion, the Supreme Court decision in Eurosail seems to have raised more questions than provided answers.The case illustrates some of the difficulties involved in applying the balance sheet test to concrete scenarios. It could be argued that the decision in question has contributed to render it more difficult to succeed in filing winding up petitions under IA 1986 s.123(2). Instead of accepting a snap shot approach, the Supreme Court firstly required identifying a net asset deficiency and then assessing whether such deficiency will exist at the time of future payments. The decision may also have impacts related to transaction avoidance claims. The test employed by the Supreme Court is not simple to be applied retrospectively. Besides, it contributes to reduce the range of time during which transactions may be set aside. As a consequence, it is possible to expect even less transactions at an undervalue and preference claims being brought.
It is noteworthy that not all creditors are in a position to adjust their claims to the risks involved in specific transactions. Some creditors are involuntary, such as tort victims and the government as a creditor of tax debts, which prevents them from adjusting their claims and protecting themselves by contract, diversification, price and other means of protection. The terms ‘involuntary creditors’ and ‘non-adjusting creditors’ will be used interchangeably throughout this article.
BNY Corporate Trustee Services Ltd & Ors v Eurosail-UK 2007- 3BL plc  UKSC 28.
The cash flow test is set forth in section 123(1)(e) of the Insolvency Act 1986, according to which “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 balance sheet test is set forth in section 123(2) of the Insolvency Act 1986, according to which “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”.
Cf.  EWCA Civ 227, para. 44.
Cf.  EWCA Civ 227, para. 61.
Cf.  UKSC 28, para. 42.
Cf.  UKSC 28, para. 45.
Cf.  UKSC 28, para. 37.
Goode, Roy M., Principles of Corporate Insolvency Law, 4th ed., Sweet & Maxwell, 2011, p. 114.
It is noteworthy that non-adjusting creditors are not fully able to free ride on efforts made by adjusting creditors. One of the key reasons for this is that the later creditors also obtain protection by means of diversification and by adjusting the price of credit. Such mechanisms do not enhance the protection of involuntary creditors.
Black, Bernard S., Corporate Law and Residual Claimants, Stanford Law and Economics, Olin Working Paper No. 217, 2001.
Easterbrook & Fischel explain that “when the firm is in distress, the shareholders’ claim goes under water, they lose the appropriate incentives to maximize [firm value] on the margin. Other groups, such […] creditors, then receive [decision rights] until their claims are satisfied”. In Easterbrook Frank H. & Fischel, Daniel R., The Economic Structure of Corporate Law, Harvard University Press, 1991, p. 69.
Considering the scope of this analysis, differences between incentives faced by different kinds of creditors are not being taken into account.
Cf. IA 1986 s.240.