BNY Corporate Trustee Services Limited and others v Neuberger Berman Europe Ltd (on behalf of Sealink Funding Ltd) and others

before

Lord Hope, Deputy President
Lord Walker
Lord Mance
Lord Sumption
Lord Carnwath

JUDGMENT GIVEN ON

9 May 2013

Heard on 25 and 26 February 2013

Appellant/Cross-respondents Gabriel Moss QC Richard Fisher (Instructed by Sidley Austin LLP)	2nd Respondent/Cross-appellant Robin Dicker QC Jeremy Goldring (Instructed by Berwin Leighton Paisner LLP )
	1st Respondent David Allison (Instructed by Allen & Overy LLP)

LORD WALKER (with whom Lord Mance, Lord Sumption and Lord Carnwath agree)

Introduction

1. Sections (1) and (2) of section 123 of the Insol vency Act 1986 ( “the 1986 Act”) provide as follows:

“(1) A company is deemed unable to pay its debts –

1. [non-c ompliance with a st atutory dem and for a debt exceeding £750 presently due]

2. to (d) [unsatisfied execu tion on j udgment de bt in terms appropriate to England and Wa les, Scotland and Northern Ireland respectively]

(e) if it is proved to the sa tisfaction of the court that the company is unable to pay its debts as they fall due.

(2) A company is also deem ed unable to pa y its debts if it is pr oved 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.”

A company in the situation described in su bsection (1)(e) is often said to be “cash- flow” insolvent. A company in the situation described in subsection (2) is often said to be “balance-sheet” insolvent, but that expression is not to be taken literally. It is a convenient shor thand e xpression, but a com pany’s statutory balance s heet, properly prepared in acco rdance with the re quirements of company law, may omit some contingent assets or som e conti ngent liabilities. There is no statutory provision which links section 123(2) of t he 1986 Act to the detailed provisions of the Companies Act 2006 as to t he form and contents of a com pany’s fina ncial statements. This appeal is concerned with the construc tion and effect of section 123(1)(e) and (2) as incorporated into the documentation of an issue of loan notes.

2. The statutory provisions were incorporated, with some small modifications, into the conditions applicable to loan notes issu ed in the course of a securitisation transaction comprising a por tfolio of non-conf orming mortgage loans secur ed on residential property in the United Kingdo m. The issuer is Eurosail-UK 2007-3BL plc (“Eurosail”), one of many similar single purpose entities (“SPEs”) set up by the Lehman B rothers group ( but off the ba lance sheet of a ny of that gr oup’s companies) not long before its collapse. Eurosail is the principal respondent to this appeal, and it has a cross-appeal on a subs idiary issue. The other respondent appearing before this court, BNY Corporate Trustee Services Ltd (“the Trustee”) is part of the BNY Mellon Group. It is the trustee for the hol ders (“Noteholders”) of loan notes of various classes issued by Eurosail. It has adopted a neutral attitude in the proceedings (as explained in its writte n case), and has not a ppeared by counsel before this court. But it will, in the ev ent that the appeal succeeds and the cross- appeal fails, have an im portant judgm ent to make as to material prejudice to the Noteholders’ interests.

3. In 2007 Eurosail (described in t he documentation as “the Issuer”) acquired a portfolio of m ortgage loans, s ecured on residential property i n Engla nd and Scotland and denom inated in sterling, to the principa l am ount of approxim ately

£650m. M ost of the m ortgages were rega rded as “non-conform ing” in that they did not m eet the lending re quirements of buil ding societies and banks. This purchase was funde d by t he issue on 16 Jul y 2007 of l oan notes in five principal classes (A, B, C, D and E) comprising 14 different subclasses, some denom inated in sterling, some in US dollars and some in euros. In the designation of the classes “a” indicated that the loan was denominated in euros, “b” US dollars and “c” pounds sterling. The senior (class A) notes were divided into thr ee sub-classes, denominated in one of the three currencies, designated and issued as follows:

A1b	US$200,000,000
A1c	£102,500,000
A2a	€ 64,500,000
A2b	US$100,000,000
A2c	£ 63,000,000
A3a	€215,000,000
A3c	£ 64,500,000

The B, C, D and E Notes wer e issued in sm aller am ounts, wi th variations in currency but no subclasses having differe nt priorities as between themselves. There were also some notes designated as ETc “revenue-back ed” notes. The total

sum raised was just under £660 ,000,000. After payment of costs and expenses of the issue the initial s urplus of assets ove r pros pective liabilities (if taken at face value) was quite small.

4. The provisions of section 123(1) and (2 ) of the 1986 Act are incorporated into an important provision in the co nditions of issue of the Notes (“the Conditions”). Conditi on 9(a) (events of de fault) provides that the Trustee may on the occurrence of any of five specified ev ents (an “Event of De fault”) serve on Eurosail a written notice (an “Enforcement No tice”) declaring the Notes to be due and repayable. In some circumstances the Trustee is obliged to serve such a notice. In the absence of an Event of Default the A1 Notes were repayable in 2027 at latest (in fact they have already been repaid, as have the revenue -backed notes). All the other Notes are repayable in 2045 at latest.

5. The Events of Default include (Condition 9(a)(iii)):

“The Issuer, otherwis e than for th e purposes of suc h amalgamation or reconstruction as is referred to in sub-paragraph (iv) below, ceasing or, through or c onsequent upon an official action of the Board of Directors of the Issuer, threatens to cease to carry on business or a substantial part of its business or being unable t o pay its debts as and when they fall due or, within the me aning of section 123(1) or (2) (as if the words ‘it is proved to the satisfaction of the court’ did not appear in section 123(2) of the Insol vency Act 19 86 (as that section m ay be am ended from time to time ), being deem ed unable to pay its debts…”

Under a proviso to Condition 9(a), an occurrence falling within sub-paragraph (iii) counts as an Event of Defau lt only if the Trustee certifie s to Eurosail that it is, in the Truste e’s sole opi nion, materially prejudicial to the interests of the Noteholders.

6. The service of an Enfo rcement Notice w ould ha ve im mediate and far- reaching consequences for all the Noteholders (o ther than the A1 and ETc Noteholders, whose Notes ha ve already b een fully redeemed). As described in more detail below, an En forcement Notice shifts th eir rights from the regime prescribed in Condition 2(g) (priority of paymen ts prior to enforcement) to the regime prescribed in Condition 2(h) (pri ority of pa yments post-enforcem ent). Under the latter regime Noteholders of Class A3 (“A3 Note holders”) rank pari passu with Noteholders of Cla ss A2 (“A2 Noteholders”) for repayment of principal. That is in contrast with the pres ent regim e, under w hich A 2 and A3 Noteholders rank par i passu for interest paym ents (clause 2(g)(vi)) but A2

Noteholders have priority over A3 N oteholders in receiving repaym ents of principal out of funds representing pri ncipal sums received on the redem ption of mortgages in the portfolio (t hose funds being included in the definition of “A ctual Redemption Funds” in the preamble to the Conditions): Cond ition 5(b)(i)(2) and (3).

7. It is in these circumstan ces that the construction of se ction 123( 2) of the 1986 Act, as incorporated into Condition 9(a)(iii), has assumed such importance. Eurosail, together with those of the A2 Note holders who a ppeared below, succeeded before 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. The Court of A ppeal considered that section 123(2) should be interpreted br oadly and in line with standards of commercial probity:

“A balance has to be draw n betw een t he r ight of a n honest and prudent businessm an, who is prepared to work hard, to continue to trade out of his difficulties if he ca n genuinely see a light at the end of the tunnel, and t he corresponding obl igation to ‘put up t he shutters’, when, by c ontinuing to trade, he would be doing so at the expense of his creditors and in disregard of t hose business considerations which a reasonable businessman is expected to observe.”

