Events of default? When is a company really balance sheet insolvent?

Meet the team:

  • Tel: +44 (0) 161 829 2599
berg logo
Share this post: linkedin Twitter facebookshare Email
Posted in:Banking and Finance, Corporate and Commercial|June 10, 2013 | Join the mailing list

Last month the Supreme Court handed down judgment in the case of BNY Corporate Trustee Services Limited v Eurosail – UK 2007 – 3BL PLC ("the Eurosail Case"). The impact of this decision requires serious consideration in relation to drafting
contracts with an event of default clause.

Contracts containing event of default provisions are varied and apply to a number of transactions including but not limited to property contracts, leases, commercial agreements, joint venture agreements, agency and distribution agreements,
franchise agreements, and financing documents. Traditionally an event of default may include if a company was deemed ‘balance sheet insolvent’ under section 123 of the Insolvency Act 1986. However, this definition needs to be reconsidered in light of the Eurosail
Case.

Background

Sub-section (1) of s123 defines insolvency of a company as that company being unable to meet its debts as they fall due. Often known as cash-flow insolvency, this definition has not been affected by the Eurosail case.

Sub-section (2) of s123 defines insolvency of a company as occurring where the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities. Commonly known as balance
sheet insolvency the Eurosail Case provides guidance on how we should asses contingent or prospective liabilities.

The case

Eurosail had issued debt by way of a variety of loan notes offering different classes various rights. The notes were due for repayment in 2045 and the issue affecting the balance sheet solvency of Eurosail was when the holders of such rights
were able to demand repayment.

Eurosail had entered into swap agreements with two of Lehman Brothers’ companies, and when Lehman became insolvent Eurosail’s net asset position deteriorated. The holders of one series of loan notes argued that this worsening of the net asset
position had resulted in Eurosail becoming balance sheet insolvent. However, for this test this would include repayment of the loan notes in full to be considered now.

Eurosail and the other loan note holders objected to this on two main grounds.

1. Eurosail was able to meet its debts as they fell due (including interest on the loan notes), accordingly the company was not cash-flow insolvent; and
2. the liability to repay the principal sum of the loan notes would not (excluding an event of default) arise until 2045 and should therefore not be taken into account as a contingent or prospective liability for the present state of the balance sheet.

The Supreme Court commented that ‘A company in the situation described in subsection (2) [s123 of the Insolvency Act 1986] is often said to be "balance sheet" insolvent, but that expression is not to be taken literally. It is a convenient
shorthand expression, but a company’s statutory balance sheet, properly prepared in accordance with the requirements of company law, may omit some contingent assets or some contingent liabilities. There is no statutory provision which links section 123(2)
of the 1986 Act to the detailed provisions of the Companies Act 2006 as to the form and contents of a company’s financial statements.’ Based on this reasoning it was held that Eurosail’s ability to pay all its debts, present or future, may not be finally determined
until much closer to the date of maturity of the loan notes. The Supreme Court also commented that as the events which affected Eurosail affected the whole market there could be significant change between now and 2045 meaning the Court could not be satisfied
that Eurosail would be unable to pay the debts in 2045.

Conclusion

The balance sheet test under s.123 has become more circumstance based as a result of the Eurosail Case. In consequence, circumstances which, pre-Eurosail, could have resulted in balance sheet insolvency, triggering an event of default, may
no longer have that effect. Therefore is an event of default clause is being drafted to include the traditional notion of the balance sheet test it may no longer be appropriate to rely on the wording of s123(2).

Key contracts should be reconsidered to ensure that they continue to provide the protection originally intended. If they merely rely on the wording of s.123 then it is worthwhile a company redrafting for more specific wording to ensure that
the concept of balance sheet solvency represents the parties’ intentions.

Should you have any concerns regarding your existing contracts, or seek guidance and advice in relation to drafting new commercial contracts please contact Stephen Foster, Head of Corporate at
stephenf@berg.co.uk or by telephoning 0161 833 9211.

The information and opinions contained in this article are not intended to be comprehensive or to provide legal advice.  No responsibility for article’s accuracy or correctness is assumed by Berg or any of its partners or employees.  Professional
legal advice should be obtained before taking, or refraining from taking, any action as a result of the contents of this article.

Join our mailing list

More from berg

Testimonial

 

"berg achieved exactly the right balance, protecting revenue streams and safeguarding against risk while maintaining our commercial and competitive approach"

Generis Technology Limited