Limited recourse or bust?

The legal effect of “limited recourse” arrangements have been thrown into fresh doubt by a first instance decision of the respected Mr Justice David Richards in the case of Arm Asset Backed Securities S.A. [2013] EWHC 3351.

This decision is relevant to the following common financing arrangements.

• Securitisation and other structures where special purpose companies are intended to be “bankruptcy remote”, being where the liabilities of a company are expressed to be limited in recourse to the value of its assets, with the intention that the company should never be capable of becoming insolvent.
• Holding companies granting “limited recourse” security with a covenant to pay all liabilities of a subsidiary but with recourse of the creditor being solely to the shares in the relevant subsidiary. The holding company may have granted several such securities in respect of different shares to different creditors with the intention that there could not be cross-contamination between such financing arrangements.
• Restructuring transactions where creditors agree to limit their recourse to the assets of an entity and allow it to pay its other creditors such that (subject to the decision in this case) it can be wound up solvently.

In all these scenarios, the view has been that as the company would ultimately be able to discharge its liability by reference to the relevant limited asset pool, in any practical sense it was solvent and could (for example) be wound up on this basis and would not be susceptible to insolvent winding up solely in relation to such debts.

However, in this case it was determined that a company was unable to pay its debts on a cash-flow basis (i.e. not being able to pay debts as they fall due) and balance sheet basis (i.e. that its liabilities exceeded its assets, taking into account prospective and contingent liabilities) because the debtor company’s liabilities were for the full debt and such debt exceeded its assets, even though “as a matter of legal right as well as a practical reality” the creditor’s rights of recovery were limited and, on recovery of that limited sum, the company’s obligations would be extinguished. The correct approach was to look at the amount that a creditor would prove for in a liquidation, rather than the amount it was entitled to recover.

The theoretical logic of the decision is difficult to fault, and in the context of the particular facts, it is clear that it was helpful and convenient to the court to reach the conclusion it did as it allowed it to make a provisional liquidation order requested by the debtor company. It follows on from similar comments in the Eurosail judgment that the economic effect of arrangements that limit recovery do not mean that a “bankruptcy remote” company cannot be insolvent. However this decision goes further. The wide-ranging impact of this decision on the structuring of new transactions, and the implication that a large number of companies not only are insolvent but could be subject to insolvency proceedings, is of real concern. The solvency of an entity can impact on the validity of security and other transactions entered into by it and the ability in a restructuring to provide a clean, solvent exit for directors. In certain financing contexts, the ability of advisers to issue “bankruptcy remoteness” legal opinions in support of bond and note issues, such opinions being essential to such transactions, would be affected by the availability of insolvency proceedings in such a scenario.

It remains to be seen whether this approach will be followed in other cases but it is important to consider the impact of this judgment in the context of structuring new finance transactions and assessing the risks in current arrangements.