The last few years have seen an increasing trend of businessmen and investors incorporating offshore holding companies in the British Virgin Islands (“BVI”) and the Cayman Islands to hold or invest in assets in the PRC and other parts of Asia. There are obvious cost and tax benefits advantages in such set-ups but it is equally important that involved parties appreciate at the outset the distinctions between their respective insolvency regimes and rights.
The author sets out here solvency test requirements in both jurisdictions and possible implications arising from the recent landmark UK Supreme Court decision in BNY Corporate Trustee Services Ltd v Eurosail-UK-2007-3BL plc  1 WLR 1408 (the “Eurosail case”).
The BVI Insolvency Act 2003 provides that a company is insolvent as long as the value of the company’s liabilities exceeds its assets (commonly referred to as the “balance sheet test”) or where the company is unable to pay its debts as they fall due (commonly referred to as the “cash flow test”). When considering the company’s liabilities, it is necessary to take into account liabilities which are “present or future, certain or contingent, fixed or liquidated”. These solvency tests essentially mirrors the position in England and Wales.
On the other hand, Cayman Islands Companies Law simply provides that a company is insolvent if it is unable to pay its debts. There is a deeming provision in the statute such that a company is deemed to be unable to pay its debts among other things when “it is proved to the satisfaction of the Court that the company is unable to pay its debts”. Unlike England and Wales or the BVI, there is no explicit reference to a balance sheet test, and indeed, it is generally thought that only the cash flow test, and not the balance sheet test, is applicable in the Cayman Islands.
The question hence is whether the absence of a balance sheet test in the Cayman Islands might pose any practical advantage or disadvantage to investors and creditors. The Eurosail case is informative in a number of important respects including in its analysis of exactly what is meant by the balance sheet test in the context of the English legislation.
The Eurosail case
Eurosail was one of the many single purpose entities set up by the Lehman Brothers group shortly before its collapse in September 2008. It had issued loan notes, graded into classes of varying priority, which provided that an “event of default” shall occur if Eurosail is deemed unable to pay its debts as and when they fall due within the meaning of Sections 123(1) or (2) of the UK Insolvency Act 1986 (the “IA”). In the absence of default, the A1 notes (which were of highest priority) were repayable at the latest by 2027, while the other notes were repayable at the latest by 2045.
With the two Lehman Brothers companies - with which Eurosail had entered into swap agreements - becoming insolvent, Eurosail suffered a deficiency in its asset position. While it managed to continue to pay its debts, the A3 noteholders took this as an event of default. If these A3 noteholders were right, it would effectively mean that they would be entitled to rank pari passu with A2 noteholders in receiving payment for the notes, as opposed to ranking below the A2 noteholders in order of descending priority.
Section 123(1) of the IA sets out five instances in which a company is deemed unable to pay its debts, including where the court is satisfied that the company is unable to do so. Section 123(2) of the IA then goes on to provide that a company is also deemed unable to pay its debts if it is proved that the value of the company’s assets is less than the amount of its liabilities, both contingent and prospective ones. The bulk of the judgment dealt with whether, on these particular facts, Section 123(2) (ie the balance sheet test) was satisfied.
The Supreme Court has now made it clear that the expressions “cash-flow” insolvency and “balance sheet” insolvency are not to be taken literally.
After a detailed review of the legislative history of Sections 122 and 123 of the IA, and case law which predated the IA, Lord Walker noted that changes in the provisions were meant to highlight inter alia the fact that the cash flow test was concerned with debts currently due and falling due from time to time in the reasonably near future. As the court moves beyond the reasonably near future the balance sheet test will become “the only sensible test” as “any attempt to apply a cash-flow test will become completely speculative”.
With regard to the balance sheet test, his Lordship held that “whether or not the test of balance-sheet solvency is satisfied must depend on the available evidence as to the circumstances of the particular case”. Specifically, in reviewing the Court of Appeal’s analysis of the balance sheet test, Lord Walker approved Toulson LJ’s statement of the test as follows:
“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.”
At the same time, Lord Walker categorically rejected the “point of no return test” which was adopted by Lord Neuberger MR in the Court of Appeal, and emphasised that the phrase “should not pass into common usage as a paraphrase of the effect of section 123(2)”.
On the facts, the Supreme Court found that Eurosail’s ability to pay its debts could only be ascertained nearer to 2045 - the final redemption date for the notes. The loan notes were issued under complex documentation which contained several mechanisms for allowing the liabilities in respect of the principal sum to be deferred until the final redemption date. In the meantime, it is difficult, if not entirely speculative, to predict the movements of currencies and interest rates. Accordingly, the Supreme Court was not convinced that there would eventually be a deficiency, and upheld the Court of Appeal’s decision that Eurosail was not unable to pay its debts.
Implications for the BVI and Cayman Islands
From the perspective of companies and creditors, the availability of the balance sheet test provides an additional avenue by which the solvency of the company can be evaluated.
On the simplest of analyses, the lack of a statutory balance sheet test in the Cayman Islands means that creditors who wish to place a debtor in insolvent liquidation would not be able to do so by relying solely on the fact that the company’s liabilities exceeds its assets. It may of course be difficult to establish that a company is unable to pay its debts as they fall due without access to current financial information. Conversely, a creditor of a BVI company is able to argue that the company is insolvent on the balance sheet test even though it may, for the time being, be able to pay its debts as they fall due. The additional dimension to the analysis now approved in the Eurosail case is something that the BVI courts are likely to take into account, with UK Supreme Court decisions being highly persuasive in the BVI.
As Lord Walker observed, the balance sheet test provides greater certainty in determining whether a company is insolvent where prospective and future debts are involved; an opposite view would suggest that in the absence of this test, a company’s prospective and future liabilities would not form part of the analysis of when a company is insolvent.
Although Cayman Islands legislation does not include a statutory balance sheet test, in setting out who may petition for the winding up of a company, it does provide that “any creditor or creditors (including any contingent or prospective creditor or creditors)” are entitled to petition. This suggests that there is at least scope for the Cayman Islands court to consider a company’s future debts in determining whether it can pay its debts as they fall due. Hence, insofar as it relates to whether a creditor is in a position to petition for the winding up of the company, the practical distinction between the BVI and Cayman Islands may not be as great as it first appears.
But whilst the decision in the Eurosail case can be viewed as an acceptance of the need to analyse the commercial reality of any potential distressed scenario before an petition is presented, in practice, it may now be more difficult for creditors and liquidators in both jurisdictions - upon whom the burden of proving insolvency ordinarily falls - to establish insolvency given the potential additional complexity in the application of the relevant tests.
By Xiaowei Zhang, Associate Walkers