UK: Construction Of A Series Of Agreements

Last Updated: 4 April 2011
Article by Edward Davis and Sue Millar

In Royal Bank of Scotland PLC v Highland Financial Partners LP & Ors [2010] EWCA Civ 809, the Court of Appeal considered points of construction of agreements entered into in respect of a proposed collateralised debt obligation. The Court subsequently considered issues of quantum.

During the course of 2006 and 2007, Royal Bank of Scotland PLC ("the Bank") and Highland Financial Partners LP and/or associated entities ("Highland") had entered into a number of agreements in respect of a proposed Collateralised Debt Obligation transaction ("CDO"). The CDO failed to close by the issue of securities because of the collapse of the financial markets in the latter part of 2008. The agreements between the Bank and Highland included a mandate letter (the "Mandate Letter"), a variable funding note purchase agreement (the "Financing Agreement") and an interim servicing deed (the "Interim Servicing Deed"). By these agreements (as varied), two of the roles assumed by the Bank were adviser to Highland for the issue of securities and financier of the CDO assets for their initial purchase and during the warehousing period.

A few key points to note about the agreements are: (1) the Mandate Letter gave both the Bank and Highland the right to terminate the Mandate Letter by notice at any time; (2) one of the events leading to a Termination Date (as defined) in the Interim Servicing Deed was the termination of the Mandate Letter; (3) if the Termination Date under the Interim Servicing Deed occurred prior to the closing of the CDO, the Bank could call for full repayment of advances it had made under the Financing Agreement. The significance of (3) was that in order to repay the advances, Highland was obliged to realise the assets in the CDO warehousing facility and then make up any shortfall between the sums realised and the total amount due to the Bank under the Financing Agreement.

On 30 October 2008, the Bank gave notice to terminate the Mandate Letter. The Bank contended that this gave rise to a Termination Date under the Interim Servicing Deed and that as this date occurred prior to the closing of the CDO, under the terms of the Interim Servicing Deed it triggered the obligation for Highland to pay the Bank any shortfall in covering the amount due to it under the Financing Agreement. The Bank therefore claimed the shortfall in the sum of EUR 40 million from Highland.

The Court of Appeal approached the construction of the agreements in accordance with the principles set out in (i) Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, in which Lord Hoffmann set out the principles applicable when drafting had been careless or a mistake made, and (ii) Re Sigma Finance Corporation [2009] UKSC 2 in which the Court emphasised the need to construe an agreement which was part of a series of agreements by taking into account the overall scheme of the agreements and reading sentences and phrases in the context of that overall scheme.

The Court was willing to correct a minor typographical error involving the substitution of one word for another on the basis that it was plain that there had been a mistake in the language. This did not, however, have the effect of changing the meaning of the clause as understood by the parties and the Court. Highland advanced two further arguments of construction of the agreements in the Court of Appeal in an attempt to counter the Bank's contention.

Commercial purpose of the overall scheme of the agreements

Highland contended that if the overall scheme of the transaction was considered, the parties cannot have intended the Bank to have the right, via termination of the Mandate Letter on notice, simply to terminate the financing arrangements for the CDO. Highland argued that the parties can only have intended termination of the Mandate Letter by Highland to give rise to a Termination Date under the Interim Servicing Deed. Otherwise, the nature of the financing of the CDO did not make commercial sense as the financing would effectively be an "on demand facility". Highland argued that the relevant clause should therefore be read with a number of words inserted which would give express effect to Highland's interpretation.

The Court of Appeal rejected this argument on several grounds. In particular, the language of the relevant clause (save as to the typographical error) was clear. The ordinary meaning of the clause as drafted was not in dispute. It undoubtedly gave the Bank the right to recall the financing for the CDO if it terminated the Mandate Letter. The Court also considered that a clause entitling the Bank to recall the financing for the CDO if it terminated the Mandate Letter made good commercial sense and fitted with the commercial purpose of the overall scheme.

