Court of Appeal upholds High Court contractual construction of CLO transaction

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) [2020] 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.

Background

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 [2011] 1 W.L.R. 2900Arnold v Britton [2015] A.C. 1619 and Wood v Capita Insurance Services Limited [2017] 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.

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High Court applies contractual interpretation principles in collateralised loan obligation transaction

The High Court has recently considered the contractual interpretation of documentation in a collateralised loan obligation (“CLO“) transaction: Deutsche Trustee Company Ltd v Duchess VI CLO B.V. & Ors [2019] EWHC 778 (Ch). Applying established principles of contractual interpretation, the court held that an incentive fee was not payable to the collateral manager of the CLO, following the exercise of a right of early redemption by the holders of the equity notes.

The court found that the documentation read as a whole was clear in the context of the transaction. It emphasised the “particular, even paramount” importance of the words used when the court is construing the terms of a traded instrument which will exist for a long time and pass through many hands (Re Sigma Finance Corp [2009] UKSC 2). Having considered the specific language used, the court concluded the parties to the notes were entitled and would expect to be bound by the language used.

In the latter context, the most interesting issue on rival commercial constructions was what the court described as the “supposedly perverse incentive” for the relevant noteholders to exercise their right of early redemption in order to avoid paying the incentive fee to the collateral manager. The court’s pragmatic response to this argument was that, if the notes were performing sufficiently well that the incentive fee was triggered, it would be in the interests of the relevant noteholders to “stick with it” and pay the incentive fee from quarter to quarter, rather than redeeming the notes purely to deprive the collateral manager of the incentive fee.

It is understood that the High Court has granted permission to appeal.

Background

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 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.

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.

Decision

General approach to interpretation

The court summarised the (well-established) approach to the interpretation of contracts as set out in the Supreme Court’s recent decisions in Rainy Sky v Kookmin Bank [2011] 1 W.L.R. 2900Arnold v Britton [2015] A.C. 1619 and Wood v Capita Insurance Services Limited [2017] 2 WLR 1095.

In the context of interpreting the CMA (and other Transaction documents), the parties agreed that construction was an iterative process which involved the court checking the rival meanings against other provisions and investigating their commercial consequences. This followed the approach taken in Re Sigma (and in Rainy Sky). The court emphasised commentary in Re Sigma as to the “particular, even paramount” importance of the words used when the court is construing the terms of a long term, transferable instrument and that the matrix of fact ought only to be relevant in the most generalised way. As was explained by Lord Collins, the commercial intention which could be inferred from the face of the document, and the nature of the parties’ business, could be used as an aid to construction, but no more.

Interpretation of the Transaction documents

The key issue considered by the court was the Collateral Manager’s entitlement to an ICM Fee under Clause 14.1 of the CMA when the Class F Noteholders exercised their Optional Redemption rights under Condition 7. Commenting that the Transaction documentation read as a whole was unambiguous, it held that the Collateral Manager was not entitled to an ICM Fee in such circumstances.

The court started its analysis by looking to Clause 14.1 of the CMA, which provided that the ICM Fee would be paid “on each Payment Date, subject to Condition 4(d) (Limited Recourse) of the Conditions and in accordance with the Priorities of Payment“. It said that this was simply governing the timing of payment and that, to see in what circumstances such a fee would be payable, it was necessary to look at the definition of the ICM Fee. The definition made clear “in no uncertain terms” that it was a fee which was only payable to the Collateral Manager in accordance with the payment waterfalls which applied during the on-going lifetime of the Transaction, not those that applied following an Optional Redemption under Condition 7.

The court held that the reference to the specific waterfalls could not be ignored; if the draftsman had intended that an ICM Fee would accrue when different waterfall provisions were triggered, there would have been a reference to the that waterfall in the ICM definition.

Rival commercial constructions

The Collateral Manager argued that the result of an interpretation which led to the ICM Fee not being payable upon an Optional Redemption was that there would be a “perverse incentive” for the Class F Noteholders to trigger an Optional Redemption to avoid the ICM Fee. The court’s pragmatic response to this argument was that, if the issue was performing sufficiently well that the ICM Fee would be triggered by the returns being generated, it would be in the interests of the Class F Noteholders to “stick with it” and pay the ICM Fee, rather than redeeming the notes purely to deprive the Collateral Manager of the ICM Fee.