(That is a quotation from paragraph 216 of the Report of the Review Committee on Insolvency Law and Practice (1982) ( Cmnd 8558), better know n as the C ork Report, reflecting the view of Professor Goode; this passage is quoted in para 54 of the judgment of Lor d Neuberger MR i n the Court of A ppeal). The appellant A3 Noteholders say that this passage is not in point. The y have ar gued for a m uch stricter construction. They have emphasised that a co mpany’s inability to pay its debts is no m ore than a precondition to th e exercise of the court’s jurisdiction, which is discretionary, to make a winding up order or an administration order. The precondition to be satisfied shoul d be, they have argue d, transparent and certain, leaving scope for the exercise of discretion on the hearing of the petition. There has also been argument as to whet her the statutory text (as incor porated in an amended form, and al so allowing for possi ble future legislativ e amendment) must bear the same meaning as it would in act ual winding-up proceedings, or whether it can and should, as incorporated, take account of the commercial context of the Conditions.

8. Those, in outline summary, are the pos itions of the oppos ing parties on the appeal. The cross-appeal, which is releva nt onl y if the appeal is successful, is concerned with the so-called Post-Enf orcement Call Option (“PECO”) which is a subsidiary (but technically important) part of the securitisation transaction.
9. Before going further into the complexities of the appeal I would comment that the im age invoked by Pr ofessor Go ode of an honest and prude nt trader working ha rd to t urn his bu siness round relates, as wa s pointed out by Mr Moss QC for the appellants, to the law of insolvency as it applies to individuals. Even if translated into corporate te rms, it has very little bear ing on the situation in which Eurosail now finds itself. Its present financial position and future prospects are not matters for which Eurosail and its managers merit either praise or criticism, since those matters are almost entirely out of their contr ol. They depend on three imponderables: first, (since the currenc y a nd interest-rate hedging arrangem ents with the Lehman Brothers group have faile d, leaving Eurosail wi th a claim in its insolvency) the m ovements of the US dollar and the eu ro relative to the pound sterling; secondly, m ovements i n LI BOR or equivale nt interest rates on loans denominated in those t hree currencies; and thirdly, the performan ce of the United Kingdom econom y in ge neral, and th e United Ki ngdom residential pr operty market in particular, as influencing the performance of the mortgage portfolio.

The transaction documents

10. The legal documents rela ting to the securitisation issue are, as Lord Neuberger MR put it, regrettably and fo rbiddingly vol uminous. A part from the Conditions themselves there was a formal trust deed made between the Trustee and Eurosail, a Liquidity Facility Agreem ent, currency swaps agreements, a Fixed/Floating Swap Agreement, a BBR Sw ap Agree ment and other agreements relating to administrative matters (there is a full list of “transaction documents” in the definiti on of t hat expression in t he pream ble to the C onditions). Se veral expressions used i n the Conditi ons invol ve a paperchase to othe r doc uments in order to find their definitions. Mr Moss opene d the docum ents very lightly, moving rapidly from Condition 9(a)(iii) to concentrate his submissions on the construction of section 123( 1) and ( 2) of the 1986 Act. Mr Dicker QC (for Eurosail) went into the Cond itions more fully to pave the way f or his cont extual arguments. Without pre-judging those argu ments I think it is necessary, if only in order to appreciate the consequences of the opposing arguments, to have an outline understanding of how the SPE (which counsel concurred in describing as a “closed system” or “wrapper”) operated before the collapse of Lehman Brothers, of how it operates now (after the collapse of Lehm an Brothers but before any Enf orcement Notice), and of how it would operate after the service of an Enforcement Notice.

11. Interest is paya ble on all unrede emed Notes quarterly in arrears, the first payment having been made on 13 Septem ber 2007. The annual rate of interest is linked to LIBOR or its do llar or euro equivalents (Condition 4(c)(i)), exceeding that rate by a margin (the “Relevant Margin” as defi ned in t he pream ble) which varies from 0.07% for A1b Notes to 4% for E Notes.
12. Mortgage interest received by Eur osail (the principa l com ponent in the “Available Reve nue Fund”) cascades dow n the m etaphorical wat erfall set out in the 24 s ub-paragraphs of C ondition 2( g) (pri ority of paym ents prior to enforcement). The first claims on the income stream are for remuneration, charges and expenses; then (sub-pa ragraph (iv)) sums due to the Liquidity Facility Provider, and (s ub-paragraph (v), but only until the collapse of Lehman Brothers) sums payable under or in connection with the Fixed/Floating Swap Agreement and the BBR Swap Agreement (but not a ny currency swa ps). Paym ents to cur rency swaps counterparties were li nked to interest paym ents to particular classes of Noteholders, so that paym ents to counterparties in resp ect of A Not eholders come into the provision for payment of interest to those No teholders, which is made pari passu as between all the A sub-classes (C ondition 2(g)(vi)). The next priority (Condition 2(g)(vii)) was for payment-off of any A Principal Deficiency (another expression defined i n the preamble), but in practice such a defi ciency could arise only if all the junior cl asses of Notes had become valueless. Next in the waterfall come sim ilar groups of pr ovisions for payment of interest, sums due to the currency swaps counterparties (and any B Principal Defi ciency) in respect of B Notes (Condition 2(g)(viii) and (ix)) and so on for all the other classes (Condition 2(g)(x) to (xv)).

13. On 15 Se ptember 2008 Le hman Brot hers Holdings Inc (“LBHI”), the guarantor of the swa ps counter party, Le hman Brot hers Special Fina ncing Ltd (“LBSF”) filed for C hapter 11 ba nkruptcy, as did LB SF on 3 October 2008. The swaps were terminated on 13 November 200 9. Eurosail has made a claim against LBHI’s and LBSF’s bankrupt estates for about $221,000 ,000. At the time of the hearings below, the claim had not been admitted and no distribution has been made in respect of it. During the last three years sterling has depreciated significantly against both the euro and the dollar, but th e prevailing low level of interest rates has resulte d in a surplus ( “excess spread ”) of mortga ge interest received by Eurosail, which has enabled it to continue to pay in full the interest on all the outstanding Notes of every class.

14. In the meantime, both before and afte r the collapse of Lehm an Brothers, Eurosail received principal su ms from time to time as principal secured by the mortgages was repaid, either by way of pa rtial or total rede mption by mortgagors, or by enforcement of the security agains t mortgagors who were in default. These sums have been and are at present a pplied under Condition 5(b)(i) as “Actual Redemption Funds”, on each date for payment of interest, in repaying the principal of the Notes in the order of priority A1 (now fully repa id), A2, A3, B, and so on. There is a proviso to Cond ition 5(b) under which t he or der of priority m ay be altered. The first possible variation (pr oviso (A)) applies if all the A1 and A2 Notes ha ve been redeem ed and ot her (favourable) specified conditions are satisfied: the A3 to E1c Notes then rank pari passu. Conversely, under the other

variation (proviso (B)), which applies if there is an A Principal Deficiency, priority is granted to the A Notes as a single class ranking pari passu.

15. Events of default are regulated by C ondition 9. The events specified in Condition 9(a) are, apart from that alre ady set out (para 5 above): defaul t in payment for three bus iness days of any pr incipal or i nterest due on a ny of the Notes; breach by Eurosail of any of its obligations and failure to remedy the breach (if remediable) for 14 days after notice of the breach give n by t he Tr ustee; the making of an order or resolution for the winding up of Eurosail, otherwise than for an approved amalgama tion or reconstruction; and th e initiation of insolvency or administration procee dings, or the levyi ng of e xecution (subject to var ious qualifications which it is unnecessary to set out in detail).

