CoCos – Supreme Court decision in litigation between Lloyds and its noteholders
BNY Mellon Corporate Trustee Services Limited v. LBG Capital No 1 Plc and another  UKSC 29
June 2016 saw the publication of the Supreme Court judgment in this case involving Lloyds Banking Group (LBG) and its attempt to redeem contingent convertible securities (CoCos) (please see our previous summary, CoCos - litigation between Lloyds and its shareholders).
In 2009, LBG issued, via two special purpose vehicles, the so-called Enhanced Capital Notes (ECNs) which were CoCos. Although the ECNs had different maturities, they could be redeemed early if a Capital Disqualification Event (CDE) took place. The dispute arose between LBG and holders of the ECNs (represented by the trustee, BNY Mellon) as to whether a CDE had in fact taken place which would entitle LBG to redeem the Ł3.3 billion of ECNs, which would otherwise have carried a rate of interest over 10% p.a.
The ECNs were issued in November 2009, at a time when LBG was seeking to increase its capital in order to satisfy the relevant regulatory requirements, then governed by the EU Capital Requirements Directive (CRD I).
In relation to the ECNs, a CDE was defined as including an event whereby, as a result of changes to regulatory capital requirements, the ECNs would cease to be taken into account in whole or in part for the purposes of any stress test applied by the regulator "in respect of the Consolidated Core Tier 1 Ratio".
However, the drafting of this definition did not take into account the possibility that Core Tier 1 (CT1) capital ratios could disappear as a concept, as subsequently took place under the Fourth Capital Requirements Directive (CRDIV), published in July 2013, which replaced CT1 with Common Equity Tier 1 (CET1) capital.
In December 2014, the PRA carried out a stress rest in relation to LBG's CET1 ratio. That stress test did not include the ECNs. Therefore, LBG declared a CDE and sought to redeem the ECNs early.
BNY Mellon argued that this was wrong. Firstly, because the stress test was not "in respect of Consolidated Core Tier 1 Ratio" as set out in the definition of a CDE; rather, it was a stress test in respect of a CET1 capital ratio. Secondly, BNY Mellon argued that the fact that the ECNs were not taken into account by the PRA in the December 2014 stress test was not enough to trigger a CDE; in order to satisfy the CDE definition, ECNs must be disallowed in principle from being taken into account for the purposes of the Tier 1 ratio. At first instance, the judge rejected the first of these arguments but accepted the second and found in favour of BNY Mellon that the ECNs were not redeemable. The Court of Appeal agreed as regards the first point but disagreed with the second argument and, accordingly, allowed LBG's appeal having concluded that the ECNs were redeemable.
The Supreme Court agreed with the Court of Appeal that the ECNs were redeemable. The court considered that it made no commercial sense to limit the reference to "Core Tier 1 Capital" to CT1 capital as opposed to holding that it could apply to CET1 capital; the definition should be treated as a reference to "its then regulatory equivalent" i.e. in the current context, CET1 capital. In that respect the Supreme Court noted, as had the Court of Appeal, that it was one of the essential features of the ECNs that, if necessary, they could be converted into LBG core capital, whatever expression was used to define it.
Interestingly, the Supreme Court questioned whether this conclusion even required a departure from the "literal meaning" of the definitions of "Core Tier 1 Capital" and "Tier 1 Capital"; the Court considered that, if this was the case, such a departure amounted to a rather pedantic approach to interpretation.
As regards the second of BNY Mellon's arguments, the Supreme Court agreed with LBG's position that, in light of changes to the regulatory capital requirements, the ECNs could no longer be taken into account in assisting LBG in passing the stress test.
Unusually, the case gave rise to judicial disagreement with the Majority of the Supreme Court (Lord Neuberger, President, Lords Mance and Toulson) agreeing with the Court of Appeal and Lords Sumption and Clarke dissenting. Lord Sumption considered that the ECNs, as long dated securities, cannot have been intended to be redeemed early except in some extreme event undermining their intended function and requiring their replacement with some other form of capital. The function of the ECNs was to be available to boost LBG's top tier capital in the event that the ratio of top tier capital to risk-weighted assets fell below the conversion trigger; the ECNs had, and still did, serve that function and Lord Sumption considered it irrelevant whether that function remained as important to LBG now as it had in 2009.
