Limited recourse provisions in finance documents have been viewed as providing protection for borrowers and lenders alike against the risk of insolvency. For borrowers and their directors, insolvency may give rise to risk of civil or criminal liability. Lenders may agree to limit recourse to the borrower's assets to avoid the possibility of claw back actions affecting their recoveries.
Following the observation of the Supreme Court in the Eurosail case (BNY Corporate Trustee Service Limited and others v Eurosail - UK 2007 - 3BL Plc and others  UKSC 28) that a post enforcement call option (PECO) (a structure used in certain securitisations to replicate limited recourse) would not protect against insolvency, the decision of the High Court in ARM Asset Backed Securities S.A.  EWHC 3351 Ch, raises new concerns. The High Court found that the contractual limited recourse provisions did not mean that the corporate borrower was incapable of being insolvent, either on a balance sheet or cash flow basis.
Facts of the Case and the High Court Decision
The company in question was incorporated in Luxembourg and issued bonds governed by Luxembourg law, investing the proceeds in the purchase of life insurance policies. The company, acting by its directors, applied for the appointment of provisional liquidators, following the company's failure to obtain necessary licences.
The application was heard as a matter of urgency and the Court did not have the opportunity to consider full argument on certain of the complex matters that arose. This is not unusual in the context of an application for the appointment of a provisional liquidation which is an interim order pending the hearing of a full winding up petition. It appears to have been unopposed.
The first issue that Richards J faced in determining jurisdiction concerned the COMI of the company for the purpose of Council Regulation (EC) No 1346/2000 on Insolvency Proceedings (the "EC Regulation"). The Judge held that the COMI was in England, rebutting the presumption based on the location of its registered office.
The question about insolvency arose indirectly. The winding up petition had been based on the just and equitable ground (in this case, under s 221(5) Insolvency Act 1986). The English Courts have previously relied on this ground where the company was solvent (for example, Leyland Printing Company Limited and another  EWHC 3788 (Ch)). However, the Court considered that, for the purpose of jurisdiction under the EC Regulation, it was relevant to determine whether the company was insolvent or that the application was based on insolvency.
Richards J noted that this aspect had not been fully considered and so did not express a final conclusion about the applicability of the EC Regulation if the proceedings were not based on the insolvency of the company. But the Judge considered that if that was the correct interpretation, the company's insolvency was a relevant consideration.
The question then turned to whether the company was insolvent. The terms of the bonds are not set out in the judgment, but the summary indicated that bondholders were entitled to recover sums due to them only to the extent that the company had available to it funds derived from the policies purchased and possibly other funds raised from the issue of bonds. The bonds also provided that the bondholders could not take steps to attach assets of the company, nor could they apply for a winding up order of the company or other insolvency related orders.
The Court, in a fairly short summary of the position, noted that:
"if a company has liabilities of a certain amount on bonds or other obligations which exceed the assets available to it to meet those obligations, the Company is insolvent, even though the rights of the creditors to recover payment will be, as a matter of legal right as well as practical reality, restricted to the available assets, and even though, as the bonds in this case provide, the obligations will be extinguished after the distribution of available funds". Richards J went on to conclude that the company was unable to pay its debts, both on a cash flow and balance sheet basis. The Judge noted that a useful way of testing that was to consider that the bondholders would prove in the liquidation for the face value of their bonds and the interest payable on those bonds. The order appointing provisional liquidators was made on the basis of insolvency as well as the just and equitable ground, there being real prospects that a winding up order on those grounds would be made".
The tentative conclusion that the proceedings must be based on the company's insolvency reflects observations in Re Rodenstock GmbH  EWHC 1104 (Ch). Briggs J noted that the English court's jurisdiction to wind up insolvent companies was limited by the EC Regulation, whereas the jurisdictionto wind up solvent companies was limited by the Council Regulation (EC) 44/2001 of 22 December 2000 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters ("Judgment Regulation") and the two "were intended to dovetail almost completely with each other" (the only exception being winding up on the public interest ground). Accordingly, it was Briggs J's view that if the company had its "seat" outside the UK and was solvent, the English Court would have had no jurisdiction to make the order due to Art 22.2 of the Judgment Regulation.