16. If the Event of Default is an event und er Condition 9(a)(iii) or a breach of Eurosail’s obligations, there is a further requirement th at the Trustee shall have certified to Eurosail “that such event is, in its sole opinion, materially prejudicial to the interests of the Noteholders.” For this purpose the Trustee may under the trust deed (as recorded in Condition 2(c)) “have re gard only to (i) th e interests of the A Noteholders if, in the Trus tee’s sole opini on, there is a conflict between the interests of the A N oteholders (or any Cl ass thereof) and the interests of the B Noteholders, the C Noteholder s, the D Noteholders a nd/or t he E Note holders.” This provision does not indicate how t he Trustee is to exercise its discretion in the event of a conflict (such as there now potentially is) be tween the interests of the A2 Noteholders and t he A3 N oteholders. I f there is an Event of Default (and, in the cases just mentioned, it is materia lly prejudicial) the Trustee may at its discretion serve an Enforcement Notice on Eu rosail. Moreover it is obliged to do so if reque sted or directed (i) by hol ders of at least 25% of the outstanding “Most Senior Cla ss of Not es” (defined as meaning t he A Note holders, rather than a subclass of them) or (ii) by an extraordinary resolution of the hold ers of that class. This court was not show n any evidence, and did not hear any s ubmissions, as to whether either of those requirements would be likely to be satisfied in practice.

17. On service of the Enfo rcement Notice the Notes become immediately due and payable and th e Noteholders’ security becomes enforceable (Condition 9(b)). Thereupon the order of priority shifts fro m that in Condition 2(g) to that in Condition 2(h). It is unnece ssary to go through all th e detail of Condition 2(h). The all-im portant change is that under Condition 2(h)( v) the avai lable funds are applicable to pay “pari passu and pro rata (1) all am ounts of interest and pri ncipal then due and payable on the A1c Notes, the A2c Notes and the A3c Notes and (2) [subject to provisions about currency swaps that have now lapsed] any interest and principal then due and payable on the A1 b Notes, the A2a No tes, the A2b Notes and the A3a Notes, respectiv ely.” In practical terms, the A2 Notes would no longer have priority, in terms of principal, to the A3 Notes.
18. The opening words of co ndition 2(h) expres s the Trustee’s obligation as being to m ake pa yments “to the extent of the funds available to [Eurosail] and from the proceeds of enforcem ent of the Security” (with exceptions that need not be detailed). The penultimate provisio n of Condition 2(h) provides: “The Noteholders have full recourse to [Eur osail] in respect of the payments prescribed above and accordingly are entitled to bri ng a claim under English law, subje ct to the Trust Deed, for the full amount of such payments in accordance with Condition 10 (Enforcement of Notes)”. Mr Dicker did not challenge Mr M oss’s submission that the opening words do not contradict the penultim ate provision, and that seems to be correct. The opening words are dire cted to the Trustee’ s obligations, not to those of Eurosail.

19. Condition 5(j) contains the P ECO (Post Enforcement Call Option) which is the subject of the cross-appeal. This option (which has been gi ven effect to as a separate written agreement between the Tr ustee and a company named or referred to as OptionCo) is regarded in the industry as a mean s of achievi ng the effect of limited recourse without t he adverse tax consequences that would t hen have followed from a sim ple express non-reco urse provision. The ope rative part of Clause 5(j) is as follows:

“All of the Noteholders will, at th e request of the holder of the Post Enforcement Call O ption, sell all (but not som e onl y) of t heir holdings of the Notes to the holde r of the Post Enforcement Call Option, pursuant to the option gran ted to it by the Trustee (as agent for the Noteholders) to acquire all (but not som e only) of t he Notes (plus accrued interest thereon), for the consideration of one euro cent per Eur o Note outstandi ng, on e dollar cent per Dollar Note outstanding and one penny per S terling Not e outstandi ng (and for these purposes, each Global Note shall be one Note) in the event that the Security for the Notes is enforced, at any time after the date on which the Trustee determines that the proceeds of such enforcem ent are insufficient, after payment of all other claim s ranking higher in priority to the Notes and pro rat a payment of all claim s ranking in equal priority to the Notes and af ter the application of any such proceeds to the Notes under the Deed of Charge, to pay any further principal a nd i nterest and any ot her amounts whatsoever due in respect of the Notes.”

Bankruptcy remoteness

20. “Bankruptcy rem oteness” was the expre ssion used by Standar d & P oor’s credit-rating agency, and gene rally in the industry, to describe one criterion for a SPE to obt ain a satisfactory credit rating fo r its loan notes (see “European Legal

Criteria for Structured Finance Transacti ons” published by Stan dard & Poor’s (28 August 2008), a nd the com ments of the Chancellor [2011] 1 WLR 1200, para 8 and Lord Neuberger of Abbotsbury MR [2011] 1 WLR 2524, para 28). This is not the place to consider either the reliability of the credit-rating agencies’ judgments on N otes secured by sub- prime m ortgages, or t he infl uence t hat their judgm ents seem to have ha d in the m arket (caused, som e have suggested, by the industr y’s general inability to comprehe nd the risks inherent in its own creations). But the notion of “bankruptcy remoteness”, even if imperfectly understood, underlay many features of the Conditions and the arrangements of which they formed part.

21. In developing his c ontextual argument that this court s hould (if necessary ) mould the meaning of sec tion 123(1) and (2), as in corporated into Condition 9(a)(3) so as to take accoun t of commercial realities, Mr Dicker drew particular attention to five features of the arrangem ents. They are set out and discussed in section B2 of Eurosail’s ca se.  Most of th em have been mentioned already, at least in passing, but it m ay be help ful to bring them together in summary form. They are relevant not only (arguably) to the issue of construction but also (without room for argum ent) to determ ining t he likely length of deferm ent of Eurosail’s long- term liabilities under the Conditions, in t he absence of an Even t of Default which triggers an Enforcement Notice. These points are covered at som e length in the witness statements of Mr Mark Filer, a di rector of Wilm ington Trust SP Ser vices (London) Ltd, Eurosail’s corporate services provider.

22. The five salient features of the Conditions an d the supporting documentation bearing on the li kely deferment of Eurosail’s obligations in respect of principal and interest are as follows:

1. C ondition 2( g) de fines Eur osail’s obligations for payment of interest on the Notes (after remune ration, charges and expe nses) in terms of the Availabl e Reve nue F und (see para 12 above). If that source is insufficient for paym ent of intere st on any of the Junior Notes (that is, those which are not A Notes) th e obligation is deferred (while accruing interest) under Condition 6(i) and (j), if necessary until the final redemption date in 2045.

2. Temporary s hortages of inco me can be provide d f or by t he Liquidity Facility (reimbursements to which have a high order of priority under Condition 2(g)(iv)).

3. As to principal, redemption of Notes (oth er than the redeemed A1 Notes and the revenue-backed Notes) is not due until 2045. Until then redemption is limited to th e Actual Redemption Funds (as

defined in the pream ble) which are applied in the appropriate orde r of priority under Condition 5(b) (see para 14 above).

4. Any loss of principal resulting from default on m ortgages is termed a ‘Principal Deficiency’ a nd is recorded in the Principal Deficiency Ledger (the detailed provisions as to this are found not in the C onditions but in Cla uses 8 and 9 of the Cash/B ond Administration Agreement). If th ere is surplus income from the mortgage paym ents, the ‘excess sp read’ can be used to reduce or eliminate any Principal Deficiency on whatever is the highest- ranking class of Notes with a defi ciency. Recoupment of a Principal Deficiency takes priority to the payment of interest on lower-ranking Notes (see para 12 above).

5. Finally there is the PECO, which is intended to produce the same, or a similar result as an express limited-recourse provision (see paras 18 and 19 above).

The legislation

23. This court was taken to the legislative history of sections 122 and 123 of the 1986 Act, and it will be necessary to refer to it in some detail. But it may be better to start with the sections themselves. The 1 986 Act was a cons olidating statute which gave effect to the amendments made by t he Insolvency Act 1985. Se ction 122(1), as am ended, provides seven case s in w hich a company may be w ound up by the court, of which the most important are the last two:

“(f) the company is unable to pay its debts,

(g) the court is of the opinion that it is just and equitable that the company should be wound up.”

Section 123(1) the n sets out five cases (s tated or sum marised in para 1 above) in which a company “is deemed unable to pay its debts.”