Lord Sumption also noted that although the case was of financial importance to the parties, it raises no issues of wider legal significance.
Skilled person not amenable to judicial review in relation to IRHP review
The Queen on the application of Holmcroft Properties Limited v. KPMG LLP (Defendant) and Financial Conduct Authority and Barclays Bank PLC (Interested Parties)  EWHC 323
KPMG was appointed by Barclays as a skilled person (pursuant to section 166 of FSMA) in relation to a review agreed with the FCA, pursuant to which Barclays (and other banks) would set up a process to provide redress for customers missold interest rate hedging products (IRHPs). KPMG's role was to oversee the implementation and application of the review process, and to approve any offers of redress Barclays made. Holmcroft was offered redress as part of the review, but its claim to be compensated for consequential losses failed. It applied for judicial review, on the basis that KPMG had reached a decision on redress that was not properly open to it, having been reached via a defective process.
The court rejected, with some hesitation, the suggestion that KPMG was amenable to judicial review. The court accepted that KPMG's role was "woven into" the regulatory function, and that Barclays would not have given KPMG the extensive powers that it did, had it not been required to do so by the FCA. However, the court also noted that:
- the review scheme adopted was an entirely voluntary one, and that the precise role KPMG played could not have been imposed by the FCA as part of the exercise of its powers, had Barclays not agreed to it;
- KPMG were appointed contractually by Barclays, not by the FCA, and that they had no relationship with those of Barclays' customers who were participating in the review;
- merely assisting with the achievement of public law objectives was insufficient to render a body amenable to judicial review;
- it was highly unlikely that the FCA could have performed KPMG's role had KPMG not agreed to do so, and it would have had to choose a different route to secure the objectives that were met by the review; and
- the FCA retained the ability to play an active role.
The court went on to consider whether, if judicial review was available as against KPMG, Holmcroft's claim would have been made out. It decided that it would not. Holmcroft's argument rested on the fact that in deciding on an appropriate offer of redress, Barclays (and KPMG) had considered material that was not supplied to Holmcroft. The court agreed with Barclays that there was no obligation, in the circumstances, to provide Holmcroft with all of the bank's records, provided that Barclays fairly summarised the reasons for its decision (which the court found that it had).
The court declined to make any finding that potential skilled persons would be discouraged from agreeing to act, if they believed that they might be amenable to judicial review. Nonetheless, the reasoning contained in this judgment may be relevant to the FCA's appetite for appointing skilled persons directly. The judgment also provides some support for banks in the context of the IRHP review, assuming that other banks have followed a similar process to that adopted by Barclays.
Right to convert bonds
Citicorp International Ltd. v. Castex Technologies Ltd.  EWHC 349 (Comm)
This claim was brought by the claimant as trustee of convertible bonds issued by the defendant. The issue to be determined was whether a conversion notice (which would have the effect of converting the bonds into equity shares) served by Castex was valid. The judge held that it was.
The judgment necessarily turns on the drafting and construction of the terms and conditions of both the bonds and the relevant notice, but it raises (albeit obiter) an issue relevant to construction generally.
There was a dispute between the parties as to whether the heading of the controversial clause in the terms and conditions of the bonds could be taken into account in construing the clause's meaning. The trustee relied on a standard provision in the trust deed (that headings were to be ignored in construing the trust deed) in order to persuade the judge that he was not entitled to take the relevant heading into account. The judge disagreed, on two bases.
The first was that the relevant language about headings was included in the trust deed, not the terms and conditions of the notes. Although the trust deed referred to the terms and conditions, they could not be treated as forming part of the trust deed.
Second, the judge held that he would, in any event, "find it impossible not to be assisted by the heading", and that it would "astonish" the commercial parties to the contract were he to ignore the clear words in the heading. This conclusion was based upon dicta in earlier cases that the court could look at a heading where it was "descriptive of what the provision is about". The judge in this case appears to have taken the view that this was permissible to the extent that the heading was not inconsistent with the content of the clause (which he held that it was not).
