The Court of Appeal has upheld the High Court’s decision that no incentive fee was payable to a collateral manager in a collateralised loan obligation (CLO) transaction following the exercise of a right of early redemption by the holders of the equity notes: Barings (UK) Ltd v Deutsche Trustee Company Ltd & Ors (Rev 1)  EWCA Civ 521.
While the Court of Appeal conducted the necessary iterative process of comparing the rival constructions and their commercial consequences, it was prepared to deal with the appellant’s various arguments in a robust but short form judgment. It will be interesting to see if the Court of Appeal’s willingness to do so leads to a trend of greater reluctance in giving permission to appeal contractual interpretation judgments than we have seen over the last few years. The decision is also noteworthy for emphasising that in a complex negotiated transaction, the contractual documents reflect the negotiated trade-offs agreed by the parties.
You can read our previous blog post on the High Court decision here: High Court applies contractual interpretation principles in collateralised loan obligation transaction.
The parties entered into a CLO securitisation transaction in August 2006 pursuant to which Duchess VI CLO B.V. (the Issuer) issued various classes of notes (the Transaction). Deutsche Bank Trustee Company Limited acted as trustee (the Trustee). Napier Park Global Capital Limited held Class F Notes (the equity tranche of the CLO). Barings (U.K.) Limited acted as the collateral manager (the Collateral Manager).
The Collateral Manager was appointed pursuant to a collateral management agreement (the CMA), under which it was responsible for the investment decisions which determined the performance of the Transaction as a whole. In addition to receiving an ongoing base collateral management fee, a separate incentive collateral management fee (the ICM Fee) was payable, in certain circumstances, to the Collateral Manager to incentivise its management of the portfolio.
The Transaction did not perform as hoped, at least in part due to the 2008 global financial crisis. In January 2018, the Class F Noteholders exercised their right to an Optional Redemption under Condition 7 of the Conditions of the Notes, requiring the Collateral Manager to liquidate the portfolio and make a distribution of principal according to the applicable waterfall (set out at Condition 11).
The Collateral Manager duly liquidated the portfolio, but it also claimed that an ICM Fee was due on redemption of the principal, which was said to have triggered the threshold of return which would lead to the ICM Fee being payable.
The Trustee, who took a neutral position, brought proceedings under CPR Part 8 which focused on the entitlement of Collateral Manager to payment of an ICM Fee in relation to the redemption.
High Court decision
The High Court dismissed the Collateral Manager’s claim to the ICM Fee.
Applying well-established principles (as set out in, in particular, Rainy Sky v Kookmin Bank  1 W.L.R. 2900, Arnold v Britton  A.C. 1619 and Wood v Capita Insurance Services Limited  2 WLR 1095), the High Court compared the rival contractual constructions put forward and considered their commercial consequences. In interpreting the Transaction documents, the court found that the Collateral Manager was not entitled to the ICM Fee in an Optional Redemption scenario.
The Collateral Manager appealed.
Court of Appeal decision
The Court of Appeal considered the principal issue of whether the ICM Fee was payable in an Optional Redemption scenario under Conditions 7 and 11 of the Notes.
The Court of Appeal dismissed the appeal in a short-form judgment, the key points of which are summarised below.
The Court of Appeal noted that the definition of the ICM Fee did not refer to Condition 7 (providing the right of Optional Redemption) or Condition 11 (setting out the payment waterfall to apply in the event of an Optional Redemption). Rather, the definition of the ICM Fee stated expressly that it would be payable in accordance with Condition 3 (setting out how regular Interest and Principal Proceeds should be applied), which did not apply in an Optional Redemption scenario. The Court of Appeal considered that the Collateral Manager’s attempts to read in references to Conditions 7 and 11 into the definition of ICM Fee would “…not be re-interpreting but re-writing” the definition, which it was not prepared to do. Nor was it prepared to infer that was the drafter’s intention from the approach taken to other provisions.
Similarly, the Court of Appeal rejected the Collateral Manager’s attempts to trace through various related provisions to demonstrate that the ICM Fee was payable in an Optional Redemption scenario. It held that the “convoluted exercise of interpretation and implication” which the Collateral Manager had put forward was inconsistent with the express wording of the definition of ICM Fee, and incorrectly assumed that the drafter was not conscious of the difference in the payment waterfalls applicable under Condition 3 and in an Optional Redemption scenario under Conditions 7 and 11.
In the Court of Appeal’s view, the Transaction documents, including the CMA and related documents (read as a whole), showed that the drafter “had well in mind, and made careful choices between” the waterfalls applicable to Optional Redemption and those applicable in other circumstances.
It was, therefore, not in accordance with the definition of the ICM Fee for it to be paid on an Optional Redemption under Conditions 7 and 11.
The Court of Appeal said that it was “impossible” in the circumstances of this case to say that this interpretation was “so patently inconsistent with business common sense…that it undermines that interpretation being the correct one”. In this context, the Collateral Manager had made an overarching submission that it would lack business sense for the ICM Fee – as a performance fee – to be calculated without taking into account capital distributions to the Class F Noteholders on the Redemption Date itself where the redemption was triggered on Optional Redemption.
In rejecting the business sense argument put forward by the Collateral Manager, the Court of Appeal recognised that “In this highly complex set of agreements it is plain that there are negotiated trade-offs”, and there were other examples in the transaction documents which provided enhanced protection to the Collateral Manager.