BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc & Ors>

This is an appeal and a cross-appeal from a decision of the Chancellor of the High Court given on 30 July 2010 – [2010] Bus LR 1731; [2010] EWHC 2005 (Ch). Both the appeal and the cross-appeal involve questions of interpretation of the terms of interest-bearing notes (“the Notes”), which were issued by Eurosail-UK 2007-3BL PLC (“the Issuer”), a special purpose vehicle formed to hold income-producing assets, consisting of mortgage loans, to be used to meet the liabilities on the Notes.

Although the documentation supporting the issue of the Notes is regrettably and forbiddingly voluminous, neither the basic contractual and financial concepts underlying the Notes nor the nature of the problems which have arisen is particularly complex. The relevant factual background is as follows.

In July 2007, in accordance with the purpose for which it was formed, the Issuer acquired, for just under £646m a portfolio of about £650m sterling denominated mortgage-backed loans (“the mortgages”) all relating to UK residential properties. These mortgages were in the main so-called non-conforming residential mortgages, i.e. the borrowers did not satisfy the requirements of building societies and banks.

The mortgages were at varying rates of interest, and had different final redemption dates (although most, possibly all, were redeemable early at the option of the mortgagor). In order to fund the acquisition, the Issuer sold investors various instruments. The total amount raised on the sale of different classes of interest bearing Notes was £659.75m. £9.75m of this amount was raised by way of different classes of interest bearing Notes. The balance of £9.75m was raised through the sale of so called ETc Notes which have been repaid, and which, although referred to in argument, do not appear to me to have any bearing on the issues on this appeal.

The balance of £13.75m, being the difference between the cost of the mortgages and the amount raised, was devoted to the expenses of the issue, which were some £2.46m, and two reserve funds, amounting to some £11.3m in aggregate.

The Notes were marketed in the usual way by means of a detailed Prospectus, and the arrangements governing the issue of the Notes were set out in a number of documents referred to as the “Transaction Documents”. The most significant of these were the “Terms and Conditions of the Notes”, a Trust Deed, a Deed of Charge, a “Securitisation Agreement” and a “Post Enforcement Call Option Agreement” (a “PECO”).

Pursuant to the Trust Deed, the claimant, BNY Corporate Trustee Services Ltd (“the Trustee”), was effectively constituted the trustee of the rights of the holders of the Notes against the Issuer, including the right to enforce rights contained in the Trust Deed. Under the Deed of Charge, the Issuer granted to the Trustee, for the benefit of the Noteholders, security (“the Security”) for the performance of its obligations, and a major aspect of the security was the grant of rights over the mortgages.

Some of the Notes were denominated in euros, some in US dollars, and some in sterling: the denomination of the Note determined the currency in which both the capital was repaid and interest was paid in the meantime. The Notes were in five Classes, Class A to Class E, with descending priority rights; the A Class had three subclasses 1, 2 and 3 (also with descending priority rights as to principal payments prior to enforcement), and Classes B to E only had a subclass 1. Many of the subclasses had more than one group, identified by a lower case letter identifying that group’s currency denomination (“a” for euros, “b” for dollars, “c” for sterling), and every group within a subclass ranked pari passu.

The rate of interest payable on the Notes was linked to LIBOR, an inter-bank floating rate, and was lowest for the Class A1 Notes and highest for the Class E1 Notes. Each Class of Notes had a final maturity date (June 2045, except for the Class A1 Notes, for which the date was September 2027). The Class A Notes represented the majority in value of the Notes and were divided into three subclasses, A1b and A1c (a mixture of sterling and dollar Notes), A2b and A2c (also a mixture of sterling and dollar Notes), and A3a and A3c (mostly euro Notes, but some sterling Notes).

The evidence establishes that it was vital to the success of the issue that all the Class A Notes were accorded a AAA rating (or the equivalent) from the rating agencies. This was duly achieved, as was prominently recorded in the Prospectus, which also recorded that Notes in the Classes B1, C1, D1, and E1 (“the junior” Classes) were respectively accorded AA, A, BBB, and BB ratings (or their equivalents).

For the purpose of the present proceedings, the effect of the Terms and Conditions can be summarised as follows, although it is right to emphasise that what follows is a considerable simplification, which concentrates on what are the essential aspects of the transaction for present purposes.

The interest received under the mortgages is used to pay the interest due under the Notes. At least until a contractual “Enforcement Notice” (as explained below) is served, interest is paid quarterly to the Noteholders, and if the interest is insufficient, the junior Noteholders become at risk of having their rights to receive interest deferred to the date on which the relevant Notes are redeemed. There is no such provision for deferment in respect of the interest due on the Class A Notes. If the aggregate of the interest paid under the mortgages is greater than the interest which the Issuer has to pay out to holders of the Notes, this produces what is known as “excess spread”.

As the mortgages are redeemed, the proceeds are to be used to pay off the Notes, on the quarterly dates on which interest is payable. The order in which principal amounts outstanding on the Notes are to be paid off, in the absence of enforcement, was A1, A2, A3, B1, C1, D1, E1, so A2 Noteholders received no repayment of principal until the A1 Noteholders had all been paid off, and so on down to the E1 Noteholders.

Some of the mortgages may result in a loss (typically where the mortgagor defaults and the proceeds of sale of the security are insufficient to repay the sum secured by the mortgage). In that event the “Principal Deficiency”, i.e. the book loss created thereby, is, in effect, debited to the accounts of the junior Noteholders. However, the excess spread, as described above, may be used to extinguish this book loss.

In the event of the service of an Enforcement Notice, much of the above arrangements would change. First, the principal on the Notes would become repayable immediately, so the long stop dates of 2027 and 2045 would become irrelevant. Secondly, the priorities for repayment of principal and payment of interest would change: (i) the three sub-classes of Class A Notes would be collapsed into a single Class, so that they would rank pari passu for the repayment of capital, and (ii) until all the Class A Noteholders had been paid interest and capital in full, the junior Noteholders would not be entitled to receive anything. Thirdly, the Trustee would be entitled to enforce its “Security” over the mortgages – e.g. by selling them.

Condition 2(h) of the Terms and Conditions, after setting out (in considerably more detail than I have summarised them) the “Priority of Payments Post-Enforcement”, stated that

“The Noteholders have full recourse to the Issuer in respect of the payments described above, and are accordingly entitled to bring a claim under English law, subject to the Trust Deed, for the full amount of such payments in accordance with Condition 10.”

Condition 10 empowers the Trustee to “take such proceedings against the Issuer … as it may think fit to enforce the provisions of the Notes or the Trust Deed”, but it is not bound to do so unless a specified proportion of the outstanding Noteholders request it.

By virtue of Condition 9 of the Terms and Conditions, an Enforcement Notice can only be served by the Trustee on the Issuer if, inter alia, two conditions are satisfied. The first is that one of the specified “Events of Default” has occurred; the second is that the Trustee certifies that the event in question is “materially prejudicial to the interests of the Noteholders”. The only Event of Default in play in these proceedings is that in Condition 9(a)(iii) (“Condition 9(a)(iii)”), which is in these terms:

“The Issuer … ceasing … to carry on business … or being unable to pay its debts as and when 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”.