The judgment in this case did not turn on this issue, but it: (a) provides a reminder that parties must be careful to ensure that any relevant boilerplate language is replicated in each contract, where there is more than one; and (b) highlights what is perhaps a surprising willingness by the court to look at clause headings, in circumstances where the draftsman might have expected the court to refuse to do so.
Construction of LMA terms
GSO Credit -A Partners LP (and others) v. HCC International Insurance Company PLC  EWHC 146 (Comm)
The disputed transaction in this case was agreed to be covered by the LMA's Standard Terms and Conditions for Par and Distressed Trade Transactions (Bank Debt/Claims) dated 14 May 2012 (the LMA Terms). The subject matter of the dispute was what, exactly, GSO had purchased from HCC (indirectly, via back-to-back transactions with Barclays), and consequently which of GSO and HCC was to be the payer under the transaction.
As part of a wider facilities agreement, HCC was a lender to a gaming company called Codere under a surety bonds facility. Pursuant to this facility, HCC issued surety bonds in favour of public authorities in Italy and Spain. Codere was obliged to pay HCC the amount of any claim by a public authority under the surety bonds.
The parties agreed that GSO would purchase a portion of HCC's commitment under the surety bonds facility (in fact, equal to HCC's maximum liability under the surety bonds). HCC alleged that GSO had only purchased HCC's rights as lender against Codere (and was therefore obliged to pay it some €18 million). GSO believed that it had also purchased HCC's obligations to the public authorities (which would mean that GSO was not the payer, and was entitled to receive payment of approximately €5.5 million).
The first issue decided by the judge was whether HCC was correct in its submission that the definition of "Purchased Assets" in the LMA Terms was different to (and excluded) the definition of "Purchased Obligations", and that HCC's obligations to the public authorities were therefore not included as purchased assets. The judge disagreed. He held that in a transaction in respect of a surety bonds facility on the LMA Terms, the seller ordinarily traded its position. This would include its obligations. Such a conclusion was supported by the LMA Terms.
Second, in relation to the calculation of sums due, the judge considered the meaning of the terms "funded" and "unfunded" in this context. He determined that "funded" did not mean the same as drawn, and that the purchased assets were therefore only funded to the extent that HCC had actually paid sums out pursuant to the surety bonds (which it had not). The fact that the surety bonds facility had been utilised did not mean that the assets were "funded" within the meaning of the LMA Terms.
Construction of ISDA Master Agreement
(1) Videocon Global Limited; (2) Videocon Industries Limited v. Goldman Sachs International  EWCA Civ 130
This was the appeal of a successful summary judgment application by Goldman Sachs International (GSI) in relation to a termination notice served by it under clause 6(d) of the 1992 ISDA Master Agreement. Clause 6(d) requires that notice of the amount due on early termination (and details of the account to which it should be paid) must be provided on or as soon as reasonably practicable following the occurrence of an early termination date.
In terms of background, GSI and Videocon entered into a number of currency swaps under the umbrella of an ISDA Master Agreement. GSI terminated that agreement on 2 December 2011 following Videocon's failure to meet various margin calls. GSI provided a notice setting out the amount it sought (approximately US$4 million) on 14 December 2011, and later applied for summary judgment. At the hearing of such application (in September 2013), Videocon was held to be liable to GSI in principle, but the judge at that hearing also decided that GSI had failed to provide the "reasonable detail" of its calculations which clause 6(d) requires. It therefore failed to obtain judgment, and did not serve a revised calculation until March 2014. Having done so, it made a second application for summary judgment, which was successful at first instance. The judge hearing the application determined that, even though it was a breach of contract for the party serving the termination notice not to do so as soon as reasonably practicable, such breach did not make the notice ineffective once it was served in a compliant form.
The Court of Appeal gave permission to appeal (because of the importance of the issue, rather than the merits of the appeal itself), and then rejected the appeal. In doing so, Gloster LJ noted that in clause 6 of the Master Agreement (as in other clauses), there was a difference between the debt obligation of the payer (which arose on the early termination date) and the payment obligation, as earlier cases had indicated. The question was therefore the date on which the early termination payment became payable (as opposed to due), and whether the payment obligation was subject to a condition precedent, such that it did not arise if an effective termination notice was not served as soon as reasonably practicable.
