Finance Alert Eurosail: UK Securitisations and Balance Sheet Solvency

Finance Alert
10 August 2010
Stephen Moller
Edward Smith
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Eurosail: UK Securitisations and Balance
Sheet Solvency
In the recent case of BNY Corporate Trustee Services Limited v Eurosail-UK
2007-3BL PLC [2010] EWHC 2005 (Ch) ("Eurosail"), investors sought to take
advantage of a structural feature present in many securitisations of UK assets to
argue that the trustee should call an event of default and accelerate the notes.
Eurosail included a post enforcement call option ("PECO") which was designed to
make the special purpose vehicle issuing the notes (the "Issuer") insolvency remote
while avoiding the need to limit the Issuer’s liability to its creditors to the value of
its assets. The Issuer was an English incorporated limited company.
While on the facts of the case the Issuer was found to be solvent, it was decided
that the existence of the PECO had no bearing on whether the Issuer was
technically solvent for the purposes of Section 123(2) of the Insolvency Act 1986
("Section 123(2)"). The case therefore opens the door for investors in other UK
securitisation transactions to argue that the issuer of their notes is technically
insolvent and therefore that an event of default has occurred.
The case is also of wider interest to creditors of English companies in that it
clarifies how balance sheet solvency should be determined for the purpose of
Section 123(2). Eurosail suggests that it may be harder than previously thought for
lenders to assess whether an event of default based on the test contained in Section
123(2) has been triggered.
Background: Eurosail 2007-3
Eurosail 2007-3 was a securitisation of UK non-conforming residential mortgages
issued in 2007 with a face value of £650 million. The notes were issued in five
tranches, ranking from A to E in order of seniority with each tranche being divided
into sub-tranches which were denominated in different currencies. The currency
mismatch between the Issuer’s sterling denominated assets and those of its notes
which were denominated in US dollars or euros was dealt with by currency swaps
between the Issuer and Lehman Brothers Special Financing Inc ("LBSF"). LBSF's
obligations were guaranteed by Lehman Brothers Holdings Inc ("LBHI"). LBSF
failed to make a payment due under the swap transactions on 15 September 2008
and LBHI failed to comply with its guarantee obligations. The swaps were
subsequently terminated.
The termination of the swaps was not itself an event of default under the notes, but
it clearly raised the possibility that the Issuer would not have enough money to
meet its obligations. The termination resulted in break costs in excess of $221
million payable by LBSF which LBSF (currently subject to insolvency proceedings
in the United States) has not paid. The Issuer has not been able to enter into
replacement swap transactions and is therefore currently unhedged.
Finance Group Alert
The conditions of the notes contained an event of
default which read:
"the Issuer… being unable to pay its debts as they
fall due or, within the meaning 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 Insolvency Act 1986 (as
that section may be amended from time to time),
being unable to pay its debts"; …
provided that the Trustee shall have certified to
the Issuer that such event is, in its sole opinion,
materially prejudicial to the interests of the
Section 123(2) is otherwise known as the
"balance sheet" test. As amended by the wording
of the event of default, Section 123(2) reads as
"A company is also deemed unable to pay its
debts if … the value of the company’s assets is
less than the amount of its liabilities, taking into
account its contingent and prospective
The holders of the A3 notes argued that the
termination of the swap transactions had resulted
in the Issuer becoming insolvent and that an
event of default had occurred as a result. The
Issuer and the holders of the A2 notes
argued the opposite.
the affiliate would release the Issuer from any
further liability under the notes. The PECO was
therefore thought to be an adequate substitute for
the standard limited recourse wording used in
non-UK securitisations.
The Judgment: analysis of Section
123(2) of the Insolvency Act 1986 and
the effect of the PECO
Interpretation of Section 123(2) of the
Insolvency Act 1986
A large part of the judgment was concerned with
the requirement of Section 123(2) that
"contingent and prospective liabilities" should be
taken into account in assessing a company’s
technical solvency. There is a limited amount of
judicial guidance on how this test should be
applied. The courts are usually concerned with
the more common "cash flow" insolvency test (in
Section 123(1)) as this usually forms the basis of
creditor-led winding ups and administrations.
Drawing upon Briggs J’s judgment in Re Cheyne
Finance plc [2008] 2 AER 987, the judge
concluded that "taking into account prospective
and contingent liabilities" meant that:
Only present assets (i.e. not future and
contingent assets) could be taken into
Future and contingent liabilities should not
necessarily be attributed their face value;
A pure "accounting" treatment may not be
appropriate if other factors were
indicated. The test should take into account
all the facts.
Normal practice in securitisation transactions is
to limit the liability of the issuer of the notes to
the proceeds of the realisation of its assets. That
was not done in the Eurosail transaction out of a
concern that limiting recourse under the notes in
that way would have resulted in interest payments
on the notes being treated as distributions for UK
tax purposes with the consequent denial of tax
deductions for the Issuer[2].
Turning to the specific facts of the case:
Although LBSF's liability to the Issuer in
connection with the termination of the swaps
was not recognised in the Issuer’s accounts
(because it was subject to ongoing litigation
and might not be recovered), the liability of
LBSF to make the termination payment
should nevertheless be recognised as an asset
of the Issuer for the purposes of Section
123(2) (albeit one which should be
discounted to its face value to reflect
secondary market valuations of Lehman
The loss shown in the Issuer’s balance sheet
which arose from the conversion of euro and
US dollar liabilities to sterling at the
prevailing spot rate could be ignored for the
purposes of Section 123(2): the final
Instead, the transaction addressed the rating
agencies’ requirements in relation to insolvency
remoteness by including a PECO.