The only provision of the Deed of Charge to which I should refer is clause 6.7, which provides that “no sum due or owing to any Secured Creditor or to the Trustee … from the Issuer under this Deed or under any other Transaction Document shall be payable” save to the extent that there are “sufficient funds available … to pay such sum”. This is then expressed to be subject to the qualification that the clause “shall not apply to and shall not limit the obligations of the Issuer to the [Noteholders] under the Instruments and this Deed”.

Because the Issuer’s assets (i.e, the mortgages) were all sterling-denominated but most of its liabilities (under the “a” and “b” groups of Notes) were denominated in euros or dollars, the Issuer entered into a currency hedge in order to protect its position against adverse movements in sterling. Similarly, because the Issuer could become exposed to fluctuations in interest rates, it entered into an interest rate hedge. The hedge in each case was effected by a so-called swap contract, and the counterparty under each contract was a Lehman Brothers company, LBSF, whose liability thereunder was guaranteed by another Lehman company, LBHI. LBHI and LBSF entered bankruptcy proceedings on 15 September and 3 October 2008 respectively, and the swap contracts were terminated soon thereafter. The Issuer has lodged claims for the loss of the hedges in the estates of LBSF and LBHI, but these claims have not been admitted. The Issuer has been unable to purchase substitute hedges, albeit that there is no suggestion that it has been in breach of the obligation requiring it to do so in the Terms and Conditions.

The loss of the currency hedge has been disadvantageous, because, since August 2007, sterling has depreciated significantly against both the euro and the dollar. On the other hand, the loss of the interest rate hedge has not caused any immediate disadvantage, as the aggregate interest paid under the mortgages has been significantly greater than the interest which the Issuer has had to pay out to holders of the Notes. The consequential “excess spread” (which is mentioned above) has so far been more than enough to wipe out any “Principal Deficiency” (which is also mentioned above).

Although all the Notes have a final maturity date in 2045 (or 2027 in the case of the Class A1 Notes), it was in fact anticipated that the principal of the Notes would be repaid earlier, possibly much earlier in some cases, because such repayments were made as and when the mortgages were redeemed by the mortgagors (and because no doubt some of the mortgages fall due for repayment before 2045). This has indeed happened: the holders of the Class A1 Notes have been repaid in full.

However, owing to the fact that the mortgages are all denominated in sterling, which has depreciated against the euro and the dollar, and because of the loss of the currency swaps, the money received by the Issuer when mortgages have been redeemed, has been able to repay a smaller quantum of the euro- and dollar-denominated capital than was originally envisaged. This has resulted in a significant deficiency in the net asset position of the Issuer.

As the holders of the Class A1 Notes have now been paid off in full, it is in the interests of the holders of the Class A3 Notes that an Enforcement Notice is served, and, correspondingly, in the interests of the holders of the Class A2 Notes that no such Notice is served. It is therefore unsurprising that the six appellants, who are arguing that an Event of Default has arisen, are all holders of Class A3 Notes, and that two of the three respondents opposing that argument are holders of the Class A2 Notes, the third active respondent being the Issuer.

The appellants contend that an “Event of Default” has arisen, because, principally as a result of the loss of the currency hedge, the Issuer should be deemed to be “unable to pay its debts” within the meaning of Condition 9(a)(iii). That was the issue before the Chancellor, and is now the issue before us. If such an Event has indeed occurred, then it will be for the Trustee to decide whether the event is “materially prejudicial to the Noteholders”, but that is not a matter for consideration, at least at the moment.

The issue may seem to involve one question, namely whether the Issuer should be deemed to be “unable to pay its debts” in the light of the shortfall in its assets as summarised above. However, if the Issuer would otherwise be deemed “unable to pay its debts”, the respondents have a second argument, based on the PECO. In order to explain the PECO, it is appropriate first to refer to the Prospectus.

The Prospectus explained to prospective purchasers of the Notes that:

“Although the [Notes] will be full recourse obligations of the Issuer, upon enforcement of the security for the [Notes], the Trustee … will, in practice, have recourse only to the [mortgages] and to any other assets of the Issuer then in existence ….”.

The reason for this rather paradoxical arrangement was well explained by the Chancellor at [2010] Bus LR 1731, para 40:

“As indicated … above, issuers of notes are concerned to comply with the criteria published by the rating agencies so that their instruments may attract the highest possible rating. One of those criteria is colloquially called ‘insolvency remoteness’ by which is meant the practical impossibility of the issuer being subjected to any insolvency process. In other jurisdictions this is achieved by provisions which limit the rights of Noteholders against the issuer to the value of its assets, but in England and Wales that produced adverse tax consequences. The PECO is designed to achieve the same result by ensuring, so far as practically possible, that if the assets of the issuer prove to be insufficient the Noteholder to whom a balance is due will not take steps to wind up the issuer. It appears that both the leading auditors and the major rating agencies treat the two methods of achieving insolvency remoteness as commercially equivalent.”

The “adverse tax consequences” involved stamp duty being payable on the issue. The relevant legislation has now been amended so that stamp duty no longer arises on straightforward limited recourse issues.

In this case, therefore, under the Terms and Conditions, the rights of the Noteholders against the Issuer in respect of repayment of capital and interest were unlimited, at least on the face of it, and therefore the Issuer was not “bankruptcy remote”. (I use that expression rather than the Chancellor’s “insolvency remote”, as the evidence establishes that the purpose of the PECO was to prevent the Issuer from being susceptible to insolvent winding-up proceedings, not from being insolvent). However, the PECO had the effect of limiting the Noteholders’ rights of recourse “in practice” (to quote from the Prospectus) and hence had the effect of rendering the Issuer bankruptcy remote, at least according to the market perception.

Clause 3.1 of the PECO is the grant of an option (“the option”), binding on all Noteholders, by the Trustee, on their behalf to a company called Eurosail Options Ltd (referred to as “OptionCo”):

“to acquire all (but not some only) of the Notes (plus accrued interest thereon) in the event that the Security for the Notes is enforced and the Trustee, after the payment of the proceeds of such enforcement, determines that the proceeds of such enforcement are insufficient, after payment of all claims 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 amounts whatsoever due in respect of the Notes. The Trustee shall promptly after the Security is enforced and the proceeds of such enforcement are paid, make a determination of whether or not there is such insufficiency. If the Trustee determines that there is such an insufficiency the Trustee shall forthwith give notice (the ‘Insufficiency Notice’) of such determination to OptionCo and the Issuer.”

Clause 3.2 of the PECO provides that the option may be exercised at any time after an Insufficiency Notice has been given. Clause 6 allows assignment, novation or transfer with the prior written consent of the Trustee to be given only if the Trustee is satisfied that it will not be materially prejudicial to the Noteholders.

As the Chancellor explained, OptionCo “is the wholly owned subsidiary of a company called PRS 1 Ltd the shares of which are held on trust for exclusive charitable purposes. The trustee of that trust, as of the trust of the shares in the parent company of the Issuer, are held by Wilmington Trust, a large US based banking institution. To that extent therefore the Issuer and OptionCo are associated companies” – [2010] Bus LR 1731, para 20.

There are thus two questions. The first is whether, ignoring the existence of the PECO, the Issuer should be “deemed unable to pay its debts” 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)”, under Condition 9(a)(iii). The second question, which only strictly arises if the answer to the first is in the positive, is whether the existence of the PECO justifies a different conclusion – i.e. whether, if the Issuer would otherwise be deemed unable to pay its debts, the existence of the PECO results in the conclusion that it should not be so deemed.