In relation to the first of these issues, Gloster LJ held that the early termination amount became payable at the point when there was effective service of notice of the amount payable. In that regard, Gloster LJ said that she did not agree that a notice had to comply with all of the requirements of clause 6(d) in order to be effective for these purposes (GSI had conceded this point at first instance). The word "effective" was used, rather, to identify the date on which the notice was effectively served in accordance with the service provisions of clause 12 of the Master Agreement. On that basis, she concluded that GSI's original notice had been effectively given.
In relation to the second issue, Gloster LJ held that there was no basis for concluding that the requirement to provide a notice as soon as reasonably practicable imposed a condition precedent to the payment obligation under the Master Agreement. Any other decision would be contrary to the wording, overall scheme and commercial sense of the Master Agreement.
The Court of Appeal's conclusion is not a surprising one, but its reasoning differs in some respects from the judgment at first instance, and contains a detailed and helpful analysis of clause 6 of the ISDA Master Agreement. The Court of Appeal's separate treatment of the debt obligation and payment obligation, and its interpretation of what "effective" means in the context of clause 6, are particularly significant aspects of the judgment.
Dispute as to which version of the ISDA Master Agreement applied, and construction of ISDA boilerplate
LSREF III Wight Ltd. v. Millvalley Ltd.  EWHC 466 (Comm)
In this unusual dispute, the court considered the proper approach to construction and rectification, and contrasted the two. Millvalley entered into an interest rate swap with Anglo Irish Bank (AIB) in 2006. It was common ground that the parties intended this swap to be governed by the terms of the 1992 ISDA Master Agreement, but while they executed a confirmation, they never executed either the Master Agreement itself or a Schedule.
As part of a restructuring in 2011 (with the Irish Bank Resolution Corporation (IBRC) as successor to AIB), the parties entered into a Master Agreement and Schedule in the form of the 2002 version, with the effect that, from that date, the original swap was governed by the terms of the 2002 Master Agreement. The swap was further restructured in 2012. As a result of an administrative error within IBRC, the 2012 confirmation in relation to the restructured swap again referred in generic terms to the 1992 ISDA Master Agreement. Wight (as successor to the IBRC) argued that as a matter of construction, the restructured swap was governed by the 2002 Master Agreement. Alternatively, it said that the confirmation should be rectified to that effect. The practical importance of this was that the 2002 version of the Master Agreement gave Wight the right to terminate the swap if a loan was repaid (which was the case here), whereas the 1992 version did not.
The judge held that, as a matter of construction, the clear wording of the confirmation indicated that the 1992 Master Agreement applied. This was clear from the wording, and it could not be said that something had gone so awry with the language that the parties' objectively expressed intention was for the 2002 version to apply. Nor was the plain meaning of the confirmation commercially absurd.
The judge held, however, that the confirmation ought to be rectified. In giving his conclusions on this point, he referred to an ongoing debate as to the applicable principles in this regard. He expressed some disquiet at the prospect of a judge rectifying an agreement to reflect what a reasonable observer would have understood the parties to mean, in circumstances where one of the parties did not in fact share that understanding. In this case, however, he held that the distinction was not relevant. There was a continuing intention by the parties at the time of the restructuring that the 2002 Master Agreement they had already executed would apply to the swap, and the judge noted that Millvalley did not take a point on this for some time.
The judge also considered Millvalley's submission that some of the boilerplate language in the Master Agreement (at clause 9) and the confirmation (in relation to non-reliance and operational matters) precluded a claim for rectification. The judge declined to decide whether clauses of this type could ever have such an effect, but decided that these specific provisions did not.
The judgment shows the importance of ensuring that transactions using ISDA terms are documented in the appropriate way, and it also resolves a point of construction in relation to boilerplate language that might be relevant in other cases.
