In the latest in a growing line of contractual interpretation disputes arising from complex financial instruments, the Court of Appeal has overturned a decision of the Chancellor of the High Court on the meaning of a single provision in the suite of documents forming a series of collateralised loan obligation (CLO) notes.
In doing so, it has illustrated that whilst the principles of contractual interpretation are largely settled, it is their precise application to the facts in each case which will be of critical importance, and appeals to the higher courts are currently fairly commonplace.
Harbourmaster issued 14 classes of CLO notes which were secured upon an underlying portfolio of loans. As is typical, there were senior and junior notes, and the different classes of notes had different priorities upon redemption, with the senior notes ranking in priority. A dispute arose between the senior noteholders and the junior noteholders over whether a substantial sum of money (received as a result of prepayment of the underlying loans) was available to be reinvested by the collateral manager or whether it should instead be distributed to senior noteholders (in accordance with the waterfall provisions).
Under the documentation, the critical provision was that such receipts could only be reinvested if the ratings of the senior notes “have not been downgraded below their Initial Ratings“. The senior notes had in fact been downgraded below their initial AAA rating; however they had subsequently been upgraded back to AAA.
The funds were repaid to senior noteholders rather than reinvested and the junior noteholders challenged this decision on the basis that they were disadvantaged by this interpretation.
Court of Appeal decision
The junior noteholders appealed the decision on the basis that the first instance judge had applied a narrow grammatical interpretation of the words in question, failing to take into account the purpose and context of the clause.
The Court of Appeal found in favour of the appellants. Importantly, the Court emphasised that, following Sigma Finance Corp (In Administration), Re  UKSC 2,  1 All E.R. 571 and Rainy Sky SA v Kookmin Bank  UKSC 50,  1 W.L.R. 2900,contractual interpretation should not be restricted to a narrow, textual analysis. Instead, an iterative process of interpretation should, wherever possible, be applied, during which consideration of possible meanings of the words used should be informed by, and tested against, the commercial purpose of the clause. Where such an exercise produces a clear result, the court should be wary of assuming that it knows what would and would not be a commercially sensible result. However, the exercise was “not merely a safety valve in cases of absurdity“.
On that basis, the appellants contended, and the Court agreed, that the present perfect tense (in this case, in the words ‘have not been’) could be, and often was, used to describe something that started in the past and continues in the present, or to describe something that happened in the past but whose effect is felt at the present. Accordingly, it was not correct to conclude that the language was unambiguous, and the commercial purpose of the clause therefore needed to be considered carefully to determine the its meaning.
From that starting point, the Court concluded that the purpose of the provision was to protect the senior noteholders by requiring any proceeds from prepayment of the underlying loans to be used to redeem the notes in circumstances where such noteholders were currently at greater risk (indicated by the lower rating). Where the senior notes had been upgraded by the relevant point in time, however, the noteholders were at no greater risk than at the start of the transaction. Fundamentally, the Court held that the interpretation preferred by the Chancellor would raise the impact of any historic downgrades of the Class A1 Notes “to a level of pre-dominance which it was not designed to have in a context where, if given that level of pre-dominance, it conflicts with the basic scheme” of the CLO.