The Chancellor decided that, on the first question, the Issuer should not be deemed to be unable to pay its debts, but that, if he had decided otherwise, then, on the second question, the PECO would not have altered his conclusion. The six appellants, who are holders of class A3 Notes, appeal against the first decision and support the second decision. The three respondents, who are the Issuer and two of the holders of class A2a notes, support the first decision and cross-appeal against the second decision.

It is sensible to consider the two questions in the same order as that in which the Chancellor considered them. The first involves initially determining the meaning of the reference to section 123(2) of the Insolvency Act 1986 (“the 1986 Act”), and then assessing whether the financial position of the Issuer brings it within the ambit of section 123(2) of the 1986 Act (“section 123(2)”). The second question requires the resolution of a single point, namely whether, if the Issuer would otherwise fall within section 123(2), the PECO would, as it were, take the Issuer out of the ambit of the section.

Contrary to an argument initially advanced by the respondents, it appears to me clear that, when considering the application of Condition 9(a)(iii), the incorporation of “Section 123(1) or (2)” requires one to give those statutory provisions the meaning and effect that they have in the statute without qualification or adjustment, save to the extent that it is spelt out (as it is here by the express notional deletion of the words “it is proved to the satisfaction of the court”). Such an approach accords with the normal approach to the incorporation of statutory provisions in contracts as discussed in Enviroco Ltd v Farstad Supply A/S [2009] EWCA Civ 1399, paras 53-54. In this case, that approach is reinforced, as Toulson LJ pointed out in argument, by the fact that the parties committed themselves to whatever the statutory provisions may mean, by having included the words “(as that Section may be amended from time to time)”.

Accordingly, the first question to be considered is the meaning of section 123(1) and (2). That statutory provision must, of course, be interpreted in its context. So far as its immediate statutory context is concerned, section 122(1) of the 1986 Act sets out the circumstances in which “[a] company may be wound up by the court”. Those circumstances include “(f) the company is unable to pay its debts”.

Section 123 is headed “Definition of inability to pay debts”. Section 123(1) describes five situations in which “[a] company is deemed unable to pay its debts”, and they are:

“(a)

if a creditor … to whom the company is indebted in a sum … has served on the company … a written demand … to pay … and the company has for 3 weeks thereafter neglected to pay the sum …,

(b)

if … execution or other process issued on a judgment … in favour of a creditor … is returned unsatisfied;

(c)

[applies to Scotland];

(d)

[applies to Northern Ireland];

(e)

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

Section 123(2) provides:

“A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.”

It is also relevant to refer to rule 13.12(3) of the Insolvency Rules 1986, which provides that:

“For the purposes of references in any provision of the [1986] Act or the [Insolvency] Rules about winding up to a debt or a liablility, it is immaterial whether the debt or liability is present or future, whether it is certain or contingent, or whether it is fixed or liquidated, or is capable of being ascertained by fixed rules or as a matter of opinion ….”.

Section 123(2) must also be set in its historical context. The predecessor provision of section 123 was section 518 of the Companies Act 1985 (“CA 1985”), which, in its original form, effectively reproduced its statutory predecessor, section 223 of the Companies Act 1948 (“CA 1948”). Section 223 of CA 1948, and section 518 of CA 1985 as enacted, were in fairly similar terms to section 123, except, instead of the two provisions which are now subsections (1)(e) and (2) of section 123, there was a single provision in section 223(d) of CA 1948 (which was reproduced virtually verbatim as section 518(e) of CA 1985), which was to this effect:

“A company shall be deemed 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 whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities of the company.”

The CA 1948 and the CA 1985 (which replaced it) successively consolidated the statutory provisions relating to company law, including corporate insolvency law. Para 27(3) of schedule 6 to the Insolvency Act 1985 (“IA 1985”) amended CA 1985 so that section 518(e) was replaced by provisions equivalent to section 123(1)(e) and (2). The 1986 Act largely consolidated the corporate and personal insolvency legislation in one statute, and therefore resulted in almost all the corporate insolvency statutory provisions being taken out of the company law legislation.

In the present case, it was not suggested that section 123(1)(a) to (d) applied to the Issuer. Further, was not suggested that the Issuer is currently paying its debts as they fall due: the holders of all classes of the Notes have been and are being paid in accordance with the terms on which the Notes were issued, so it was not contended that the Issuer is “unable to pay its debts within the meaning of Section 123(1)”. (A slight oddity in the drafting of Condition 9(a)(iii) is the notional deletion of the words “it is proved to the satisfaction of the court” from section 123(2), without there being a similar deletion from section 123(1)(e). No argument was addressed to that point, and, I am inclined to think, rightly so. I suspect that the notional deletion should also be treated as extending to section 123(1)(e), but, even if that is not so, I do not see how it would help on the issue which we have to resolve.)

Mr Richard Sheldon QC, for the appellants, accordingly takes his stand on section 123(2). He contends that section 123(2) requires one simply to take the assets and liabilities of a company at their respective face amounts, which are to be those in the company’s balance sheet unless good reason is shown to the contrary, and, if the aggregate of the liabilities so taken exceeds the aggregate of the assets so taken, then the company is deemed to be insolvent.

If one confines oneself to the words “the value of the company’s assets is less than the amount of its liabilities”, it is easy to see the force of this submission. It also appears to have the virtue of conceptual and practical simplicity. However, I do not accept that it is right.

In the first place, I do not consider that the question whether section 123(2) applies simply turns on the question whether the liabilities of a company (however they are assessed) exceed its assets (however they are assessed). In practical terms, it would be rather extraordinary if section 123(2) was satisfied every time a company’s liabilities exceeded the value of its assets. Many companies which are solvent and successful, and many companies early on in their lives, would be deemed 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 only just exceeded its liabilities when it was formed, and it was more than possible that, even if things went well, it would fall from time to time within the ambit of section 123(2) if the appellants are right as to the meaning of that provision.

Mr Sheldon seeks to meet that point by relying on the fact that, even if section 123(2) applies, the court still has a discretion to refuse to make a winding-up order – see the opening words of section 122(1) of the 1986 Act. I do not regard that as a satisfactory answer. The commercial undesirability of a company being at risk of being wound up simply because the aggregate value of its assets is less than that of its liabilities is self-evident. The presentation of a winding-up petition can of itself cause serious problems to a company, and, even if a petition is likely to be dismissed in the court’s discretion, the fact that it was properly presented, because the liabilities of the company concerned exceeded the value of its assets, could result in much damage.

Further, prospective investors in, and prospective creditors of, such a company would have to be advised that any creditor of the company might petition to wind it up. While they would no doubt also be told that the court may very well (or would even be very likely to) refuse the petition, the consequences of such advice would undoubtedly be to deter the making of the investment or the giving of credit. Uncertainty, in particular the risk of insolvency proceedings, is a notorious and unsurprising disincentive to investors and lenders.

More generally, I find it hard to discern any conceivable policy reason why a company should be at risk of being wound up simply because the aggregate value (however calculated) of its liabilities exceeds that of its assets. Many companies in that position are successful and creditworthy, and cannot in any way be characterised as “unable to pay [their] debts”. Such 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.

In my view, the purpose of section 123(2) has been accurately characterised by Professor Sir Roy Goode in Principles of Corporate Insolvency Law (third edition). Having referred to section 123(1)(e) as being the “cash flow test” and 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] then current and short-term creditors would in effect be paid at the expense of creditors to whom liabilities were incurred after the company had reached the point of no return because of an incurable deficiency in its assets.”