Deutsche Bank successful in its appeal in relation to Unitech
Deutsche Bank AG and others v. Unitech Global Limited and another  EWCA Civ 119
This judgment of the Court of Appeal considered a judgment at first instance of Teare J, that was itself handed down in somewhat complex circumstances. It is helpful to bear in mind that there are two related actions in the Deutsche Bank v. Unitech litigation: one relates to lending by Deutsche and others, in the sum of approximately US$150 million, and the other relates to a swap between Deutsche and Unitech, pursuant to which Deutsche claims some US$11 million. Unitech asserts that both loan and swap formed part of the same package, and that both were procured by misrepresentation (including in relation to LIBOR). There was some debate as to whether it was open to Unitech to seek rescission as a remedy at all, in that the relevant loan agreements had been novated, but that argument will proceed to trial.
Teare J's judgment (which was the subject of the appeal) reversed his own earlier judgment refusing Unitech permission to claim rescission as a remedy. It also considered an application by Deutsche for an order requiring Unitech to pay US$120 million, pursuant to any and all of: CPR Part 24 (summary judgment); CPR Part 3 (case management powers); and CPR 25.7 (interim payments). At the heart of Deutsche's arguments was the practical point that, even if Unitech succeeded at trial in its claim for rescission, it would be obliged to repay this amount in any event. If Unitech's claim failed, it would be obliged to pay some US$177 million. Teare J refused Deutsche's application, however, and Deutsche appealed (with his permission).
That application was successful. The Court of Appeal considered section 32 of the Senior Courts Act 1981, which provides (in summary) that rules of court may make provision for interim payments "on account of any damages, debt or other sum ... which that party may be held liable to pay to or for the benefit of another party to the proceedings if a final judgment or order of the court in the proceedings is given or made in favour of that other party." The Court of Appeal held that this wording was broad enough to apply to the present case. However, as the Court of Appeal also noted, this provision only allows for the making of rules, and it therefore had to go on to consider the content of the rules themselves, which were to be interpreted in accordance with the overriding objective.
The Court of Appeal therefore considered the interim payment provisions at CPR 25.1(1)(k), which it also considered wide enough to cover the present case (the drafting is similar, for obvious reasons, to that used in section 32). Unlike Teare J, the Court of Appeal did not think that Deutsche needed to show that it would succeed in a cause of action in order for the interim payment to be ordered. The Court of Appeal also concluded that as a matter of case management, it was appropriate under Part 3 of the CPR to make Unitech's right to plead its rescission defence conditional on payment of the US$120 million into court.
The Court of Appeal also considered an appeal by Unitech in relation to Teare J's refusal to allow it to make five unrelated amendments to its pleaded case. One such amendment related to an argument that Deutsche should have disclosed to the Unitech guarantor (which was itself also a party to the relevant loan agreement) unusual features of the contractual relationship between the lenders and the Unitech borrower. Such unusual features were said to include the manipulation of LIBOR. The Court of Appeal noted that the doctrine of unusual features was an evolving area of law, but considered that it was not open to Unitech to rely on it, because one of the clauses of the guarantee agreement (properly construed) meant that it was not only a guarantee but an indemnity. The Court of Appeal said that not every clause conferring on the guarantor the status of primary obligor would mean that the guarantor was also providing an indemnity, but this clause did. As such, the doctrine of unusual features did not apply.
This litigation has been closely followed to date, and the contents of this judgment in relation both to interim payments in a case such as this, and the doctrine of unusual features, are of general relevance.
Bank does not owe a duty of care in relation to the review of sales of IRHPs
CGL Group Limited v. The Royal Bank of Scotland plc  EWHC 281 (QB)
In this case, the claimant alleged (essentially) that RBS had missold it two IRHPs, in that it had failed to provide certain advice and information. There were two applications before the court. The first was to strike out the claim on the basis that it was time-barred. The second was an application by the claimant to amend, such as to include allegations in relation to RBS's conduct of the review agreed by it with the (then) FSA in relation to the sale of IRHPs.
In relation to the first application, the claimant relied on section 14A of the Limitation Act 1980 and alleged that it had not had sufficient knowledge to bring its claims until the FSA review was announced in 2012. RBS pointed to discussions between it and the claimant in 2009 in which misselling was alleged. The judge agreed that the claimant had the requisite knowledge by November 2009 (and certainly by January 2012) to bring its claim. Accordingly, the claim was time-barred and should be struck out.