Accordingly, having considered the specific language used, the court concluded that the commercial background and relevant factual matrix known to the parties at the date of the Transaction did not point to a different interpretation.

 

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Court of Appeal clarifies interpretation of default interest provisions under commercial mortgage backed securitisation documentation

The recent decision of the Court of Appeal in Credit Suisse Asset Management LLC v Titan Europe 2006-1 Plc [2016] EWCA Civ 1293 will be of interest both to finance lawyers and banking litigators whose practices touch on issues relating to commercial mortgage backed securitisation (CMBS”).

The majority of the Court of Appeal dismissed an appeal brought by the holder of so-called Class X notes in a CMBS structure (acting through its investment manager), upholding the High Court’s decision that the interest payable under such notes should be calculated by reference to the ordinary interest payable under the underlying loans, not by reference to any default interest triggered by a breach of the terms of those loans. The decision, whilst turning on the meaning of the terms and conditions of the particular CMBS, is also consistent with Hayfin Opal Luxco 3 S.A.R.L. v Windermere VII CMBS Plc [2016] EWHC 782 (Ch), which also dealt with (among other things) the issue of to whom default interest under a separate CMBS was to be paid. An appeal from that case was to have been heard in October 2016 had it not been settled.

In reaching its decision, the Court illustrated once again in the context of complex structured finance documentation that it will be reluctant to depart from the plain meaning of the language used by the parties, particularly in a bespoke agreement of this sort, unless the wording is ambiguous, in which case the more commercially likely outcome is to be preferred. However, the fact that the Court of Appeal was divided on the outcome shows how difficult this approach can be to apply in practice.

Factual Background

Titan Europe 2006-1 Plc (Titan”) was established as a special purpose corporate vehicle (SPV”) to acquire a portfolio of commercial loans from Credit Suisse International (the Originator”) and to issue the notes under the CMBS. Titan issued ten different classes of notes (A to H, X and V) for an aggregate nominal amount of approximately €723m. As is common in CMBS structures, Titan was established independently from the Originator so that the underlying loans would not impact on the regulatory capital ratios of the Originator. This structure meant that, if Titan was able to pay all of its noteholders the interest they were due, as well as extinguish any other liabilities, any surplus remaining would be paid to charity.

Under the CMBS documentation, the holders of the Class A to H notes were to receive a fixed rate coupon, based on a spread over the relevant reference rate reflecting their priority in the payment waterfall. The deal structure was premised on the basis that the total interest payments which would be payable on the Class A to H notes would be less than the interest payable on the underlying portfolio of loans. This meant that, if the entire underlying portfolio performed, there would be an excess of cash. The Class X notes enabled the Originator to retain the right to a share of these excess proceeds by entitling the holder to the payment by Titan of the difference between the rate of interest payable by the borrowers to Titan and the interest payable on the Class A to H notes. This payment structure is known as the “excess spread”. The claim was brought by Credit Suisse Asset Management LLC.

The terms and conditions of the notes provided that Class X notes would receive a “per annum interest rate” and the issue of interpretation was whether, in calculating the rate of interest payable by the borrowers to Titan for the purpose of determining the amount payable to Class X noteholders, account was to be taken only of the interest rate ordinarily payable by a borrower (the ordinary interest interpretation) or whether it included the additional interest payable under the terms of the underlying loans because of some breach of their terms (the default interest interpretation).

In his first instance decision, the Chancellor of the High Court considered that there were a number of contextual arguments which pointed in favour of the ordinary interest interpretation. He accepted as a powerful point that the consequence of this interpretation was that, in theory, a substantial sum might remain with the SPV (and therefore pass to charity) in the event that the default interest was not payable to the Class X noteholders. However, this was outweighed by the fact that, if a substantial proportion of the underlying loans performed badly and generated default interest payments, the Originator would receive the windfall which would be counter-intuitive in circumstances where the Class X note proceeds were the financial reward for its originating loans which were sound and produced the returns to support the structured note offering.