In my judgment, both the purpose and the applicable test of section 123(2) are accurately encapsulated in that brief passage. Subsection (2) was, in my view, included in section 123 to cover a case where, although it could not be said that a company “is [currently] unable to pay its debts as they fall due” (either because it has no debts which are currently payable, or because it has, or can achieve, the cash flow to pay such debts), it is, in practical terms, clear that it will not be able to meet its future or contingent liabilities. A future or contingent creditor of a company can often claim to be prejudiced by the company using its cash or other assets to pay current creditors or even for some other purpose, but, within bounds, that is an inherent risk in the futurity or contingency of the liability. It is only when it can be said that the company’s use of its cash or other assets for current purposes amounts to what may be vernacularly characterised as a fraud on the future or contingent creditors that it can be said that it “has reached the point of no return”.

This is not dissimilar from the point made in relation to section 123(1)(e) by Briggs J in Re Cheyne Finance plc [2008] 2 All ER 987, para 51, when he contrasted “a momentary inability to pay … as a result of temporary liquidity soon to be remedied” with “an endemic shortage of working capital” which renders “a company … on any commercial view insolvent, even though it may be able to pay its debts for the next few days, weeks or months before an inevitable failure.” Mr Sheldon suggested that, if the last part of the passage, with its reference to future inability to pay debts, was correct, then section 123(2), as Professor Goode suggests it should be interpreted, would add nothing to section 123(1)(e). I do not agree. The point that I think Briggs J was making is that section 123(1)(e) does not require slavish adherence to the immediate present. It is unnecessary to decide whether that is correct, although it is only right to say that, as at present advised, I am inclined to think that it is. However, that does not call into question the conclusion that section 123(2) applies to a company whose assets and liabilities (including contingent and future liabilities) are such that it has reached the point of no return.

This conclusion reflects the fact that section 123(2) is concerned with a case of a company not being able to pay its debts, not with an exercise of simply assessing its net assets or liabilities: it is true that the subsection provides that assets and liabilities should be taken into account, but that is for the purpose of addressing the ultimate question of whether the company “is deemed unable to pay its debts”. It is also true that the position described in section 123(2) is merely “deemed” to amount to inability to pay debts, but the same expression is used in section 123(1), and all its paragraphs are concerned with actual inability (or refusal) to pay debts. The fact that the state of affairs described in section 123(2) is deemed to amount to inability to pay debts can properly be taken into account when interpreting what it means.

I also consider that this conclusion is supported by the closing words of section 123(2). Because of Rule 13.12(3) “contingent and future liabilities” would be “tak[en] into account” in any event if Mr Sheldon’s interpretation were correct. In my view the closing words were included to indicate that, unlike section 123(1)(e), section 123(2) is concerned with future and contingent liabilities. In order to see whether it can be said that, in connection with those liabilities, a company has reached “the point of no return”, it is, of course, necessary to look at its assets and liabilities.

Both the appellants and the respondents relied on a decision of this court in Byblos Bank SAL v Al-Khudhairy [1987] BCLC 232, where Nicholls LJ (in a judgment with which Slade and Neill LJJ agreed) discussed the meaning of section 223(d) of CA 1948, and, in some parts of his judgment ([1987] BCLC 232, 247e-h and 248j-249d), the requirement at the end of the section to “take into account … contingent and prospective liabilities”. Despite the source of the observations in those passages, they are, in my judgment, of no assistance here, as Nicholls LJ was considering the meaning of section 223(d) of CA 1948, and it is by no means clear that the legislature intended a different form of words, contained in two different subsections, to have precisely the same meaning. Indeed, Nicholls LJ’s analysis of section 223(d) of CA 1948 at [1987] BCLC 232, 247f-g seems to me to be hard to apply to section 123(1)(e) and (2). Further, it is clear that the company in that case was insolvent, and the issue was very different from that in this case. Unsurprisingly, therefore, support can be found in his judgment for both sides of the argument.

As Toulson LJ’s researches have established, the notion that section 123(2) was not intended to introduce a wholly new basis for winding up a company, based on assets and liabilities rather than on inability to meet debts is supported by what was said in Report of the Review Committee Insolvency Law and Practice, Cmnd 8558, 1982 (better known as the Cork Report), which led to a White Paper upon which the IA 1985 and 1986 Act were founded. After stating in para 205, that “[i]n practical terms, insolvency arises at the moment when debts cannot be met as they fall due”, there is a passage in para 216 of the Report, which reflects the view expressed by Professor Goode:

“A balance has to be struck between the right of an honest and prudent businessman, who is prepared to work hard, to trade out of his difficulties if he can genuinely see a light at the end of the tunnel, and the corresponding obligation to ‘put up the shutters’, when, by continuing to trade, he would be doing so in disregard of those business considerations which a reasonable businessman is expected to observe.”

In para 529, after pointing out that failure to pay debts has always been a ground for petitioning for winding up, the Report states that “[s]pecial provision is required for the comparatively rare case of the contingent or prospective creditor”. If every company with net liabilities was susceptible to winding up, it would not be a “comparatively rare case”.

Para 535 of the Report contained a recommendation that the sole ground upon which an insolvency order could be made against a company was if it was unable to pay its debts – i.e. what is now section 123(1)(e). The Report goes on to give three types of case where “the debtor will be deemed to be insolvent and unable to pay [its] debts”, and a winding up order could be sought. The first two cases substantially mirror section 123(1)(a) and (b) – although they are in the opposite order. Section 123(2) is mirrored by the third case, which refers to circumstances where “ultimate repayment of [a contingent or prospective] debt is in jeopardy because of [sic] the debtor’s liabilities, including contingent and prospective liabilities, exceed the debtor’s assets.” This may beg the question of what is meant by “jeopardy”, but it certainly accords in its general thrust with the view I have formed.

The subsequent White Paper (A Revised Framework for Insolvency Law, Cmnd. 9175, 1984) was much more limited its scope, and, while commenting favourably on, and referring to, the Cork Report, it did not touch on the issues discussed in the passages to which I have referred. There is no reason to believe that the views expressed in those passages did not find their way into the IA 1985 and the 1986 Act. Indeed, it seems to me that they did. In particular, it was recognised that a reasonable business person should not be impeded by insolvency law from trying to trade through a difficult period, and there is no reason to think that there was any intention to expand the grounds for winding up beyond inability to pay debts. Such a notion seems positively antithetical to the strong view expressed in the Cork report.

This supports the view that section 123(2) does not amount to a wholly new, relatively mechanical “assets-based”, basis for seeking to wind up a company. It supports the view that the section can only be relied on by a future or contingent creditor of a company which has reached “the end of the road”, or in respect of which the shutters should be “put up”, imprecise, judgement-based and fact-specific as such a test may be.

(For completeness, I should mention that the amendment to the Bill which resulted in para 27(3) of schedule 6 to IA 1985 (which contained the predecessor of section 123(2) by amending section CA 1985, section 518) was discussed in the House of Lords on 4 February 1985. The discussion cannot be referred to as an aid to construction, and, even if it could, it would give no support to the notion that there might have been some last minute suggestion that there should be a wholly new, assets-based, ground for seeking to wind up a company.)