In relation to the second application, the claimant argued that having agreed to conduct the review, RBS owed it a common law duty of care to: (a) conduct the review in accordance with its agreement with the FSA, and the agreed methodology; (b) provide fair and reasonable redress; and (c) conduct the review with reasonable skill and care. Amendments to allow similar pleadings were recently allowed by the Bristol Mercantile Court in Suremime Ltd. v. Barclays Bank. In this case, the judge concluded that the decision in Suremime was reached without the benefit of the range of materials available to him. He concluded that RBS could not reasonably be said to have assumed a duty of care, when its agreement with the FSA expressly said that it had not. He also held that to impose such a duty would be to "ride a coach and horses" through a clearly defined statutory scheme.
This judgment should shut the door opened by Suremime. The judge effectively endorsed the detailed arguments advanced on behalf of RBS as to why no duty of care arose in relation to the review of interest rate hedging products, and there seems no reason why those arguments should not apply in other cases.
Effect of article 3(3) of Rome Convention and mandatory rules of law
Banco Santander Totta SA v. Companhia de Carris de Ferro de Lisboa SA (and others)  EWHC 465 (Comm)
In this case, Santander and the defendants (the Companies), which are Portuguese public transport companies, had entered into nine long-term interest rate swaps on the terms of an ISDA Master Agreement. As has happened in other cases where public, or quasi-public entities have entered into derivatives agreements, the Companies sought to argue that they had lacked capacity. They also argued that although English law governed the agreements, article 3(3) of the Rome Convention meant that, if all the elements relevant to the situation at the time when English law was selected, connected the transaction exclusively with Portugal, the choice of English law could not displace mandatory rules of Portuguese law. Such mandatory rules were alleged to give rise to two specific defences. In addition, the Companies argued that Santander had breached various elements of the Portuguese Securities Code in presenting the swaps to it. We do not consider below the first and third of these claims (which were unsuccessful), on the basis that they are specific to Portugal, and therefore less likely to be of general relevance. We have, however, summarised the judge's conclusions in relation to article 3(3).
It is worth noting that all the swaps in this case were agreed before 17 December 2009, and the Rome Convention (as opposed to the Rome Regulation) therefore applied. There is, however, little difference in substance between the two so far as the relevant provisions are concerned, so this judgment is also likely to be relevant to cases determined by reference to the Rome Regulation.
There was a fundamental difference between the parties as to the approach that the court should adopt. Santander said that there was no need to identify as relevant the law of another particular country – the issue was whether "all elements of the situation" were linked to one country only. Elements with an "international character" should therefore be relevant. The Companies argued that the court should look for connecting factors to a legal system other than that of Portugal (aside from the choice of English law). The judge agreed with Santander, concluding that "in determining whether, choice of law aside, 'all elements relevant to the situation are connected with one country only', the enquiry is not limited to elements that are local to another country, but includes elements that point directly from a purely domestic to an international situation."
In this case, the court held that the swaps were agreed in the context of an international capital market, in which a number of international banks competed for the Companies' business. The parties chose to use the internationally standard ISDA documentation (rather than a Portuguese framework agreement) and also chose the "Multicurrency – cross border" version (as opposed to "Local currency – single jurisdiction"). The judge held that use of this documentation facilitated hedging and restructuring, as well as promoting legal certainty. If the court were to hold that mandatory rules of local law also applied, it would increase the prospect of different rules applying to the swaps, agreements that were back-to-back with them, and any hedging. It was relevant that the swaps were part of a back-to-back chain, ultimately hedged by Santander Spain, the assistance of which was needed in this regard (and in others) by its Portuguese sister company in entering into the swaps, even though the Companies had no knowledge of it. The judge also held that the right of either party to assign was a relevant factor in this regard, in that such rights were not limited to assignment to Portuguese entities. It was therefore contemplated that a non-Portuguese entity might become a party to the swaps. By contrast, the judge did not find the use of international reference rates such as LIBOR and EURIBOR to be relevant. It was likewise irrelevant that Santander provided a UK address for service.