24. The four cases in paragraphs (a) to (d ) of section 123( 1) are true deem ing provisions. A com pany’s non-c ompliance with a s tatutory de mand, or non- satisfaction of e xecution of a judgm ent debt, is a m atter that can be proved quite simply, usually by a single shor t witness st atement. If proved, it establishes the court’s jurisdiction to make a winding up order, even if the company is in fact well

able to pay its debts. If howeve r a debt which has been m ade the subject of a statutory demand is disputed on reason able grounds, the petitioner is adopting what has been called a high-risk strategy, and the petition may be dismissed with indemnity costs: In Re a Company 12209 of 1991 [1992] BCLC 865, 868 (Hoffmann J).

25. Section 123(1)(e) is significantly different in form:

“if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.”

This is not what would usually be described as a deem ing provision. It does not treat proof of a single specific default by a company as conclu sive of the general issue of its inability to pay its debts. Instead it goes to that very issue. It may open up f or inquiry a m uch wi der range of factual matters, on which there may be conflicting evidence. The range is wide r because section 123(1)(e) focuses not on a single debt (which under pa ragraphs (a) to (d) has necessarily accrued due) but on all the company’s debts “a s they fall due” (words wh ich look to the future as well as to the present).

26. The words “as they fall due” did not appear in the legislation until the Insolvency Act 1985. Sim ilarly the express reference in section 123( 2) to the test of “the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities” did not appear before the Insolvency Act 1985. In the present case both the Chancellor and the Court of Appeal treated the pres ent legislative provisions as materially different from those previously in force: [201 1] 1 WLR 1200, para 24; [2011] 1 WLR 2524, para 53. Yet when this point was rais ed during the passage of th e Insolvency Bill in 1985, the government spokesman in House of Lords, Lord Lucas of Chilworth, stated:

“Commons Amendment No 458 gives effect to the way in which the courts have interpreted section 518 of the Compan ies Act [1985]; that was previously section [223] of the 1948 Act. We are not seeking to amend the law by this amendment; merely to give effect to that interpretation by the courts, namely, that section 518 c ontains both a cash flow and a balance sheet test.” Hansard (H L Debates, 23 October 1985, col 1247)

In these circumstances it is necessary to look quite closely at the legislative history. In considering it I have derived great assistance from a variety of academic

commentary, including an article by Dr Peter Walton, “Inab ility to pay debts”: beyond the point of no return? [2013] JBL 212.

27. The starting poi nt is sec tions 79 and 80 of the Companies Act 1862 (25 & 26 Vict, c 89), the ge neral structure of which is similar to that of sections 122 and 123 of the 1986 Act. Section 80(4) of the 1862 Act stated the test simply as:

“Whenever it is proved to the sa tisfaction of the court that the company is unable to pay its debts.”

However, i t is to be noted t hat under section 158, onc e a wi nding up or der ha d been m ade, “all debt s paya ble on a c ontingency, and all claim s against the company, present or future, certain or conti ngent, ascertained or sounding only in damages, shall be admissible to proof ag ainst the company, a just estimate being made, so f ar as is possible, of t he value of all such debts or cl aims as may be subject to any contingency or sound only in damages, or for some other reason do not bear a certain value.” So a contingent or prospective creditor could not present a petition, but if another creditor presen ted a petition and secu red a winding up order, contingent and prospective liabilities were admitted to proof.

28. In In Re European Life Assurance Society (1869) LR 9 Eq 122 Sir William James V-C dismissed a petition for the wind ing up of a company which had issued large numbers of life policies and annuity contracts, and appeared to be in financial difficulties. In an extempore judgment he decided, with very little reasoning, that (p127) “inability to pay debt s must refer to debts ab solutely due.” He then proceeded to consider at gr eater length, but to dismiss, the alternative “just and equitable” ground in section 79( 5) of the C ompanies Act 1862. As to this ground he said at p128:

“And in my view of the law of the case it would be just and equitable to wind up a company like this assurance comp any if it were made out to my satisfaction that it is, not in any technical sense but, plainly and commercially inso lvent – that is to say, that its assets are such, and its existing liabilities are such, as to make it reasonably certain – as to make the court feel satisf ied – that t he existing and pr obable assets would be ins ufficient to meet the existing liabilities. I take it that the court has nothin g whatever to do with any question of future liabilities, that it has noth ing whatever to do w ith the question of the probability whether any business wh ich the company may carry on tomorrow or hereafter will be profita ble or unprofitabl e. That is a matter for those who may choose to be the customers of the company and for the shareholder to consider.”

So here, it seems, the Vice-Chancellor was applying a balance-sheet test, but onl y to existing liabilities, in the context of the “just and equ itable” ground. He did not refer to any of the authorities that had been cited. It may be unfortunate that his judgment has come to be regarded as a leading case.

29. Shortly afterwards the law was changed in relation to life offices by the Life Assurance Companies Act 1870 (33 & 34 Vict, c 61) , which was effectively the beginning of the m odern statut ory re gulation of life assurance. There w as no general change until section 28 of t he Companies Act 1907 , whic h m ade an amendment which was then consolidated by the Com panies (Consolidation) Act 1908. The latter provided in section 130(iv) that a company shou ld be deem ed to be unable to pay its debts:

“if it is proved to the satisfaction of the court that the company is unable to pay its debts, and, in determining whet her a com pany is unable to pay its de bts, the c ourt s hall take into account the contingent and prospective liabilities of the company.”

The am endment m ade by the C ompanies Act 1907 was in troduced on the recommendation of the Loreburn Comm ittee (Report of the Company Law Amendment Com mittee) (1906) (Cd 3052 ), para 43, which was influenced by section 21 of the Life Assurance Comp anies Act 1870. The amendment is described by Dr Walton [2013] JBL 212, 228 as an abbreviated version of section

21. But there is not a very close parallel, since section 21 refe rred to a life office being insolvent (meaning, apparently, balance-sheet insolvent) rather than its being unable to pay its debts. But the admission of contingent and prospective liabilities, and especially long-term liab ilities, must tend to focus attention on balance-s heet considerations. Thus in In Re Capital Annuities Ltd [1979] 1 WLR 170, 185, Slade J observed:

“From 1907 onwards, therefore, one species of ‘inability to pay its debts’ specifically recognised by th e legislature as a ground for the making of a windi ng up or der in respect of any c ompany incorporated under the Companies Acts was the possession of asset s insufficient to meet its existi ng, conti ngent and pros pective liabilities.”

Essentially the same wordin g a ppeared i n s ection 223( d) of the Companies Act 1948 and in section 518(e) of the Com panies Act 1985. Tw o cases decided under section 223(d) call for mention.

30. The first is In Re a Company (also referred to as Bond Jewellers) [1986] BCLC 261, decided by Nourse J on 21 December 1983. Like In Re European Life Assurance Society, it was an extem pore judgm ent give n wit hout citation of authority, in order to avoid delay, but it has been much cited. It was referred to in both Houses of Parliament during the com mittee stages of the Inso lvency Bill. It concerned a tenant company with a propensity for postponing payment of its debts until threatened with litigation. Nourse J felt unable to make an order under section 223(d), and considered, but ultimately did not make an order, on the “just and equitable” ground in section 222(f). The case is of interest as illustrating (at p 263) that the phrase “as they fall due”, althou gh not part of the statutory text, w as understood to be implicit in section 223( d). It is also of interest for the judge’s observation on the se cond poi nt in sec tion 223( d) (now em bodied, in different words, in section 123(2) of the 1986 Act):

“Counsel says that if I take into account the contingent and prospective liabilities of the compa ny, it is clearly insolvent in balance sheet terms. So indeed it is if I treat the loans made by the associated companies as loans which are currently repaya ble. However, what I am required t o do is to ‘take into account’ t he contingent and prospective liabilities. That cannot mean that I must simply add them up and strike a balance against assets. In re gard to prospective liabilities I must principa lly consider whether, and if so when, they are likely to become present liabilities.”