I also disagree with Mr Sheldon’s submission that, when carrying out the exercise required by section 123(2), one simply takes future and contingent liabilities at face amount. “Face amount” is not a term of art, and, even on Mr Sheldon’s argument, the exercise must be more nuanced than that. If a company has a liability for £x in ten years or more, it cannot be right to treat that as a present liability of £x, unless, perhaps, it carries interest at an appropriate rate. The idea that one has to carry out a valuation exercise in relation to future and contingent debts is supported by commercial common sense as well as by the provisions of Rule 13.12(3).

The appellants are on somewhat stronger ground in their contention that the figures in the company’s balance sheet, and audited and signed off annual accounts, should be accorded weight in the exercise envisaged by section 123(2). I do not think that it is possible or helpful to describe in general terms the weight to be given to such figures in such an exercise. Clearly, the fact that the figures have been audited and are said to convey a “true and fair” view of the company’s position in the opinion of its directors should normally have real force. However, the figures will inevitably be historic, they will normally be conservative, they will be based on accounting conventions, and they will rarely represent the only true and fair view. The court will ultimately have to form its own view as to whether the company in question has reached what Professor Goode described as “the point of no return”.

It is not really possible, indeed it would be positively dangerous, to give much further general guidance as to the approach to be adopted by the court when deciding whether section 123(2) applies. The ultimate question, at least normally, is that identified by Professor Goode, and it is to be determined with a firm eye both on commercial reality and on commercial fairness. Clearly, the closer in time a future liability is to mature, or the more likely the contingency which would activate a contingent liability, and the greater the size of the likely liability, the more probable it would be that section 123(2) will apply. In so far as it is a helpful guide, the parties were agreed that the issue was to be determined on the balance of probabilities.

In assessing the financial position of the Issuer for the purposes of section 123(2), Mr Sheldon for the appellants relies on the position revealed in the Issuer’s audited accounts for the year ending 30 November 2009, which record a net liability of £74.557m. This net liability is described in the directors’ report, which accompanies the audited accounts, as being “due to the impact of adverse interest rate and foreign currency movements … which are no longer covered by interest rate swaps and foreign currency hedges, amortisation of the premium paid to the mortgage loan originators and the impairment of mortgage loans”. The evidence suggests that by far the most significant cause is the failure of the currency swaps and the consequent forced sale of sterling assets.

Mr Sheldon suggests that the Issuer’s true position may actually be worse, as the Issuer’s management accounts as at the same date record net liabilities at £129.74m. The two sets of accounts were prepared by reference to the same day, and the statutory accounts were audited and were bound to give a “true and fair” view. Accordingly, it seems to me that, at least in the absence of a good reason to the contrary (and consistently with Mr Sheldon’s reasons for relying on the audited accounts), one should start with the latest audited accounts, if one is starting with any set of the company’s own accounts in this exercise.

When considering if section 123(2) applies, I am content to take the starting point adopted by Mr Sheldon, namely the asset and liability position revealed by the company’s most recent accounts. However, that may well not be appropriate by any means in all cases. Further, in many, I suspect most, cases, in order to answer the question posed by section 123(2), it will be necessary to consider whether to depart from those figures, and whether to take into account other, sometimes more important, factors.

When faced with the figures in the November 2009 audited accounts in this case, the Chancellor appears to have taken the view that it was inappropriate to value future liabilities in foreign currencies, at least in so far as they gave rise to losses, because they were “entirely speculative” as exchange “rates continuously fluctuate” – [2010] Bus LR 1731, para 35. Mr Snowden QC, for the respondents, did not seek to support this, at least when it comes to considering the value of the assets and liabilities of the Issuer (although he said it was a point of some force when it comes to the ultimate question, namely whether section 123(2) applies).

As Mr Sheldon said, one has to value a future or contingent liability in a foreign currency at the present exchange rate. By definition, that is the present sterling market value of the liability. The present exchange rate between two currencies can be analysed as the market’s assessment of the future, in the sense that it is the rate at which each currency is seen to be equally likely to appreciate or depreciate as against the other. As events in autumn 2008 graphically illustrated, the market is not always right, but it almost always represents the best one can do when it comes to valuation in the financial and legal worlds.

Accordingly, in so far as one is carrying out an assessment of the assets and liabilities of the Issuer, it seems to me that, if, as is not inappropriate, one starts with the latest audited accounts, it is right to proceed on the basis of the figures in the audited accounts. However, although the figures relied on by Mr Sheldon are accurate in the sense that they indeed reflect what is shown by the Issuer’s audited accounts for the year ending 30 November 2009, they only represent the beginning of the enquiry in relation to the Issuer’s position for the purposes of section 123(2).

In my view, there are two substantial amendments to the net liability revealed by the November 2009 audited accounts, which, ironically and coincidentally, virtually cancel each other out.

The first major amendment arises from the loss of the currency hedge which has given rise to a claim in the insolvency of LBSF. The claim is said by the respondents to be worth in the region of £60m at current exchange rates. That figure is arrived at by taking the product of the value of the claim, assessed by accountants at rather over US $220m, and the price at which LBSF debt is currently being traded, around 40 cents in the dollar. Nothing is allowed for this in the Issuer’s audited accounts, because, according to the evidence, such claims are not recorded in audited accounts and balance sheets unless they are “virtually certain” to be paid.

In my view, although not included in the Issuer’s balance sheet, this is a claim which should be taken into account as an asset when considering whether section 123(2) applies. No reason has been advanced by the appellants as to why the Issuer does not have a good claim in LBSF’s insolvency as a matter of principle. The respondents’ evidence demonstrates exactly how the amount of the claim has been calculated, and (whilst not admitted by the Appellants) no evidence or argument has been put forward by the appellants to call the figure into question. The price at which LBSF debt is trading seems to me to be a pretty good indication of the probable level of pay-out, especially as it is now well over two years since the insolvency, and the price of the debt seems to have been pretty steady. Of course, it could turn out to be wildly wrong, but it is as likely to be too low as to be too high. The point is somewhat similar to that discussed above in relation to variations in exchange rates: one has to take the best evidence one can, and the market, though far from perfect, is normally the best one can do.

There is a small further point about the trading of LBSF debt. The trading is on the “standard recourse” basis, so that, if the full value of the debt which is sold turns out to be less than what is its actual full value, the vendor will pay the balance to the purchaser. So if LBSF debt is trading at 40, a seller would sell a $220m claim for $88m, and if, in due course, LBSF eventually pay out on the basis that the claim is worth $200m, the seller would repay $8m. I do not consider that this justifies a significant discount on the valuation of this claim, because, as already mentioned, there is no challenge to the calculation of the value of the Issuer’s claim against LBSF. Having said that, it might well be right to round the figure down a little just to allow, say, for negotiation or argument with LBSF over the quantum of the claim.

Secondly, it seems to me that there is a figure of a similar amount that has to be added back into the liabilities (which probably explains the difference between the November 2009 audited accounts and management accounts). It arises from the fact that those responsible for the audited accounts treated the Notes as being limited recourse, whereas, of course, they are not, at least on the assumption upon which the first question is proceeding.