The PECO is a common device seen in many
securitisations with a UK incorporated issuer.
The terms of the PECO provided that, if there
was an insufficient amount of money to pay all
principal and interest due on any of the notes on
enforcement, the holders of those notes could be
required to sell their notes to an affiliate of the
Issuer for a nominal consideration. In that
eventuality, the commercial expectation was that
10 August 2010
Finance Group Alert
redemption date in relation to these liabilities
is 2045 and there is no way of knowing what
the exchange rate will be at that time – the
potential loss was therefore found to be too
uncertain to be taken into account;
a PECO mechanism - one which, depending on
the factual circumstances surrounding the
valuation of an issuer’s assets and liabilities, may
be used by noteholders to allege that an event of
default has occurred.
The judge stated that the Issuer’s liability to
noteholders was "fully funded" in the sense
that any loss on the mortgage assets would
reduce the liability of the Issuer to the
noteholders through the operation of the
principal deficiency ledgers (with respect,
this was not an entirely accurate description
in that the principal deficiency ledgers
operate to divert income to pay down the
notes – they do not automatically result in the
writing down of the notes on the occurrence
of a loss in the way which would be typical
for a credit linked note);
It is very clear from the judgment that the
determination of whether an issuer is balance
sheet insolvent for the purposes of Section
123(2) is not dictated by generally accepted
accounting principles. For example, the liability
of Lehman to pay the swap termination payment
was taken into account and the unrealised loss
resulting from the conversion of the Issuer’s now
unhedged euro and US dollar liabilities into
sterling was excluded – contrary to the treatment
adopted in the Issuer’s accounts.
There was no balance outstanding on the
principal deficiency ledgers, which suggested
that the Issuer was solvent.
The judge’s conclusion was that the value of the
Issuer’s assets was greater than the amount of its
present liabilities taking into account its future
and contingent liabilities. Therefore no event of
default had occurred.
It was found that the existence of the PECO made
no difference to the analysis under Section
123(2). Even after the operation of the PECO, the
Issuer's liabilities would remain, and the fact that
they would be owed to an affiliate was irrelevant.
The commercial expectation that the affiliate
would write off the liabilities and not enforce
against the Issuer did not reduce the amount of
the liabilities - the affiliate was under no
obligation to effect the write off. The judge did,
however, express the view that the PECO was
effective to make the Issuer insolvency remote in
the sense that it provided a mechanism to divest
the noteholders of their notes in circumstances in
which they might otherwise seek to wind
up the Issuer.
Whether, following the judgment, one views the
Issuer as being insolvency remote is a matter of
definition. The fact remains that the PECO did
not protect the Issuer from becoming insolvent
for the purpose of section 123(2) of the
Insolvency Act 1986 in the way that standard
limited recourse wording might be expected to.
Arguably, therefore, there is a structural flaw in
the great number of UK securitisations which use
It is certainly possible to argue against the
finding that the Issuer was solvent in this
case. The margin between the Issuer’s assets and
its liabilities was small - like other securitisation
SPVs it had a nominal amount of capital and was
not intended to accumulate significant amounts
of profit. The termination of the swap
transactions did not create a windfall for the
Issuer - in broad terms, the termination payment
was designed to enable the Issuer to replace its
hedging protection. Therefore, had LBSF been
able to pay the termination amount in full, it
appears that the Issuer would have been back to
the position it was on the issue date - fully
hedged and solvent, but not by a very large
margin. The judge’s own assessment of the value
of LBSF's liability to pay the termination
payment was about 35 per cent of its nominal
amount - in other words about $143 million less
than its nominal amount. Unless the excess
spread in the transaction was very significant, it
is hard to see why the $143 million shortfall did
not result in the Issuer being insolvent or why in
assessing the Issuer's solvency it was appropriate
to rely upon the prevailing market value of
Lehman debt, but not the prevailing market value
of the US dollar and the euro against sterling.
Moving away from the specifics of the case, the
finding that accounting principles are not
determinative for the purposes of Section 123(2)
means that in practice it may be very difficult for
lenders and noteholders to assess whether a
borrower or issuer is insolvent on a balance sheet
basis. It is possible that, in the future, more debt
documents will include a basic balance sheet
solvency test within financial covenants in
addition to relying upon Section 123(2) to
mitigate this issue. The uncertainly around the
assessment of a company's solvency under
10 August 2010
Finance Group Alert
Section 123(2) will also dissuade many creditors
from relying upon an event of default based on
Section 123(2) in the absence of other more clear
cut events of default.
Eurosail is a first instance decision. It remains to
be seen whether the A3 Noteholders will seek to
[1] Although not relevant to the outcome of the
case , it is worth making two observations
about the event of default: firstly, the reason
that the wording “it is proved to the satisfaction
of the court” is sometimes omitted from events
of default which cross reference Section 123(2)
is to avoid any argument that the event of
default only bites after a court decides that the
borrower/issuer in question is insolvent;
secondly, it is unusual that this type of event of
default is contingent upon the trustee forming
a view that the insolvency is materially
prejudicial to noteholders – that qualification
normally only applies to events of default that
relate to breaches of covenant.
[2] It is worth noting that one of the benefits of
the tax rules for securitisation companies
introduced on 1 January 2007 is the exempting
of issuers that meet the "securitisation
company" test from the provisions that
recharacterise interest as distributions.
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10 August 2010