Decision

In her leading judgment, Her Honour Lady Justice Arden dismissed the appeal and agreed with the then Chancellor of the High Court. As a starting point, Arden LJ reiterated the correct approach to contractual interpretation, which was concerned with identifying the intention of the parties by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”. To answer that question, the Court is to focus on the meaning of the relevant words in their documentary, factual and commercial context, in light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the contract, (iii) the overall purpose of the clause and the contract, (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party’s intention.

In common with the recent leading cases on the interpretation of complex financial documentation, Arden LJ emphasised the importance of the Court not to interfere with the ordinary meaning of the words used in an attempt to rewrite what might appear to be an unwise bargain. It was more appropriate to perform a cross-check of the natural meaning of any provision in issue against the commercial common sense of the provision but this must not lightly be given precedence over the natural, contextual meaning of the language which the parties used.

Arden LJ concluded that the per annum interest rate was a term which referred to an interest rate which had already been annualised, and which was referred to as such expressly or by implication elsewhere in the documentation (i.e. account was to be taken only of the interest rate ordinarily payable by a borrower). She reached this conclusion for four reasons:

  1. The underlying loans described in the Offering Circular were described as bearing a specified rate of interest “p.a.” (per annum).
  2. There was a conspicuous absence of directions for making calculations which included default interest.
  3. The use of the words per annum in the Offering Circular was associated with the ordinary interest rate rather than the default rate. The particulars of the underlying loans in the Offering Circular stated that “Default Rate” meant the excess of (i) the interest rate of such Loan that accrues upon a Loan Event of Default over (ii) the “Loan Interest Rate”; and “Loan Interest Rate”is stated to mean “the per annum rate at which interest accrues on a Loan without giving effect to its Default Rate”.
  4. A reasonable reader of the terms and conditions of the notes would know that it was possible that there would be default and that it was likely that default rate interest was payable. In those circumstances the reasonable reader would conclude that default interest rate was not included in the expression “per annum interest rate” because it was not mentioned.

Arden LJ cross-checked this against commercial logic and concluded that it was difficult to think of any commercial transaction when parties would intend to reward a person by reference to the default of a third person. Moreover she agreed with the Chancellor in finding that the counter-intuitive consequence of the default interest interpretation pointed strongly against that result. It was difficult to see why the Class X noteholders should have the benefit of default interest payable under the terms of the underlying loans free of any of the expenses related to the default, particularly where the proceeds from the Class X notes were the reward for the Originator’s historical contribution to the issue of the notes.

His Honour Lord Justice Briggs delivered the dissenting judgment. Whilst he did not dissent from the applicable principles, he concluded that the natural meaning of the critical phrase “the related per annum interest rate due on such Loan” was the per annum rate which included all of the interest contractually due as at the relevant payment date under the relevant loan agreement. As such, this amount included what could loosely be called “default interest” whenever that was, or was part of, the interest rate due as at that date.

Comment

This appeal provides an interesting application of what are now well-established principles of contractual interpretation to a relatively complicated formula in financial documentation. It is not the first such example (nor will it be the last), and it does not develop those principles to any great extent. However, the contrast between the outcomes of the application of those principles by two of our leading judges is a stark reminder of the risk which litigants face in finely balanced contractual interpretation cases. In his dissenting judgment, Lord Justice Briggs observed that, whilst English law assumes that every question of construction has a right and a wrong answer, in reality the question of interpretation provides as much room for reasonable differences of view as there are in questions about the exercise of discretion.

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Windermere VII: Financial List provides guidance of wider market significance on the rights attaching to class X notes in a CMBS structure

A recent decision (heard in the Financial List) in Hayfin Opal Luxco 3 S.A.R.L. & Anor v Windermere VII CMBS plc & Ors [2016] EWHC 782 (Ch), relating to the interpretation of commercial mortgage backed securitisation (“CMBS“) documentation, will be of interest to finance lawyers and banking litigators alike.

The decision concerns the calculation of interest payable on certain ‘Class X’ notes. Whilst the findings relate to the specific documentation in question, they may well be of wider market significance given that such instruments are commonly used in CMBS structures and have (particularly in respect of those issued prior to the global financial crisis) been somewhat controversial. In particular, the Court confirmed that:

  1. interest payable to the Class X noteholder did not increase to include any default interest payable by the borrower under one of the underlying loans;
  2. interest payable to the Class X noteholder did not include interest on an underlying loan that had been capitalised;
  3. unpaid interest on the Class X note itself did not accrue interest (although this element of the decision was obiter).