In this connection, the notes to the Issuer’s audited accounts for the years ending 30 November 2008 and 2009 reveal that “the mortgaged-backed loan notes are stated at amortised cost”. As Mr Dicker QC for the respondents accepted, that was, and in the light of the expert evidence can only be, justifed if they are limited recourse Notes – i.e. as explained above, on the assumption that the Noteholders cannot have recourse against the Issuer beyond the value of the assets held pursuant to the Trust Deed (almost exclusively the mortgages). But that cannot be right, at least when one is assessing the Issuer’s net asset or liability position, once one is proceeding on the basis that the PECO does not have the effect for which the respondents contend on the second question. This means that the net liabilities are understated in the November 2009 audited accounts to the extent of £53.3m.

The two figures of some £60m and £53.3m roughly cancel each other out, especially if one applies a small discount to the former figure (which may well be appropriate). It is therefore right to proceed on the basis that the current value of the Issuer’s liabilities is in the region of some £70m in excess of its assets.

However, that stark fact has to be seen in its context, which includes a number of factors. First, the principal outstanding on the mortgages is just over £420m, so the current asset deficit is less than 17% of the assets. Secondly, and here I think there is force in the Chancellor’s approach, the deficit is largely based on the assumption that exchange rates will remain as they are. Of course, they are as likely to move in an adverse direction as they are to move in a favourable direction, but the volatility of those rates tells against the appellants, given that they have to establish that the Issuer has reached the point of no return. The point is emphasised by the fact that the asset deficiency revealed by the audited accounts for the previous two years, ending 30 November 2007 and 2008, was around £3m and £99.4m respectively.

Of the £70m or so deficiency, only about £20m has actually been lost, as that is the amount by which the actual redemption of Class A1 euro and dollar Notes has fallen short of what would have been expected if the currency hedge had survived. That does not mean that the balance of the £70m deficiency is fictitious, but it emphasises that most of it is based on anticipated mortgage redemptions and Note repayments.

Thirdly, it appears that one is probably looking a long way ahead. Not only do all the unredeemed Notes have a final redemption date in 2045, but it appears from the evidence that the weighted average term of the remaining mortgages is in the region of 18 years, and that the rate of early redemption has slowed significantly, and is likely, according to expert assessment, to remain low for the time being.

I accept that the financial circumstances of the Issuer are such that there is a real possibility that, if no Enforcement Notice is served, the continued payment of interest to all Noteholders, coupled with the repayment of capital to the holders of the A2 Notes, could redound to the eventual disadvantage of the holders of the A3 Notes. However, as mentioned, a future or contingent creditor of a company can very often show that he would be better off if the company was wound up rather than being permitted to carry on business. In a commercially sensible legal system that cannot of itself justify the creditor seeking to wind up the company.

Bearing in mind the substantial assets of the Issuer, the relatively long period over which the Issuer’s liabilities have to be met, and the potential for significant change in the differences between the value of the Issuer’s assets and liabilities, I agree with the Chancellor that the appellants have not established that the Issuer has reached what Professor Goode called the point of no return, or the Cork Report’s point at which the shutters should be put up. The financial situation of the Issuer, bearing in mind its assets and liabilities, in particular its liabilities to the Class A3 and junior Noteholders, has not been shown to be such that, to use Briggs J’s language, the Issuer is on any commercial view insolvent.

That conclusion is reinforced by the nature of the Issuer’s business, as any prospective Noteholder would, or should, have appreciated. Almost from the start, the Issuer must have been in a position where its liabilities exceeded its assets, given the small margin of about £15m (if one can take into account the initial reserve funds of some £11m), the risks of either of the hedges being lost or proving insufficient to cover losses, and the inevitability of some of the mortgagors defaulting and the proceeds of sale being less than the debt. Further, by providing that, in the event of the currency and interest rate hedges being lost, the Issuer would try to find alternative hedges, the parties clearly envisaged that the hedges might be lost. I accept that those two points do not directly bear on the issue, but they highlight the point that the Noteholders envisaged that there would be asset deficiencies, and that in turn supports the notion that they would not have intended that such deficiencies would represent an Event of Default.

(For completeness, it should be added that the respondents argued that (i) the provisions of the Terms and Conditions with regard to early redemption of the Notes, the “Principal Deficiency Ledger” and the “Liquidity Facility” assisted their case, and that (ii) what remained of the excess spread, after being used to extinguish the Principal Deficiency, could be used to reduce the £70m-odd deficit. I am unimpressed by (i) for the simple reason that Condition 9(a)(iii) does not operate automatically: the Issuer may be unable to pay its debts, but the Trustee may not certify that that is “materially prejudicial to the interests of the Noteholders”, so the early redemption provisions, the Principal Deficiency Ledger and/or Liquidity Facility provisions (whether as interpreted by the appellants, or by the respondents and Issuer) would come into play even if Condition 9(a)(iii) has the effect for which the appellants contend. As for (ii), it raises a rather intricate point which does not need to be decided: if it was resolved in the respondents’ favour it would only serve to reinforce my conclusion, and if it was resolved in the appellants’ favour it would have no effect on my conclusion. Accordingly, I have not dealt with those arguments, particularly as this judgment is quite long enough anyway).

Accordingly, I would dismiss the appellants’ appeal. This renders it unnecessary to determine the cross-appeal, but the parties fully argued the question it raises, it is said to be of some more general significance, and the Chancellor reached a conclusion on it (albeit briefly). Accordingly, I propose to deal with it.

This question is based on the assumption, contrary to my conclusion, that, in the absence of the PECO, the Issuer is to be deemed to be unable to pay its debts within the meaning of section 123(2), and this part of the judgment proceeds on that assumption.

The respondents’ case on this question, as developed by Mr Dicker QC, is that, once there were no further mortgages to be redeemed, and the assets of the Issuer were exhausted, the option would be exercised, so that any claim which Noteholders had against the Issuer in respect of unpaid interest or unrepaid principal would be assigned to OptionCo, and, given the effective identity of ownership of the Issuer and OptionCo, that would be an end of the claims. Accordingly, runs the argument, viewed in terms of commercial reality, the Noteholders would never have any recourse against the Issuer save to the extent of its assets, in effect the mortgages. So, it is said, it would be wrong to treat the Issuer as falling within section 123(2), as the liabilities alleged to be debts which it was unable to pay, namely the eventual inability to pay interest or to repay principal because of the exhaustion of its assets, would be liabilities which it would never have to meet thanks to the PECO.

The option cannot be exercised until after the enforcement of all the available “Security”, payment of all the available proceeds, and a determination by the Trustee that there is an “insufficiency” to meet the claims of every Noteholder. The appellants accordingly rely on the fact that, until the option is exercised, the Noteholders have full rights of recourse against the Issuer, and that, even after the option has been exercised, OptionCo would have the ability to enforce those rights.

If it was clear that section 123(2), as interpreted and applied in accordance with this judgment on the first question, was satisfied in relation to the Issuer, and there was no bar in any of the Transaction Documents to the presentation by a Noteholder or the Trustee of a winding-up petition on that ground, I would be prepared to accept that the petition would nonetheless be dismissed, in the light of the PECO. The court, faced with such a petition, would, in my view, look at the commercial reality of the Issuer’s position with regard to its liabilities, rather than a hypothetical or theoretical analysis based on the strict legalities. As the Cork Report (op. cit.) said in para 198(k), insolvency law should “produce practical solutions to financial and commercial problems”. Accordingly, bearing in mind the effective identity of ownership of the Issuer and OptionCo and the whole purpose of the PECO, once the Issuer’s assets are exhausted, the option would be exercised, and so the petitioners would have no real interest as creditors in respect of their outstanding debt.