31. The second case, Byblos Bank SAL v Al-Khudhairy [1987] BCLC 232, was a considered judgment of Nicholls LJ (with whom Slade and Neill LJJ agreed) delivered a fter 11 da ys of argum ent. It concerned t he dispute d vali dity of the appointment of a receiver in June 1985, before either the Companies Act 1985 or the Insolvency Ac t 1985 was in f orce. The ostens ible ground f or appointment of the receiver was not made out, but the bank relied on a new ground, section 223(d). Nicholls LJ observed (p 247):

“Construing this section first with out reference to authority, it seems to me plain that, in a case where none of the deeming paras (a), (b) or (c) is applicable, what is cont emplated is evidenc e of (and, if necessary, an investigation into) th e present capacity of a company to pay all its debts. If a debt pres ently payable is not paid because of lack of means, that will normally suffice to prove that the company is unable to pay its debts. That will be so even if, on an assessment of all the assets and liabilities of th e company, there is a surplus of assets over liabilities.  That is trite law.

It is equally trite to observe that the fact that a company can meet all its presently paya ble debts is not necessarily the end of the matter, because pa ra (d) requires account to be taken of conti ngent a nd prospective liabilities. Take the simple, if extreme, case of a company whose liabilities consist of an obligation to repay a loan of

£100,000 one year hence, and whos e only assets are worth £10, 000. It is obvious that, taking into ac count its future liabilities, such a company does not ha ve the present capacity to pay its debts and as such it ‘is’ unable to pay its debts.”

Nicholls LJ then referred to the judgment of James V-C in In Re European Life Assurance Society LR 9 Eq 122, including the passage quoted at para 28 above, and commented (p 248):

“In my view the exercise descri bed by Jam es V-C is the exercise required to be done under sectio n 223 (now section 518 of the 1985 Act).”

He also referred to the decisions of Slade J in In Re Capital Annuities Ltd [1979] 1 WLR 170 and Nourse J in In Re A Company [1986] BCLC 261 as consistent with the views he had expressed.

32. In my view these authorities go quite a long way to establishing that neither the notion of payi ng debts “as t hey fa ll due”, nor the notion of balance-sheet insolvency, was unfamiliar befo re the enactment of the In solvency Act 1985. But petitions by contingent or prospective creditors have been rare even after the repeal in 1986 of the standard re quirement for such a credito r to provide security for costs. One reason for that is no doubt the difficulty of quantifying contingent and prospective liabilities to the satisfaction of th e court. Another may be the fact that well-advised commercial lenders will insist on contractual cond itions under which deferred liabilities are accelerated in th e event of the borrower getting into financial difficulties.

33. The far-reaching reforms effected by the Insolvency Acts of 1985 and 1986, together with related subordin ate legislation, were influe nced by the report of the Cork Committee, published in 1982. One of its reco mmendations (para 535) was that “the sole ground upon which the c ourt may make an ins olvency order in respect of a debtor, whether individual or corpor ate, will be that the debtor is unable to pay his or it s debts.” The C ommittee proposed three cas es in which the debtor would be deem ed to be insolvent and unable to pay his or its debts. The first two corresponded to the cases in section 123(1)(a) to (d) of the 1986 Act. The third case was:

“(c) Where the applicant is a con tingent or prospective creditor to whom the debtor is or may become indebted in a sum of not less than the prescribed amount, being a debt not yet presently due a nd payable, and it is prove d to the sa tisfaction of the court that the ultimate repayment of th e debt is in jeopardy because the debtor’s liabilities, including contingent and prospective liabilities, exceed the debtor’s assets.”

This pr oposal lim ited the bal ance-sheet insolvency test to applications by contingent or prospective creditors whereas the Byblos Bank case suggested that it was also relevant to the payment of debts “as they fall due”. That point was noted by Briggs J in his perceptive judgm ent In Re Cheyne Finance plc (No 2) [2008] Bus LR 1562. He referred at pa ras 42- 43 to sim ilar language (“as they bec ome due”) used in Australian companies’ legislation, which until 1992 had a single test based on an inability to pay debts “as they become due” – a phrase which looks to the future, as Gri ffith CJ said in Bank of Australasia v Hall (1907) 4 CLR 1514, 1527. There is a good d eal of later Australian au thority, mentioned in the judgment of Briggs J, to the same effect.

34. In Re Cheyne Finance Plc (No 2) was concerned with a security trust deed which (in contrast to Conditio n 9(a)(iii) in the present a ppeal) incorporated into its definition of “insolvency event” the te rms of section 123(1), but not section 123(2). It was therefore necessary to consider how far section 123(1)(e) was concerned, not only with debts that were immediately payable, but also with those that would be payable in the future. Briggs J decided, rightly in my view, that that is what section 123(1)(e) requires (para 56):

“In my judgment, the effect of th e alterations to the insolvency test made in 1985 a nd now found in se ction 123 of the 1986 Act was to replace in the commercial solvency test now in section 123(1)(e), one futurity requirement, name ly to include c ontingent and prospective liabilities, with another more flexible and fact sensitiv e requirement encapsulated in the new phrase ‘as they fall due.’”

Briggs J considered (para 35), agai n rightly in my view, that the Byblos Bank case was a case about abil ity to pay debts as they became due, but t hat the Court o f Appeal recognised that balance-sheet insolvency is not irrelevant to that issue.

The practical effect of section 123

35. There is no doubt that, as a matter of form, the statutory test for a company being una ble to pa y i ts debts is m aterially different (as the Chancellor and the Court of Appeal observed) from the po sition under the Com panies Act 1985. Section 123(1)(e) introduced the words “as they fall due” and section 123( 2) has introduced a direct refere nce to a company’s assets and liabilities. These two provisions, both la belled as “dee ming” provisions (though neither is obvi ously of that character) stand side by side in se ction 123(1)(e) and se ction 123(2) with no indication of how they are to interact.

36. It seems likely that part of the explan ation lies in the history of t he passage through Parliament of the In solvency Bill in 1985, and the lengthy and interrupted process of review and consultation w hich had preceded it. This process bega n as long ago as October 1976 when the Secretary of St ate announced his intenti on of setting up what became the Review Committe e chaired by Mr (later Sir) Kenneth Cork. It produced an inte rim report in October 1979 (after a change of government) and its final report in 1982. The whole protracted process is described by Professor Ian Fletcher QC in his Law of Insolvency 4^th ed (2009), pp 16-22. He explains how there was no official reac tion to the final report until a spate of financial scandals early in 1984:

“At relatively short notice the gove rnment White Paper, referred to above, was published in Febr uary 1984 together with an indication that legislation was imminent. In consequence, very little time was allowed for interested parties to submit comments before the drafting of the Insolvency Bill was embarked upon, and the Bill itself w as introduced in t he H ouse of Lord s on 10 Decemb er 1984. This regrettable m ishandling of the peri od of preparation for the first major overhaul of ins olvency law for over 10 0 years cannot but b e lamented. The i nadequate m anner in w hich c onsultation w as conducted, couple d with the near-tot al lack of any form of public debate about the issues of policy and principle at the heart of a ny radical recasting of ins olvency law, were an inaus picious prelude to what was to become a most cont entious a nd confuse d epis ode of legislative history. Thereby, what ought to have been a largely non – controversial, non- Party Bill bec ame the subject of hi ghly dramatic proceedings before both Houses, and also in Committee, and damage was unquestionably inflicted upon the ultimate quality of a highly technical piece of leg islation whos e detailed provisions were but vaguely understood by all but a m inority of those participating in its enactment, but w hose social and econom ic im portance was nonetheless immense. The Bill’s deficiencies, due to haste in preparation, together with the vicissitudes of the parliamen tary

process, resulted in a quite exceptional number of amendments being tabled to the Inso lvency Bill, estimated to have approached 1,200 by the tim e of R oyal Assent. A high proportion of t hese am endments were tabled by the Governm ent itself, and m any w ere adopte d virtually w ithout de bate during t he closing stages of proceedings.” (para 1-034)

37. Despite the difference of form, the pr ovisions of secti on 123( 1) and ( 2) should in m y view be seen , as the Governm ent spokesman in the House of Lords indicated, as making little significant cha nge in the law. The changes in form served, in my view, to under line that the “cash-flow” test is concerned, not sim ply with the petitioner’s own presently-due de bt, nor only with ot her 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 reas onably near future, fo r this purpose, will depend on all the circum stances, but es pecially on the nature of the com pany’s business. That is consistent with Bond Jewellers, Byblos Bank and Cheyne Finance. The express reference to assets and liabilities is in my view a practical recognition that once the court has to move beyond the reasonably near future (the length of whic h depends, again, on all th e circumstan ces) any attempt to apply a cash-flow test will become completely speculative, an d a comparison of present assets with present and future liabilities (discounted for contingencies and deferment) becomes the only sensible test. But it is still very far from an exact test, and the burde n of proof m ust be on the party which asserts balance-sheet insolvency. The omission from Condition 9(a)(iii) of the reference to proof “to the satisfaction of the court” cannot alter that.