Indeed, the first point above on default interest has also recently been considered in Credit Suisse Asset Management LLC v Titan Europe 2006-1 plc & Ors[2016] EWHC 969 (Ch), in which the Chancellor of the High Court reached the same conclusion in respect of a different set of Class X notes and underlying loan documentation. Whilst the specific analysis of the contractual wording was therefore also different, the same outcome was reached on the basis of an interpretation that was most likely to carry the commercial outcome intended by the parties given the overall scheme of the notes.

This judgment also provides guidance as to the approach to interpreting contracts governing complex financial instruments more generally. The case confirms (in line with previous Court of Appeal authority), that the Court will be reluctant to depart from the plain language used in an agreement unless the provision is ambiguous.

Permission to appeal has been granted and the appeal is due to be heard in early 2017.

Background

The case concerned the rights attaching to a Class X note, issued as part of a CMBS structure arranged by Lehman Brothers International (Europe) called ‘Windermere VII’ (the “Class X Note”).

As is common in a CMBS structure, a special purpose vehicle was established to issue notes of various classes, in this case Windermere VII CMBS plc (the “Issuer”). The payment of interest and principal on the notes was funded through payments of interest and principal on a portfolio of underlying loans secured against commercial real estate.

Interest on the notes was – in respect of all but the Class X Note – calculated by reference to EURIBOR (with an additional margin reflecting the seniority of the relevant note). In respect of the Class X Note, the Issuer did not pay a conventional rate of interest. Rather, the noteholder would receive any excess interest which the Issuer could expect to earn from the underlying loans, over and above the amounts that the Issuer was obliged to pay in respect of (a) the other notes; and (b) certain other fees and costs associated with the CMBS structure (the “Class X Interest Rate”).

Among the mortgage loans acquired by the Issuer was part of a loan made by Lehman Brothers Bankhaus AG (the “Nordostpark Loan”). The principal due on this loan was not repaid on the loan maturity date in 2012, constituting an ‘Event of Default’. The claimants, two related companies collectively referred to as “Hayfin” or the “Class X Noteholder”, subsequently acquired the Class X Note (and the Class B Notes) in 2015. Since acquiring its interest, Hayfin advanced a number of arguments as to how the amounts payable on the Class X Note should have been calculated and contended that the amounts paid by the Issuer were inadequate.

Decision

Hayfin issued a Part 8 Claim in the Financial List to determine a number of issues as to the rights attaching to the Class X Note. Four of these issues are of particular interest and are described in more detail below.

(1) Was interest paid to the Class X Noteholder improperly calculated by reference to EURIBOR?

The first issue was whether interest payable on the Class X Note ought, as a matter of construction, to have been calculated by reference to EURIBOR, or to a fixed rate of interest. As explained above, because the rate of interest payable by the Issuer was dependent upon interest earned on underlying loans, it was necessary for the Court to consider a number of defined terms in the loan documentation and this issue therefore turned on the facts of the case. The Court followed the most recent authority of the higher courts on contractual interpretation and rejected Hayfin’s submission that the relevant definitions could be corrected by construction or by necessary implication by the addition of further words.

There was an interesting discussion as to whether the proposed additional words would amount to implication of terms into the agreement (the strict requirements for which are set out in the recent Supreme Court judgment in Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Ltd [2015] UKSC 72, see blog post) or be characterised as the process of correction of mistakes by construction referred to in Chartbrook Ltd v Persimmon Homes Ltd & Ors [2009] UKHL 38. The Court held that there were certain features common to both lines of authority and, on either view, the test that must be satisfied is a strict one. The Court will “only add words to the express terms of an agreement if it is necessary to do so because the agreement is incomplete or commercially incoherent without them”.

The Court further held that there was considerable force in the Issuer’s argument that the relevant definitions were not mere boilerplate, but carefully drafted and central to the commercial deal. It therefore accepted that the definitions were likely to have been given careful attention by the contracting parties: Arnold v Britton & Ors [2015] UKSC 36. Accordingly, the Court did not consider that there was any reason to alter the plain language used by the parties. Interestingly, the Court observed that there was a “premium” to be placed on the language used in commercial documents forming the basis of tradeable financial instruments, although the Court did not rely upon this premium in its decision.