One of the interesting aspects of the judgment in this regard is that it arrives at a different conclusion from that reached in a judgment we considered in the last edition of this update, Dexia Crediop v. Comune di Prato. In that case, the judge held that mandatory rules of Italian law applied, and that neither the use of ISDA documentation nor the international hedging of the relevant swaps were elements connecting the transaction with a jurisdiction other than Italy. The Companies said this approach ought to be followed. The judge in the present case said little specifically about this, other than distinguishing a particular factual issue, and noting that he respectfully disagreed to some extent with the judgment in Dexia.
The court also considered (because the point had been fully argued) the circumstances in which a rule could be said to be mandatory. In that regard, the judge held that it was sufficient to take a rule out of article 3(3), if the rule could be disapplied by agreement between the parties. The rule did not need to be capable of being ousted altogether.
It seems to us that the court's approach to article 3(3) in this case is significant. In particular, for banks seeking to do business in a number of jurisdictions on the basis of standard documentation, the decision in this case must be preferable to that in Dexia, which requires banks to take into account some potentially complex local factors when pricing and entering into agreements. In that case, mandatory rules were said to include the obligation to specify a cooling-off period during which the relevant transaction could be terminated at no cost to the counterparty. The approach in the present case allows for more consistency. Until one or other judgment is appealed, however, it will be impossible to know which approach is correct.
Rights of Class X noteholder in CMBS transaction
Hayfin Opal Luxco 3 Sarl and another v. Windermere VII CMBS PLC and others  EWHC 782 (Ch)
This judgment considered the proper calculation of interest due to the claimants (Hayfin), who were the holders of class X notes issued by the defendant (Windermere), as part of a CMBS transaction. The proceeds of the notes were used to purchase various loans made in relation to (and secured on) commercial property, and the income generated by such property was intended to service the payments due under the terms of the notes. In common with class X notes issued as part of other CMBS transactions, the class X notes here did not involve a right to payment of a specific rate of interest, but to payment of any excess interest in the hands of the issuer (excess spread) arising from the underlying commercial properties, after payment of the interest due on the other classes of note, and certain other costs. The class X notes were originally retained by the Lehman Brothers entity that arranged the CMBS transaction, and then sold. The judge noted commentary on the traditional opacity as to the calculation and use of excess spreads.
Hayfin's first two arguments related to the proper construction of provisions in the intercreditor agreement relating to one of the loans purchased with the proceeds of the notes. The relevance of this issue was that the payment of excess interest to the class X noteholder was to be calculated by reference to expected available interest (in essence, the amount of interest that should be available by applying the provisions of the relevant agreements). Hayfin asserted that one of these provisions ought to be construed so as to correct what Hayfin claimed was a clear mistake in the drafting. The way in which Hayfin contended that the relevant provision ought to be interpreted involved (in effect) the addition of a substantial amount of further text to that already contained in the agreement. The judge considered the authorities and concluded that, in this case, it was impossible to conclude that the parties would, had they discussed it, have agreed the alternative wording proposed by Hayfin. In this context, the judgment is interesting to consider in conjunction with that in the LSREF III Wight judgment referred to above.
The second category of argument articulated by Hayfin related to the capitalisation of unpaid interest due from another borrower. Such capitalisation had the effect of removing the unpaid interest from the calculation of expected available interest, and so reducing the amount to be paid to Hayfin. The judge held that this was the correct approach to the clause – capitalisation of unpaid interest was plainly a possibility under the loan agreement, and the class X noteholder must therefore have understood that it could be utilised as a tool.
As a final point, there was a dispute as to what interest rate should apply in the event that the judge found there to have been historic underpayments of the amounts due to the class X noteholder. Hayfin asserted that any underpayments should attract interest at the contractual class X rate, whereas the issuer asserted that any interest should only be payable pursuant to statute. The judge did not find that there had been any underpayments, but reached a conclusion on the point nonetheless. He agreed that, based on the wording of the relevant clause, interest was only payable to the class X noteholder on determination of the relevant amount. If that determination was incorrect, the clause did not provide that the class X noteholder was entitled to interest from that point on the correct sum. Instead, the issuer could be ordered to compensate any shortfall, with interest claimed pursuant to statute.