This analysis could be said to overlook the possibility of OptionCo as a contingent creditor presenting such a petition. I consider the answer to that is that such a possibility is purely hypothetical. The close connection between the Issuer and OptionCo, and the purpose of the PECO as explained by the Chancellor at [2010] Bus LR 1731, para 40, render such a possibility academic. In other words, the court would take the view that the Issuer was, indeed, bankruptcy remote.

Accordingly, it is said that, while the literal interpretation of section 123(2) in the context of Condition 9(a)(iii) can (albeit ultimately unsuccessfully) be deployed against the respondents and Issuer on the first question, it appears to assist them on this second question. A court faced with a winding up petition relying on section 122(1)(e) of the 1986 Act, would conclude on the facts assumed for present purposes, that the Issuer was not within the ambit of section 123(2).

However, that is not the end of the matter. As Mr Sheldon rightly said, the issue raised by the second question is not whether the Issuer should be wound up on the grounds in section 123(2), but whether its financial position is such that it falls within the ambit of section 123(2) within the meaning of Condition 9(iii)(a). This distinction is highlighted by the difference between “insolvency remoteness” and “bankruptcy remoteness” briefly discussed in para 28 above.

At first sight, the respondents can say that this does not alter the fact that, viewed in the context of the arrangements embodied in all the Transaction Documents, the effect of the PECO is that, in circumstances where the Issuer would otherwise be within the scope of section 123(2), the PECO effectively would take it out of that scope.

I see the force of that simple point, but I consider that matters are a little more sophisticated than that. Reading the relevant provisions of the Transaction Documents together, I consider that they establish that, at least until the Security is enforced, and arguably until the option is exercised and the transfer to OptionCo is completed, the way in which the transaction is structured is on the basis that the Issuer’s liability to pay the Noteholders principal and interest is to be treated as a liability of full recourse.

There are three provisions which appear to spell that out. The first is the statement in the Prospectus, set out in para 26 above, that the rights of the Noteholders would be “full recourse obligations of the Issuer”, although “upon enforcement of the security” those rights would “in practice” be limited recourse. That suggests a two stage process, under which the Issuer’s liability is initially treated as full recourse, the second, which only arises on enforcement of security, when the liability is limited recourse. Even if not part of the Transaction Documents, the Prospectus both has legal force and can be expected to give a clear idea to prospective Noteholders of their rights.

Secondly, there is the closing part of clause 6.7 of the Deed of Charge, referred to in para 18 above. After restricting the ability of the Trustee to enforce the Noteholders’ rights on enforcement of the Security beyond the Issuer’s assets, it provides that this “shall not apply to and shall not limit the obligations of the Issuer to the [Noteholders] under the Instruments and this Deed”. This appears clearly to spell out in part of the Transaction Documents that the rights of the Noteholders are to be treated as being full recourse. Mr Dicker suggested that little weight should be given to a provision stuck away at the end of a clause in the Deed of Charge, but, given that it is not inconsistent with any other provision and reflects what is in the Prospectus, and is not inconsistent with the commercial requirement that the Issuer is bankruptcy remote, I do not consider that the provision can be so lightly shrugged off.

Thirdly, there is the provision in Condition 2(h) of the Terms and Conditions, quoted in para 16 above, which states in terms that the Noteholders “have full recourse to the Issuer in respect of the payments” due under a post-Enforcement Notice regime, and that they “are accordingly entitled to bring a claim under English law, subject to the Trust Deed, for the full amount of such payments”. I would make the same point about this provision as I have made in relation to clause 6.7 of the Trust Deed; further, the two provisions reinforce each other.

It is interesting to note that the two provisions in the Transaction Documents which spell out that the Noteholders’ rights are full recourse are dealing with cases where things have gone wrong financially: either an Enforcement Notice has been served – Condition 2(h) – or the Security has been enforced – clause 6.7. It seems to me that it would have been unnecessary to spell out the full recourse nature of the rights so long as neither of those events had occurred. On any view, it would make no sense if the Noteholders’ rights were full recourse after an Enforcement Notice was served, but only limited recourse until then.

There is a fourth reason for reaching this conclusion, and it lies in Condition 9(a)(iii) itself. If the Noteholders’ rights against the Issuer are not to be treated as full recourse until enforcement of the security, or at least until an Enforcement Notice is served, it is hard to see why there was any reference to section 123(2) in the Condition in the first place. It would require the most unusual, not to say fanciful, set of facts for it to have any conceivable function if the Noteholders’ rights are treated as being limited recourse. At least on the face of it, the reference to section 123(2) was carefully thought out, as the drafter of the Terms and Conditions went so far as specifically to exclude some of the statutory words.

It is true that, as the respondents said, there appears to be very substantial overlap between Condition 9(a)(i), which permits the service of an Enforcement Notice if the Issuer fails to pay principal or interest when it “ought to be paid”, and Condition 9(a)(iii) in so far as it refers to section 123(1). I do not regard that as a particularly relevant point, not least because overlap is not the same as redundancy or repugnancy, as Toulson LJ pointed out in argument. The respondents also argued that the reference to section 123(2) in Condition 9(a)(iii) was a standard “boilerplate” provision, which was unthinkingly included in the Terms and Conditions, as is evidenced by the fact that it is included in transactions of this sort where the Noteholders’ rights are, on any view, limited recourse. The evidence is not entirely consistent on that, and, while I accept that there may have been many such cases, that does not seem to remove the force of this fourth point, although it may slightly weaken it.

I had thought that there was a fifth point in favour of the conclusion that the PECO did not prevent the Noteholders’ rights being treated as full recourse for the purpose of Condition 9(a)(iii), namely that there would thereby be an inconsistency with the Issuer’s case: for the purpose of liability for stamp duty, the Noteholders’ rights are full recourse, but for the purposes of Condition 9(a)(iii), their rights are limited recourse. However, on reflection, I do not think that this is a good point. As Wilson LJ said in argument, there is a difference in approach between the commercial effect of the PECO, which is what the respondents rely on, and the assessment of the transaction arrangements for stamp duty purposes.

There is nothing commercially insensible in the conclusion that, for the purpose of Condition 9(a)(iii), the Noteholders’ rights against the Issuer are treated as full recourse, notwithstanding the PECO. The purpose of the PECO was to render the Issuer bankruptcy remote, in the sense of ensuring that it could not be wound up. But this conclusion does not cut across that purpose: it merely entitles the Noteholders and Trustee to invoke a ground which would support a winding up petition to justify the service of an Enforcement Notice. Further, whatever else may be in doubt, it is hard to argue against the view that the parties envisaged an Enforcement Notice being served if the Issuer’s liabilities were not met, as Condition 9(a)(i) provides.

Accordingly, for my part, I would dismiss the appellants’ appeal and the respondents’ cross-appeal.

Finally, there is one further point I should mention. Leading and junior counsel, together with more than one instructing solicitor, attended on behalf of the Trustee throughout the two full days of the hearing of this appeal. No points of any substance were advanced, either in the brief skeleton argument, or in the very brief oral submissions, made on behalf of the Trustee. The absence of any such submissions is not a matter for criticism. On the contrary: given that all relevant points had been fully and clearly made, this was very sensible (just as it was sensible of Mr Snowden QC, for the Class A2 Noteholder respondents, and Mr Dicker QC, for the Issuer, to divide the oral argument for the respondents between themselves).