38. Whether or not the test of balance-shee t insolvency is satisfied must depend on the available evidence as to the circ umstances o f the particular case. The circumstances of Eurosail’s business, so far as it can be said to have a busine ss at all, are quite unlike those of a compan y engaged in normal trading activities. There are no decisions to be made about c hoice of s uppliers, stock levels, pricing policy, the raising of new capital, or other matters such as would constantly engage the attention of a trading com pany’s board of directors. Instead Eurosail is (in M r Moss’s phrase) in a “closed system” with some rese mblance to a life office which is no longer accepting new business. The only important management decision that could possibly be made would be to attempt to arrange new hedging cover in place of that which was lost when Lehman Brothers collapsed. To th at extent Eurosail’s present assets should be a be tter guide to its ability to meet its long-term liabilities than would be the case with a c ompany actively e ngaged in tra ding. B ut against that, the three im ponderable factors identified in para 9 above – c urrency movements, interest rates and the United Kingdom economy and housing market – are and always ha ve been out side its control. Over th e period of m ore than 30 years until the final redemption date in 2045, they are a matter of speculation rather than calculation and prediction on any scientific basis.
39. At first instance the Chan cellor started with three propositions derived from the case law (paras 29 to 32): that the assets to be valued are the present assets of the company; that “contingent and prospective liabilities” are not to be taken at their full face value; and that:

“‘Taking account of’ must be recognised in the context of the overall question posed by the subs ection, namely whether the company is to be deemed to be insolve nt beca use the amount of its liabilities exceeds the value of its assets. This will involve consideration of the relevant facts of the case, includi ng when the prospective liability falls due, whet her it is payable in sterling or som e ot her currenc y, what assets will be available to m eet it and what if any provision is made for the allocation of losses in relatio n to those assets.” (para 32)

He then set out four reasons (paras 34 to 37) for conc luding (par a 38) that the value of Eurosail’s assets exceeded its liabilities, “h aving taken account of its contingent and pr ospective liabilities to such extent as appears to be necessary at this stage.”

40. In the Court of Appeal Lord Neuberger MR did not disa gree with anything in the Cha ncellor’s judgment so far as it related to stat utory construction. He did however go further in his detailed discussion of section 123(2). He observed (para 44):

“In practical terms, it would be rath er extraordinary if section 123(2) was satisfied every time a comp any’s liabilities exce eded the value of its assets. Many companies which are solvent and successful, and many companies early on in their lives, would be dee med unable to pay their debts if this was the meaning of section 123(2). Indeed, the issuer is a good example of this : its assets onl y j ust exceede d its liabilities when it was fo rmed, and it was more than possible that, even if thi ngs went well, it would fall from time to time within the ambit of section 123( 2) if the appe llants are right as to the meaning of that provision.”

41. Lord Neuberger MR developed this at paras 47 to 49 of his judgment:

“47. More generally, I find it har d to discern any conc eivable policy reason why a company should be at risk of being wound up simply because the aggregate value (howev er calculated) of its liabilities

exceeds that of its assets. Many companies in that position are successful and creditworthy, and can not in any wa y be characterised as ‘unable to pa y [their] debts’. Su ch a mechanistic, even artificial, reason for permitting a creditor to present a petition to wind up a company could, in my view, only be justified if the words of section 123(2) compelled that conclusion, and in my opinion they do not.

48. In m y view, t he purpose of s ection 123( 2) has bee n accurately characterised by Professor Sir Roy Goode in Principles of Corporate Insolvency Law, 3 ^rd ed (2005). Having referre d to section 123(1)(e) as being the ‘cash flow test’ an d to section 123(2 ) as being the ‘balance sheet test’, he said this, at para 4-06:

‘If the cash flow test were the only relevant test [for insolvency] th en current and short-term creditors would in e ffect be paid at the expense of creditors to whom liabilities were incurre d after the company had reached the point of no retu rn because of an incurable deficiency in its assets.’

49. In m y judgm ent, bot h the pur pose and the applicable test of section 123(2) are accurately encapsulated in that brief passage.”

42. Toulson LJ agreed wi th Lord N euberger MR but expressed hi mself in a more guar ded way. He agreed that Professor Sir Roy Goode had “rightly discerned the underlyi ng polic y” (para 115) but added (p ara 119) that Professor Goode’s reference to a compa ny having “reached the point of no return because of an incurable deficiency in its assets” i lluminates the purpose of the subsection but does not purport to be a paraphrase of it. He continued:

“Essentially, section 123( 2) require s the court to m ake a judgm ent whether it has been established that , looking at the company’s assets and m aking proper allowance for its prospective and conti ngent liabilities, it cannot reasonably be expe cted to be able to meet those liabilities. If so, it will be deemed insolvent althoug h it is currently able to pay its debts as they fall due. The more distant the liabilities, the harder this will be to establish.”

I agree with what Toulson LJ said here, and with great respec t to Lord Neuberger MR I consider that “the po int of no return” s hould not pass into common usage as a paraphra se of the effect of section 1 23(2). But in the ca se of a company’s

liabilities that can as matters now stand be deferred for over 30 years, and where the company is (without any permanent increase in its borrowings) paying its debts as they fall due, the court shou ld proceed with the greatest caution in deciding that the company is in a state of balance-sheet insolvency under section 123(2).

Reasoning in the courts below

43. Sir Andrew Morritt C, having set out some general propositions as to the effect of section 123 (1)(e) and ( 2) (in paras 29 to 32 of his judgment, summarized above), rejected the A3 Noteholders’ submission that Eurosail was plainly insolvent for the purposes of section 123 (2) as applied by Cond ition 9(a)(iii). He relied on f our points, set out in paras 34 to 37 of his judgm ent. First, Eurosail’s claims in t he insolvencies of LBHI a nd LBSF, though not adm itted, could not be ignored. The secondary market indicated that the claim was worth 35% to 37% of US$221m (that is, a value of the order of £60m). Second, a large part of the total deficiency that was claimed to exist wa s due to conversion into sterling at the prevailing spot rate of liab ilities not due for paym ent until 2045. Th ird, the future liabilities were fully funded in the limited sense that deficiencies resulting from mortgage defaults reduced Eurosail’s li ability to the Noteho lders through the operation of the Principal Deficiency Ledg er. Fourth, the Chan cellor was able to infer that a calculation of th e then present values of a ssets and liabilities would not show a deficiency, since Eu rosail was well able to pay its debts as they fell due, there was no deficiency on the Principal Deficiency Ledge r, and pr ojected redemptions of each class of A Notes were in advance of the maturity dates.