In this case, the court focused on the EC Regulation (it is not apparent from the reported facts why this was the case), and the insolvency of the company under English law. This is understandable given that the question was the basis on which the winding up petition was presented (rather than the insolvency of the company per se). This approach avoids the difficult question about the meaning of insolvency, about which the EC Regulation is notably silent and is consistent with the discussion in the Virgos Schmidt Report on the Convention on Insolvency Proceedings (at para 49).
In deciding that the limited recourse language did not prevent the company from being either cash flow or balance sheet insolvent, Richards J did not expressly refer to the Supreme Court's decision in Eurosail, though its relevance is obvious. Eurosail also related to an SPV which had been structured to be bankruptcy remote, albeit through the use of a PECO. These options are intended to be exercised by an issuer friendly entity, after all the issuer's assets have been realised and distributions made, to avoid the issuer's insolvency. In the Supreme Court, Lord Hope concluded that the PECO had no effect on the amount of the issuer's liabilities, and thus the question of its solvency.
Lord Hope referred to the views expressed at first instance and in the Court of Appeal, that the documents did not affect the noteholders' liabilities until certain events had occurred (including the enforcement of the security). This may be considered to support a distinction between the amount of the liability (relevant to insolvency) and the rights of the bondholders to recover the debt.
However, Lord Hope did appear to implicitly accept that limited recourse provisions may be effective in law (at para 63). This may well depend on the precise drafting as to whether the liabilities are limited.
The approach taken by Richards J is noteworthy since, if followed, it may point in a different direction to that taken in relation to the insolvency test in other European jurisdictions. The German Federal Court of Justice (Bundesgerichtshof), for example, has ruled in 2005 that a company does not satisfy the test of insolvency on a cash flow basis even if it has outstanding payment obligations that are due and payable but where the creditor is not actually demanding payment. So even though a company is per se under a contractual obligation to pay but does not have the necessary funds, it does not meet the requirements under the cash low test if and for so long as the creditor has expressly agreed not to demand payment. Other European jurisdictions generally seem to be somewhere in the middle between these two views. Neither in Luxembourg nor in the Netherlands would a company generally satisfy the insolvency test if the only relevant payment obligation was subject to limited recourse language. On the other hand, the German approach would not suffice in Luxembourg or the Netherlands to avoid insolvency.
Against this background, the view taken by Richards J seems to imply that under the Insolvency Act 1986 a company can be considered insolvent at an earlier stage than in other European jurisdictions. This possibility appears to be in line with, or at least not to contradict, the Virgos Schmidt report, which states a preference to leave the meaning of insolvency undefined due to the lack of a consistent test around Europe. However, the approach of the English Courts to the interpretation of insolvency may indirectly impact on other European jurisdictions and their insolvency regimes due to Art 3(3) and Art 27 of the EC Regulation. If primary insolvency proceedings are opened in one member state, secondary proceedings can be opened in other member states without the requirement to show that the company also satisfies the insolvency tests of that other member state. While this has only a limited effect if a member state narrows the requirements for a company to be considered insolvent, it has an immediate though indirect effect if a member state roadens its insolvency test requirements so that a company is considered insolvent at a stage where in other member states the test would not be satisfied.
While this is arguably inherent to the system of the European Union, it requires lawyers to consider this carefully when drafting limited recourse wording. This will be of concern in securitisation structures and from the perspective of a restructuring lawyer, the decision in ARM Asset Backed Securities also leaves some uncertainty as to whether a similar approach would be taken by a court with regard to other comparable instruments commonly used in restructurings. One example would be a (partial) waiver of debt combined with a hope note, ie an agreement pursuant to which the waived debt revives if and to the extent the distressed company recovers and has again free cash available. Another example would be an agreement by the creditor to subordinate its debt to all other creditors and to demand payment only if the company has free cash available.
The continuing lack of clarity in relation to the test for insolvency in England, especially regarding the balance sheet test, requires lawyers to consider more carefully whether they can describe a company as insolvency remote or insolvency proof in the future.
1.) In the context of complex lending programmes, the contractual terms will be determinative.
2.) As to how an Agent with only "mechanical and administrative" duties is to form a "reasonable opinion" as to whether particular events constitute a Material Adverse Effect, the answer is that it need not do so