The statutory gateway to an insolvency process under U.K. law hinges on the definition of insolvency in the Insolvency Act 1986 (IA 1986). However, a 2013 decision by the Supreme Court of the United Kingdom has created ambiguity over the definition and has cast significant doubt on whether creditors can continue using a long-standing test to determine whether a company is insolvent.
Traditional UK Insolvency Definitions
In the U.K., a company may be wound up if one of two statutory provisions are proved to the satisfaction of a court:
- 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).
Eurosail is a special purpose vehicle that was formed by Lehman Brothers in 2007. It acquired sterling-denominated mortgage-backed loans using the proceeds of long-term notes denominated in sterling, U.S. dollars and euros. The rights of the various noteholder classes, including their relative priority, were set out in the finance documents. Such provisions sometimes are known as the payment or priority “waterfall”: As cash becomes available, it flows down to meet payment obligations, starting with the most senior noteholders and ending with the most junior class.
Lehman’s collapse in 2008 caused adverse movements in foreign exchange rates after currency hedging arrangements were terminated between Eurosail and Lehman. This resulted in a slowdown in the rate at which Eurosail was repaying the non-sterling notes. One class of noteholders wanted to trigger a contractual change to the payment waterfall to improve the speed at which they would have been repaid (albeit at the expense of other noteholders). The finance documents provided that either cash-flow or balance-sheet insolvency was an event of default. The dissatisfied noteholder group alleged that Eurosail was insolvent on a balance-sheet basis only as it was patently able to pay its obligations as they fell due. The latest financial statements of Eurosail showed net liabilities of about £75 million and assets exceeding £600 million, and the applicant noteholders relied on this as clear evidence that the balance-sheet test had been triggered.
The Court’s Decision
Last year, the Supreme Court unanimously held that the noteholders had failed to establish that Eurosail was insolvent on a balance-sheet basis. A petitioner has to establish to the satisfaction of the court that, on the balance of probabilities, a company has insufficient assets to be able to meet all its liabilities, including prospective and contingent liabilities. Eurosail was a structured finance vehicle with income and payment obligations stretching out for 30 years. In such a case, a court should be very cautious in finding balance-sheet insolvency when the company was meeting current liabilities as they fell due. The noteholders faced an even greater hurdle in making their case, as there are inherent uncertainties to determining the levels of future interest and foreign exchange rates over an extremely long period of time.
The Court also held that the assessment of whether a company is balance-sheet insolvent may differ from a company’s balance sheet prepared in accordance with U.K. companies legislation. In particular, the assessment of future and contingent liabilities may be different from the standard company accounting approach. Significantly and unfortunately, the Court offered no guidance on how this assessment should be conducted.
A hostile creditor rarely has access to anything other than a company’s publicly available financial information. On the back of this judgment and absent extreme facts, it will be extremely challenging for a creditor to establish balance-sheet insolvency, and it remains for future cases to cast meaningful light on what valuation approach or approaches are appropriate. In the meantime, a prudent lender may wish to negotiate a balance-sheet event of default measurable by reference to the accounting standards ordinarily applicable to the borrower rather than the test set out in the Insolvency Act 1986.
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.
* This article appeared in the firm's sixth annual edition of Insights on January 16, 2014.