44. In the Court of Appe al counsel appe aring for the A2 Note holders did not feel able to give complete support to the Cha ncellor’s second poi nt, and Lor d Neuberger MR accepted (para 67) the submission of counsel for the appellants:

“As Mr Sheldon [then appearing fo r the A3 Notehol ders] said, one has to value a future or contingent liability in a foreign currency at the present exchange rate. By definition, that is the p resent sterling market value of the liability.”

I would al so respectfully questi on t he C hancellor’s third poin t. The Chancello r had earlier in his judgm ent, at para 13, referred to clause 8 of the Cash/B ond Administration A greement, which provi des for the maintenance of Principal Deficiency Ledgers. That seems to be the basis of his p oint about liabilities being self-cancelling. But clause 8 seems to be concerne d with no m ore than an accountancy exercise, not with a permanent extinction of liabilities. It operates to defer liabilities for principal until the fi nal redemption date, if circumstan ces require, and provided that an Enforcemen t Notice is not given in the meantime.

But Condition 2(h) provides for Eurosail to be liable on a f ull recourse basis post- enforcement, as already noted (para 18 above).

45. Lord Neuberger MR did not accept that a forecast de ficiency based on then current exchange rates could be dismissed as entirely speculative. He started (para 63) from Eurosail’s audited accounts for the year e nding 30 Novem ber 2009, which showed a net liability of £74.557m. He noted (paras 63 to 74) that this figure required two substantial am endments (one for t he Lehman Brothers claim, and the other for the full recourse facto r) “which, ironically and coincidentally , virtually cancel each other out” (para 69 ). So his final discussion and conclusion (paras 75 to 83) starts with an assumed deficiency of the order of £75m.

46. Against that Lord Neuberger MR set th ree factors. The first was that a deficiency of £75m , with a n aggre gate principal s um of j ust over £420m outstanding on t he m ortgages, was less than 17% of the assets. Secondly, the deficit was largely based on the assump tion that exchange rates would remain constant (para 76):

“Of course, they are as likely to move in an adverse direction as they are to move in a favourable direc tion, but the volatility of those rates tell against the appellants given that they have to es tablish that the issuer has reached the point of no return.”

Thirdly, the court was looking a long way ahead (para 78):

“Not only do all the unredeemed not es have a final redem ption date in 2045, but it appears from the evid ence that the we ighted average term of the remaining mortgages is in the region of 18 years, and the rate of early redem ption has slow ed significantly and is likely, according to expert assessment, to remain low for the time being.”

47. Lord Neuberger MR accepte d that there was a real possibility that, if no Enforcement Notice was served , events might turn out to the disadva ntage of the A3 Noteholders (para 79):

“However, as mentioned, a future or conti ngent creditor of a company c an ver y of ten show t hat he w ould be better off if the company were wound up rather than being permitted to carry on business. In a com mercially sensib le legal system that cannot of itself justify the creditor seeking to wind up the company.”

Toulson and Wilson LJJ agr eed with this reasoning. Toulson LJ em phasised the importance of the liabilities being distant in time (para 119, quoted in para 42 above). The appeal was therefore dismissed, as was the cross-appeal.

Conclusions

48. The crucial issue, to my mind, is ho w far the Court of Appeal’s conclusion depended on the “ point of no r eturn” te st. F or reasons already m entioned, I consider that that is not the correct test, if and in so far as it goes beyond the need for a petitioner to satisfy the court, on th e balance of probabilities, that a company has insufficient assets to be able to meet all its liabilities, including prospective and contingent liabilities. If it mean s no more than that, it is unhe lpful, exce pt as illuminating (as Toulson LJ put it) the purpose of section 123(2).

49. In my view the Court of A ppeal would have reached the sam e conclusion without reference to any “ point of no re turn” test; an d I would myself reach the same conclusion. Eurosail’s ability or inability to pay all its debts, present or future, may not be finally determined until much closer to 2045, that is more th an 30 years from now. The comp lex documentation under wh ich the loan notes were issued contains several mechanisms (iden tified in para 22(1) to (4) above, the PECO being disregarded for present pur poses) for ensuring that liabilities in respect of principal are, if necessary , deferred until the final redemption date, unless the post-enforcement regime come s into oper ation. The m ovements of currencies and interest rates in the mean time, if not entirely speculative, are incapable of prediction with any c onfidence. The c ourt cannot be satisfied that there will eventually be a deficiency.

50. I would therefore dismiss the appeal. I would also dismiss the cross-appeal, for the same reasons as were given by the Chancellor and the Court of Appeal. It is not necessary to c onsider Mr Dick er’s argum ents based on suppose d inconsistencies and commercial realities, except to say that they woul d have encountered serious difficulties in the light of this court’s decision in Enviroco Ltd v Farstad Supply A/S [2011] UKSC 16, [2011] 1 W LR 921: see the j udgment of Lord Collins of Mapesbury, with which the other members of the court agreed, at paras 51 and 52. The loan notes documentation did indeed contain some provisions (identified in paras 128 t o 134 of Eurosail’s case) which are inconsistent with the post-enforcement regime being triggered by a temporary deficiency of assets. But the court m ight well have taken the view, on documents of such complexity, that the draftsman had simply failed to grasp all its many and various implications, and that it was not for the court to rewrite the documents for the parties.

LORD HOPE

51. I would dis miss the appeal for the reas ons given by Lord Walker. I would also dismiss the cross-appeal, which conc erns the effect of the PECO on the application of section 123( 2) of the 1986 Act as in corporated into Condition 9(a)(iii). The question which it raises no longer needs to be answered as th e Noteholders’ appeal on the question whether Eurosail (“the Issu er”) was unable to pay its debts was not successful. But Sir Andrew Morritt C [2011] 1 WLR 122 gave his view on it in para s 39-44 of his judgment, and so too did Lord Neuberger MR in the Court of Appeal [2011] 1 WLR 2524 in paras 84-100. A P ECO is widely used in securitisation transactions of the kind that was entered into in this case, and we have been told that the question is of som e importa nce to the securitisation market more generally. So it is appropriate that we should give our reasons for agreeing with the Chancellor and the Court of Appeal that it has no effect on the way the liability of the Issuer to the Noteholders for the purpos es of the default provision in Condition 9(a)(iii) is to be calculated.

52. The Trustee entered into a PECO Agre ement on behal f of the Noteholders on 16 Jul y 2007, whic h is the sam e date as that on w hich the Not es were issued. By Clause 3. 1 it granted a n option t o a company called Euros ail Options Ltd (referred to in the Agreement as “OptionCo”):

“to acquire all (but not some only) of the Notes (plus accrued interest thereon) in the event th at the Security for the Notes is enforced and the Trustee, after the pa yment of the procee ds of such enforcement, determines that the proceeds of such enforcement are insufficient, after payment of all claim s ranking in priority to or pari passu with the Notes pursuant to the Deed of Charge, to pay in full all principal and/or interest and any other am ounts whatsoever du e in respect of the Notes. The Trustee shall promp tly after the Secur ity is enforced and the proceeds of such enforcement are paid, make a determination of w hether or not t here is such an insufficiency. If the Trustee determines that there is such an insufficiency the Trustee shall forthwith give notice (the ‘In sufficiency Notice’) of such determination to OptionCo and the Issuer.”

53. Clause 3.1 has to be re ad together with Condition 5(j) (see para 19, above), which provides that each Note holder will, on the exerci se of the option conferred on OptionCo, sell to the company the whole of his holding of notes for the nominal consideration for w hich the PEC O provides. It also has to be read toget her with the Event of Default described in Condition 9(a)(iii): see para 5, above. Under that provision a default occurs, among other things, in the event of the Issuer:

“being una ble to pay its debts as and when they fa ll due or, within the meaning of section 123( 1) or (2) (as if the words ‘ it is proved to the satisfaction of t he court’ did not appear in sectio n 123(2)) of the Insolvency Act 1986 (as that section m ay be amended from time to time), being deemed unable to pay its debts”.