The judge also noted that he agreed with the point underlying two further submissions by the issuer, that it would be surprising for shortfalls in payment to be compensated at the class X rate, which was not a conventional rate of interest, and rose at points to levels around 6,000 per cent. He pointed out, however, that the issuer's assertion was not reflected in the contractual drafting, and that there was no indication in that drafting as to what rate the parties would have agreed, even if use of the class X rate was commercially absurd. He also considered the issuer's argument that use of the class X rate would effectively be a penalty, in light of the Supreme Court's recent decision in Cavendish Square Holdings v. Makdessi. The judgment on this point is somewhat unusual, in that it is obiter, and the judge was not convinced that the penalties doctrine applied at all. He found that, if it did, the amount of interest payable using the class X rate would most likely be exorbitant, and therefore a penalty. These conclusions are tentative to say the least, but they represent an early analysis of what has been a much commented-upon Supreme Court decision. In addition, the draftsmen of future CMBS documentation may wish to be alive to the need to draft class X rights more tightly.
Credit Suisse Asset Management LLC v. Titan Europe 2006-1 plc and others  EWHC 969 (Ch)
This judgment followed shortly after the one in Hayfin above, and also considered the rights of the holders of class X notes in four securitisation structures, in respect of which the documentation was identical. In this case, there had been significant defaults in the loans underlying the CMBS structure, such that some €17 million in accrued default interest remained unpaid. All classes of notes issued by the four issuers had maturity dates of 25 January 2016.
The Credit Suisse entity that was the claimant in this case was the investment manager. The holder of the class X notes was, however, another Credit Suisse entity (the Originator), which had been the originator of the loans and had assigned them to the issuer as part of the securitisation process. The judge recorded that the class X notes were intended to provide the Originator with a "fee". The principal amount of the class X notes (much of which had been repaid by the time of the judgment) was paid into a segregated account, and secured by a charge on that account. Class X interest was calculated in accordance with a series of definitions in the terms of the notes but, in practice, varied between 9,024 per cent and 114,508 per cent. According to the priority order for payments, payment of class X interest ranked equally with class A, both ahead of class A principal and the principal and interest due in relation to other classes.
The first issue considered by the judge was whether the calculation of the class X interest rate ought to take account of any additional interest due under the loans (which Credit Suisse said it should). The judge disagreed, holding that the words "per annum interest rate" were not intended to include default interest. He reached this view on the basis of a number of points of construction of the relevant documents, but also by considering the interpretation that was most likely to carry the commercial outcome intended by the parties. In this context, the judge accepted that it was not intended for the issuer to be left with any proceeds of the structure, and noted Credit Suisse's argument that its interpretation had the effect of "mopping up" any such surplus. However, the judge said that Credit Suisse's interpretation meant that the worse the loans performed, the higher the proportion of loan income that would be paid to the Originator, which (he held) was counter-intuitive, and there was no indication that this was what was intended. The judge also questioned whether the parties could have intended the complex calculation of class X interest that would follow a finding in Credit Suisse's favour. He also noted that the calculation of class X interest (unlike the other classes) did not take into account periodic expenses associated with the recovery of default payments, and that it would be commercially extraordinary were the Originator to benefit from additional payments referable to defaults under the loans, when it did not contribute to the costs of making good those defaults.
The judge accepted the argument made by certain of the defendants that the class X notes should be redeemed immediately on maturity. Credit Suisse argued against this, again on the basis that unless the class X notes remained outstanding, there was no mechanism to absorb any surplus in the hands of the issuer. The judge held that redemption was mandatory under the terms of the notes, and also relied on his findings in relation to the issue summarised above. He held that it could not have been intended that the class X notes should exist indefinitely, "creaming off payments from the borrowers", given that the Originator had never risked any capital for the purchase of the notes, and the remaining €5,000 in principal outstanding was available to be paid.
Finally, the judge agreed that interest should accrue on the class X notes after the maturity date at a rate of 8 per cent (being the judgment rate), rather than at the class X rate.
This judgment considers the construction of specific contractual provisions, but is interesting for the judge's approach to the question of the commercial intention behind the relevant agreements, particularly in the specific class X context.
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