(2) Should the interest paid to the Class X Noteholder have included default interest payable on the Nordostpark Loan?

The second issue was whether interest payable to Hayfin in respect of the Class X Note ought to include any default interest payable by the borrower under one of the underlying loans, the Nordostpark Loan (notwithstanding the fact that the borrower could not pay that default interest). This issue arose because the definition of ‘Expected Available Interest Collections’ in the conditions to the Class X Note, which determined the Class X Interest Rate, included an assumption that interest payable on the underlying loans had been paid in full. Accordingly, Hayfin argued that the Class X Interest Rate ought to have included any default interest payable on the Nordostpark Loan.

The Court accepted that the definition of Expected Available Interest Collections required an assumption that the borrower of the Nordostpark Loan had paid default interest. However, it was necessary to ask whether any such monies would actually become available to the Issuer under the loan documentation. Pursuant to this documentation, the clear intention and effect of the waterfall provisions was to subordinate the payment of default interest to the Issuer until any unpaid interest and principal was paid. Interest payable to the Class X Noteholder therefore did not include default interest, as such monies would not become available to the Issuer until the waterfall was paid in full.

(3) Should the interest payable to the Class X Noteholder have included interest on an underlying loan that had been capitalised?

The Court was asked to determine the effect of capitalising interest paid on an underlying loan (the “Adductor Loan”) on the calculation of interest payable to the Class X Noteholder. The loan agreement governing the Adductor Loan provided that interest would be capitalised where it had been due for at least one year. After capitalisation, this amount was not included by the Issuer in the cumulative interest due and payable under the Class X Note. Hayfin argued that this capitalisation of interest could not have been intended to adversely affect the Class X Noteholder.

The Court concluded that the Issuer was correct to reduce the interest payable to the Class X Noteholder because the capitalisation of interest was specifically allowed for in the loan agreement. The Court held that if it had been intended that the capitalisation of interest ought not to reduce the amount of interest payable to the Class X Noteholder, then that could have been spelt out in the documentation. This finding was notwithstanding the fact that the offering circular in relation to the Class X Note made no mention of the possibility that the Class X Interest Amount might be affected by any capitalisation of interest owing on an underlying loan.

(4) Did unpaid interest on the Class X Note itself attract interest?

The fourth issue of interest was whether unpaid interest on the Class X Note itself accrued interest, either at the same rate as the Class X Interest Rate, or at some lower rate. Hayfin relied upon a condition of the Class X Notes entitled ‘Deferral of Interest’. It contended that any failure to pay the correct Class X interest amount would give rise to a shortfall as defined in that condition, which would itself accrue interest at the Class X Interest Rate.

Given the Court’s conclusion that there had been no underpayment of interest, this issue did not fall strictly to be determined. However, the Court nevertheless expressed the view that unpaid interest did not attract interest at the Class X Interest Rate because:

  • The relevant provision of the Class X Note conditions did not provide a remedy for miscalculation and resultant underpayment of amounts due under the Notes. Rather, it provided a mechanism to address a situation where the Issuer suffered a cash-flow shortage and could not meet its obligations under the Notes. Only in the latter case would the unpaid amounts accrue interest under the provision.
  • Under the Note conditions, no money was payable until the cash manager had determined the amount of interest payable on the Class X Notes. Accordingly, until the cash manager had made such a determination, interest was not payable and could not itself accrue interest.

The Court also expressed its view on two alternative arguments raised by the Issuer. It rejected the Issuer’s argument that the parties could not have intended for unpaid interest on the Class X Note to accrue interest at the Class X Interest Rate (which was much higher than any normal commercial interest rate). On the other hand, the Court – while not finally determining the point – was minded to accept the Issuer’s argument that a requirement to pay interest at the Class X Interest Rate for unpaid interest on the Class X Note would be an unenforceable penalty.

Comment

This judgment represents a detailed and considered decision from the Financial List, further illustrating the current approach of the Court to contractual interpretation and providing guidance of wider market significance for the use of Class X notes in CMBS structures, as noted in the introduction.