54. The Pr ospectus at p 26 c ontains this explanation of the effect of these provisions, under the heading “Considera tions related to the Instruments”, for prospective purchasers:

“Although the Instrument s will be full recourse obligations of the Issuer, upon enforcement of the s ecurity for the Ins truments, the Trustee … will, in practice, have recourse only to the Loans and Collateral Security, and to a ny other assets of the Is suer then in existence as described in this document…”

55. The purpose of a PECO is to achieve bankruptcy remoteness for the issuer. Its aim is to prevent the issuer from being susceptib le to insolvent winding up proceedings by ensuring so far as possible that, if its assets prove to be insufficient to meet its liabilities, a director of the issuer will not instigate bankruptcy proceedings in respect of it. Bankruptcy remoteness is one of the criteria used by the rating agencies which issu ers of notes seek to satisfy so that their instruments will achieve the highest possibl e credit rating. That criterion is satisfied in other jurisdictions by provisions which limit the rights of note holders against the issuer to the value of the issuer’s assets. Until recent tax legislation altered the pos ition, limited recourse provisions of that kind gave rise to UK stamp duty reserve tax at the rate of 1.5% of the am ount subscribed for them . As the Cha ncellor explained in para 40, the PEC O is designed to achie ve the same result as limited recourse provisions, but without the adverse tax consequences.

56. The Issuer accepts that, as a matter of contract, the liabilities were unlimited in recourse. But it maintains that the commercial reality wa s that the liabilities alleged to be the de bts that the i ssuer was una ble to pay to t he Note holder were liabilities which it would never have to meet. In the event that the assets o f the Issuer were exhausted, any claim that th e Noteholder had against the Issuer would be assigned to the opti on holder. That, it is said, would br ing an end to the claim. So it woul d be wr ong to treat the Issuer as falling within sect ion 123( 2) as incorporated into Condition 9(a)(iii) on the ground that it was unable to pay its debts, as in practice it was never intended or expected that the liabilities would be paid except out of the underlying assets available to the Issuer.
57. The soundness of this approac h depe nds however on whet her, in law, the PECO affects the liability of the Issuer to the Note holder. In answering this question it is important to appreciate that the question is not whet her the Issuer should actually be wound up on the grounds desc ribed i n section 123( 2), but whether its financial position is such that it falls within that subsection for the purposes of the default provision in C ondition 9(a)(iii). The answer to that question is to be found by examining th e wording of the Cond ition in the context of the provisions of the transaction docum ents as a whole. Do es the PECO in any way alter the concl usion that w ould ot herwise be drawn that the Issuer’s assets were less than its liabilities and that it was unable to pay its debts?

58. The Chancellor based his judgment that it did not on the wording of section 123(2), as amended for the pu rposes of Condition 9(a)(iii). He held that if, in the application of that subsection the court co ncluded that the value of the company’s assets was less than the amount of its liab ilities, taking into account its contingent and prospective liabilities, th e PECO had no effect on t hose liabilities at all: para

43. As he put it, the liabilities of the Issu er remain the same, whether or not there is a PECO or, if there is, wh ether or not the call option ha s been exercised. Unless and until the option holder rele ases the Issuer from all fu rther liability, which it is under no obligation to do, the liability of the Issuer is unaffected.

59. Lord Neuberger reached the same conc lusion, but for fuller reaso ns: see paras 92-97. He said that, reading th e relevant pr ovisions of the docum ents together, they established that the Issue r’s liability to the No teholders was to be treated as a liability of full recourse at least until the security was enforced and, arguably, until the option was exercised and the transfer to th e option holder was completed. There was the statement in the Prospec tus m entioned in par a 54, above. It suggested a tw o-stage process, under whic h the Issuer’s liability was treated initially as full recourse and liability would become limited recourse only on enforcement of the security. There was the closing part of clause 6.7 of the Deed of Charge which, havi ng restricted the ability of the Trustee to enforce the Noteholders’ rights on enforce ment of the Security beyond the Issuer’s a ssets, provided that this “shall not apply t o and shall not limit the obligations of the Issuer to the [Notehol ders] under the Inst ruments and this Deed.” And there was the provision in Condition 2(h), which stated in terms that the Noteholders had full recourse to the Issuer in respect of paym ents due and that they were entitled to bring a claim under English law for the full amount of such payments.

60. Finally Lord Neuberger refe rred to the wording of C ondition 9(a)(iii) itself. It was hard to see why any reference shou ld be m ade in that Condition to section 123(2) if the Note holders’ rights against th e Issuer were not to be treated as full recourse until the enforcement of the security . He also said that there was nothing commercially insensible in the conclusi on that, for the purpose of Condition

9(a)(iii), the Noteholders’ rights against th e Issuer were treated as being of full recourse, notwithstanding the PECO: para 100.

61. The A3 Noteholders submit that the key operative provision is Clause 3.1 of the PECO itself. It makes it plain that it does not ha ve the e ffect of limiting the liability of the Issuer in resp ect of the Notes to the value of the Issuer’s assets. Its reference to there being an “ins ufficiency” of assets after en forcement to meet whatever is “due in respect of the Notes” is a clear indication that it contem plates that the amount of the liab ilities that the Notes have cr eated must be capable of exceeding the value of the asse ts of the Issuer. Then ther e is the time at which the option is e xercisable. It is not said to have any oper ative effect at all prior to enforcement of the security. So at all ti mes prior to its exer cise the Noteholders remain entitled to payment in accordance with the C onditions. And even when exercised all it does is provide a mechanis m by which the right to be paid under the Notes is assigned to OptionCo.

62. As the Issuer relies on commercial rea lity rather than legal form, the legal effect of the doc uments is not really in dispute. The com mon i ntention of the parties is said by the Issuer to be quite different. Its argument is th at, as inclusion of a PECO rather than a contractual limite d recourse provision was done solely for tax reasons, it was not intended or unders tood to alter the commercial nature, effect and operation of the asset-backed se curitisation. As a matter of contract the liabilities were unlimited in recourse. As a matter of commercial substance and in practice, they were the equi valent of a provision by which the rights of Noteholders were expressly limited. The Issue r’s case is that its future obligations to pay principal under the No tes should be taken into ac count only to the extent that its assets were sufficien t to pay for them. As Mr Dicker QC for the Issuer put it at the end of his argument, legal fo rm should not triumph over commercial substance.

63. I do not think that it is possible to distinguish the intended com mercial effect of these provisions from their legal effect in th is way. The exercise that Condition 9(a)(iii) predicates is the quantification of th e amount of the Issuers’ assets and liabilities in order to determin e whether there has been an Event of Default. The legal effect and the commerc ial effect of the PECO, on its true analysis, both point in the same direction. It has no effect, for the purpose of that quantification, on the amount of the Issuer’s liabilities. To limit those liabilities as the Issuer contends would c ontradict th e parties’ clearly expres sed com mercial intention as found in the co ntractual documents.  The fa ct that the econom ic result of the PEC O may be the sam e as if the Noteholders’ ri ght of rec ourse had been limited to the Issuer’s assets is beside th e point. It can be expected to achieve bankruptcy remoteness as effectively. B ut it would not be in acc ordance with the true meaning of the docum ents to treat the two methods as if they had the s ame effect in law.
64. The ultimate aim in construing provisions of the kind that are in issue in this case, as it is when construing any contract , is to determine what the parties meant by the language that they ha ve used. C ommercial good sense has a role to play when the provisions are open t o different interpretations. The court shoul d adopt the more, rather than the le ss, commercial construction: Rainy Sky SA v Kookmin Bank [2011] UKSC 50, [2011] 1 WLR 2900. But, for the reasons given by the Chancellor and Lord Ne uberger MR, the meaning to be given to the language that the parties used in this case is not open to doubt. The suggestion that to give effect to that m eaning is to s urrender to lega l form over com mercial substance am ounts, in effect, to an invitation to depart from the settled role of commercial good sense. Its role is to find out what the par ties meant when they entered into the arrangement, not to replace it with someth ing w hich i s not to be found in t he language of the documents at all.