Inconsistency with a deed of amendment

Highland contended that the Interim Servicing Deed had to be read consistently with a recent deed of amendment which provided expressly that, in the event of inconsistency or conflict between the provisions of the Interim Servicing Deed and the recent deed of amendment, the provisions of the recent deed of amendment were to prevail. Highland's case was that if the Bank's position were allowed to prevail, certain provisions of the recent deed of amendment would (1) make no commercial sense, and (2) be effectively rendered nugatory. Highland therefore argued that the Termination Date provision of the Interim Servicing Deed should be read so that termination by the Bank of the Mandate Letter did not give rise to a Termination Date under the Interim Servicing Deed. The Court of Appeal rejected this argument. There was no basis for re-writing part of the Interim Servicing Deed. The recent deed of amendment operated consistently as actually drafted and the Court could see no commercial merit in the argument put forward.

The quantum hearing

There then followed a separate High Court hearing to assess the amount owed by Highland to the Bank. The dispute arose in respect of the amount which the Bank sought to credit against amounts due from Highland, being the sum the Bank claimed was received by the sale of underlying loans. Under the Interim Servicing Deed, the Bank was obliged to "mutually agree" with Highland the procedures in respect of the sale of the underlying collateral, but did not do so. The Bank had decided to retain some of the underlying loans in order to take advantage of a favourable accounting treatment, without telling Highland. The retained loans were selected on the basis that they were a good credit risk. Before the CDO was terminated, the Bank had regularly marked each of the loans to market in the Bank's books. The last such mark was on 15 October 2008. The Bank, however, elected not to use this value as a way of setting the price of the loans. Instead, all of the loans (those it intended to retain and those it wished to sell) were placed in a "bids wanted in competition" ("BWIC") process. The Bank's salesmen were not told which of the loans in the BWIC were reserved for the Bank's own use. The Bank did not itself bid in the BWIC process and used the bids it received in relation to the retained loans to set the price at which it bought them. Having calculated the value of the loans on this basis, the Bank found that there was a significant shortfall between the amount of the warehouse financing and the value of the collateral as set by the Bank's BWIC process.

Highland disputed the Bank's valuation of the loans and argued that the balance payable to the Bank was in fact far lower once the true value of the loans was taken into account. It argued that the Bank's method of establishing the price for the loans was in breach of the Interim Security Deed and in breach of the Bank's equitable duties as a mortgagee exercising a power of sale.

The Court held that the Bank was in breach of its contractual obligation to seek mutual agreement about the way in which the loans should be disposed of. It found that no genuine mutual agreement could be obtained if the true position was concealed from Highland. Further, the Bank was found to be in breach of its equitable obligation as a mortgagee exercising a power of sale to act in good faith. The BWIC process created a serious conflict of interest for the Bank because the sales team were trying to keep the prices low to benefit the Bank, in its role as a buyer, but at the same time were trying to obtain a good price for the benefit of Highland as it was obliged to do as a mortgagee exercising a power of sale. Also, the failure to disclose the nature of the process by which the loans were being valued and sold in itself amounted to a breach of the Bank's duty to act in good faith. The Court therefore ruled that the related loans should be re-valued using the Bank's own mark-tomarket value of 15 October 2008 to which a margin was added to reflect what the Court considered to be the value Highland would have been able to secure in an open negotiation.

Practical implications

The Court of Appeal's decision is a useful demonstration of the Court implementing the principles of construction laid down in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38 and Re Sigma Finance Corporation [2009] UKSC 2. In this case the Court displayed a reluctance to alter the ordinary meaning of the clause in question based on one party's explanation of what made commercial sense. This was particularly so in circumstances where the Court viewed the ordinary meaning of the clause as also making good commercial sense, albeit one much more favourable to the Bank.

While the quantum hearing was decided on its facts, it dealt with a problem that financial institutions often face where financial products are hard to value because there are not enough buyers to set a price at a particular time. Although the BWIC process was not unique to the Bank, this case shows the need for banks to adhere to the contractual framework and to act in good faith in accordance with the obligations of a mortgagee in possession.

This article was originally written for Stephenson Harwood's quarterly publication, Finance Litigation Legal Eye. If you would like to receive this publication, please contact Stephenson Harwood

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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