Over and above the key takeaway points on the interpretation of Class X notes, the Court’s comments in relation to the penalty clause argument are noteworthy. The Supreme Court recently considered penalty clauses in detail in Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67 (see blog post). Under the new more flexible test as to whether or not a clause will be found to be penal (and therefore unenforceable), it is generally expected that there will be less interference in contracts by the Courts. Against this background, it is perhaps surprising that a Financial List judge was willing (albeit on an obiter basis) to find that the requirement to pay interest at the Class X Interest Rate would amount to an unenforceable penalty. Whilst the Court commented that the interest payable otherwise would have been “exorbitant (if not extortionate)”, it is a high bar for a clause to be found to be out of all proportion to the legitimate interest in enforcing the obligation under the contract, particularly where the contract has been carefully drafted and negotiated. It may be that the issue would have been treated differently if it had been determinative.

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CBRE Loan Servicing v Gemini: High Court applies key principles of contractual interpretation to CMBS documentation

CBRE Loan Servicing Limited v Gemini (Eclipse 2006-3) plc & Ors [2015] EWHC 2769 (Ch) concerns the construction of contractual provisions in a complex commercial mortgage backed securities (“CMBS“) structure.

The Court had to determine, looking at the suite of documentation, how funds were to be classified: as “principal” or “interest”, where those terms were not defined. The consequence for the parties as to how receipts were classified, was that they would fall to be paid in different priorities under the applicable payment waterfalls.

In an interesting development in how provisions in this context fall to be construed, the Court adopted an approach which confirmed:

  1. The fact that the terms “principal” and “interest” were not defined suggested that determination of their meaning was not envisaged as one requiring any legal sophistication but merely the application of commercial common sense; and
  2. The receipts should be categorised as “principal” or “interest” depending upon their source and the role they played in the context of the loan and its security, viewed again as a matter of commercial common sense.

Adopting that approach, the Court concluded that in respect of a portfolio of commercial properties, rental payments constituted interest, whereas the proceeds of sale of properties and any surrender premiums paid by the tenants were to be characterised as principal.

Background

In August 2006, a loan was advanced to refinance a portfolio of commercial properties (the “Loan“), with the intention that rental income would be used by the borrowers to service commitments under the Loan. The Claimant, CBRE Loan Servicing Limited (“CBRE“) was the “Master Servicer” and the “Special Servicer” of the Loan.

In November 2006, the Defendant, Gemini (Eclipse 2006-3) (Plc) (the “Issuer“), purchased the Loan and its related security from the original lender (Barclays), funding that purchase by issuing secured floating-rate notes which fell due in July 2019 (the “Notes“). The Notes were constituted by a Trust Deed and divided into five classes – A to E – ranking in order of priority accordingly.

The structure performed prior to the financial crisis, and the rental income from the properties was used as intended to service the interest payments due under the Loan, which was in turn used to pay the interest due under the Notes. However, from October 2009, the borrowers under the Loan failed to repay the interest due in full and the value of the properties decreased significantly. These events led to default under the Loan, which was accelerated by the Claimant, such that the full amount became due. The Notes continued to be satisfied and were not accelerated.

Following the acceleration of the Loan, administrators were appointed over the borrowers and receivers appointed over certain of the properties. The administrators and receivers continued to collect rental income from the properties, some of which were subsequently sold.

Issues

The question for determination by the Court was whether certain payment receipts (after meeting various other obligations which had priority under the securitisation arrangements) should be characterised by CBRE (in its role as Master Servicer) as “principal” or “interest” within the meaning of the relevant documentation. Neither term was expressly defined in the documentation.

The particular context in which the question arose was a Cash Management Agreement dated 14 November 2006 (the “CMA“). The CMA contained the following Clause 13.1(j):

The Master Servicer will on or before each Calculation Date identify funds paid under the Credit Agreement [i.e. the agreement governing the Loan] and any Related Security, as principal, interest and other amounts on the relevant ledger in accordance with the respective interests of the Issuer and the Seller (if any) in the Loan.