My concern is that the presence in court of two counsel and at least one solicitor on behalf of the Trustee appears, at least on the face of it, to be excessive. I appreciate that it would have been possible that, during the hearing, some point might have unexpectedly arisen on which the court might want assistance from the Trustee or on which the Trustee might wish to be heard. However, a single junior lawyer could have taken a note of the hearing, which could have been submitted to a more senior lawyer, and if that had revealed any point of concern to the Trustee, counsel could have been instructed to make submissions to the court. Indeed, there was a daily transcript of the hearing, so even a note-taking lawyer would not appear to have been needed.

Given that the Trustee will no doubt seek to recover the costs of attending the hearing from the funds which it holds, it seems appropriate to express concern about this state of affairs. It is only fair to add that the course taken by the Trustee, through its legal advisers, on this appeal is by no means unusual, and these observations are made with an eye to saving costs in future case, not with the aim of criticising the Trustee or its advisers.

It appears to me that, unless a trustee has good reason to think that its actions will be subject to criticism or there is some other special reason, it should normally be unnecessary for it to make representations or to be represented at a hearing (save for instructing a note-taker), where, as here, its stance on the issues dividing the warring parties, is neutral. Directions can be sought at a relatively early stage to enable the trustee to make submissions (possibly in writing) if a point arises on which its assistance is required or on which it desires to have a say.

I agree with the judgment of the Master of the Rolls. I add some words of my own on the first issue because of its general importance.

It is perhaps surprising that there has been no decided case, or at least no cited case, on the interpretation of the words now contained in section 123(2) of the Insolvency Act 1986 in the quarter century since its enactment. It is also noteworthy that in the present case the issue arises not in the context of a winding-up petition, but because of a dispute about the construction of a commercial contract which incorporates the words of the statute. The explanation may be that the discretion available to the court on a winding-up petition has made it unnecessary in practice to decide the point of controversy in the present case. A disadvantage is that we are now remote in time from the Cork Report and the White Paper which led to the introduction of the section, and no reference was made to either document in the course of the argument. If the argument had taken place twenty-five years ago, it is likely that the circumstances leading to the Act would have been well known to the court. The Cork Committee was a distinguished body which included lawyers and accountants with great knowledge and experience of insolvency law.

I am conscious of the need to resist the temptation to decide the present issue in the way that would seem to make best commercial sense in the particular context of a securitisation agreement. I see much force in Mr Snowden QC’s argument that it would cause considerable concern in the securitisation market if section 123(2) were interpreted in the way for which Mr Sheldon QC contends. But to construe the section by reference to the particular interests of players in the securitisation market would be to allow the tail to wag the dog. The drafter of the agreement chose to incorporate words of a section “as it may be amended from time to time”, and the task is therefore to construe the agreement by reference to the statute, not to construe the statute by reference to the agreement.

The appellants have made two major criticisms of the Chancellor’s approach to section 123(2): that he has elided the test under that subsection with the test under section 123(1)(e), and that he has elided factors which go to the exercise of the court’s discretion with factors which go to the existence of the discretion.

Section 123(1) sets out five circumstances in which a company is deemed unable to pay its debts. The first four categories cover cases of unpaid creditors. Section 123(1)(e) applies “if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due”. Section 123(2) provides:

“A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.”

The structure and phraseology thus suggest that subsection (2) was seen as a supplement to subsection (1)(e). Previously there had been a combined test as set out in paragraph 39 of the judgment of the Master of the Rolls. The splitting of the test and the formulation of section 123(2) as a supplement to section 123(1)(e) are readily understandable from reading the Cork Report.

The Cork Committee observed at paragraph 196 that “Insolvency law is not an exact science”. At paragraph 205 the report stated:

“In practical terms insolvency arises at the moment when debts cannot be met as they fall due. That moment is often difficult to pinpoint precisely, yet it is the pivot on which all else turns.” (Emphasis added)

This is the test under section 123(1)(e). It follows the recommendation of the Cork Committee at paragraph 535 (referred to in paragraph 56 of the judgment of the Master of the Rolls.)

However, there remained the question of what to do about the contingent or prospective creditor. In the passage quoted by the Master of the Rolls at paragraph 55 of his judgment, the Cork Committee considered that special provision was required for this “comparatively rare” type of case. Such special provision is contained in section 123(2), and it is reasonable to suppose that it was intended by the drafter to reflect the Cork Committee’s thinking. Special provision is needed because a company may be able to pay its debts as they fall due for the time being, but it may be apparent that this state of affairs is not going to continue, or is unlikely to continue, having regard to the company’s contingent and prospective liabilities.

Section 123(2) does not prescribe in what way a company’s contingent and prospective liabilities are to be taken into account. I do not accept that the words should be interpreted as requiring that a prospective liability must be treated in the same way as an immediate liability. The language of the subsection does not compel such a conclusion. In some circumstances it would not make good commercial sense, for reasons given by the Master of the Rolls. Nor in my view would it reflect the underlying policy. Like the Master of the Rolls, I believe that Professor Sir Roy Goode has rightly discerned the underlying policy.

In the paragraph from his Principles of Corporate Insolvency Law quoted in paragraph 48 of the judgment of the Master of the Rolls, Professor Goode went on to observe that it may be difficult to decide whether the test of insolvency under section 123(2) is satisfied, because (echoing the words of the Cork Report) the value of assets, and, where these are required to be taken into account, of contingent liabilities, is “not an exact science”. The same may be true of prospective liabilities, particularly if they are distant in time.

In the instant case the amount of the prospective liabilities will depend on currency fluctuations. Mr Sheldon argued that the language of the section requires such debts, however remote they may be in time, to be taken into account at their current face value. In my view it is a matter of judgment how such liabilities should be taken into account, having regard to all the facts. Mr Sheldon argued that this was to apply “commercial” considerations to what he described as purely a “balance sheet” test, but I do not see why Parliament should be taken to have excluded from the court’s consideration, under section 123(2), such an obviously significant matter as how a reasonable commercial person would view the prospects of a company being able to meet its prospective and contingent liabilities (or to have relegated it to the stage of the exercise of the court’s discretion whether to order the company to be wound up). The Cork Report at paragraph 198(k) identified as one of the features of “a framework of law for the governing of insolvency matters, which commands universal respect and observance” that it should be “seen to produce practical solutions to financial and commercial problems”.

I do not accept that the Chancellor’s approach elided section 123(1)(e) and section 123(2). Section 123(2) serves an additional purpose, but it does not mandate the way in which a company’s contingent and prospective liabilities are to be taken into account. Nor does the Chancellor’s approach elide the question of a company’s inability to pay its debts within the meaning of section 123(2) and the question whether the court should order the company to be wound up. There may well be situations in which a company is judged to be unable to pay its debts within the meaning of section 123(2), but for particular reasons the court does not consider that the best course would be to order that it should be wound up.

I recognise that Professor Goode’s reference to a company having “reached the point of no return because of an incurable deficiency in its assets” illuminates the purpose of the subsection but does not purport to be a paraphrase of it. Essentially, section 123(2) requires the court to make a judgment whether it has been established that, looking at the company’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet those liabilities. If so, it will be deemed insolvent although it is currently able to pay its debts as they fall due. The more distant the liabilities, the harder this will be to establish.

On the particular facts of the present case, I agree that for the reasons given by the Master of the Rolls this was not established.

I agree with both judgments.