The consequences of this characterisation were important in the application of the payment waterfall provisions between the different classes of Noteholders. If the receipts were “interest” then they would be apportioned to all of the Noteholders (ranked by priority) to pay interest due and overdue on the Notes before principal. The rate of interest payable on the class A Notes was lower than the rate applicable to the other classes, reflecting their greater security. If, on the other hand, the receipts were “principal” then they would have been exhausted by the repayment of principal to the class A Notes before the principal could be repaid on the other classes. It was therefore economically advantageous to the class B to E Noteholders that the receipts were classified as “interest”.

The class A Noteholders sought to argue that the proceeds of sale of properties and any surrender premiums should be characterised as “principal”, although they accepted that rental income should be categorised as “interest”. In support of their argument, the class A Noteholders pointed to the fact that the overall rationale of the transaction documents was such that rental income was to be applied to make repayments of interest on the Loan, while the proceeds of disposals of the properties were to be applied to repay principal on the Loan (which, before the default on the Loan, is how those payments had been treated).

The class B to E Noteholders argued that, as the parties had not sought to specify or define whether the relevant receipts constituted “principal” or “interest”, the approach to the interpretation of the relevant provisions should adopt the common law presumption that receipts are applied as interest first and, only when all arrears of interest have been discharged, as principal.

Decision

The Court summarised the general principles of contractual interpretation and in the familiar way observed that there was no dispute about those principles. It referred in particular to the decision in Rainy Sky SA v Kookmin Bank [2011] UKSC 50 and the now well established principle that, where there are two possible constructions, the Court is entitled to prefer the construction which is consistent with business common sense. However, if the parties have used unambiguous language, the Court must apply it. The Court “had regard” to the observations made in Arnold v Britton [2015] UKSC 36, although judgment in that case was not delivered until after the hearing. [See our blog posts for these respective cases here and here.]

As to whether a different approach is required to interpret a complex suite of documentation where it has been said that inconsistencies or ambiguities across the provisions are likely to be found, the Court quoted guidance from Re Sigma Finance Corp [2009] UKSC 2:

The instrument must be interpreted as a whole in the light of the commercial intention which may be inferred from the face of the instrument and from the nature of the debtor’s business. Detailed semantic analysis must give way to business common sense …

The Court also took account of the observations made in Napier Park European Credit Opportunities Fund Ltd v Harbourmaster Pro-Rata CLO 2 B.V. [2014] EWCA Civ 984. In summary, the Court should not focus on linguistic ambiguities, but rather look at whether the meaning of the language is open to question (which is not limited to cases of ambiguity).

In the light of these principles, the Court found as follows:

  • The focus of enquiry in Clause 13.1(j) of the CMA was on the Loan and its related security, rather than on the rights of the Noteholders and the priorities flowing from the securitisation.
  • Clause 13 as a whole appeared to envisage the process of identification of funds as a relatively routine matter which could be performed without undue difficulty or delay, the fact that the terms “principal” and “interest” were left undefined suggested that legal sophistication was not required, but merely the application of commercial common sense.
  • Viewed in this way, the answer was “tolerably clear” – receipts should be characterised on the basis of the role they played in the context of the Loan and its security viewed as a matter of commercial common sense.
  • As a result, the Court determined that rental payments were to be characterised as “interest” whereas the proceeds of sale (and surrender premiums which should be considered in the same way as the proceeds of sale) as “principal”.
  • This conclusion needed to be tested by considering its consequences in the context of the overall structure of the transaction documents. The Court was satisfied, in particular on the basis that treatment of the sale proceeds/premiums as principal was consistent with the way in which they were treated before the Loan was in default.

The relevant question was therefore not how receipts should be appropriated as between “principal” and “interest” in the hands of the Noteholders but rather how the receipts should be characterised in the hands of CBRE as Master Servicer. The relevant common law principles were those which distinguished capital receipts from income receipts in the economy of a business, not those which allocate payments received by a creditor as between interest and principal.

Comment

The Court in this case found it tolerably clear that an approach to the interpretation of complex securitisation documents which centred on commercial common sense was appropriate. However, the decision is nevertheless interesting, since the Court has had to grapple in a growing number of cases since the financial crisis with the precise application of what are largely uncontroversial general principles. As was illustrated most recently by the Court of Appeal in Wood v Sureterm Direct Ltd & Capita Insurance Services Ltd [2015] EWCA Civ 839 (see our e-bulletin here), different judges have shown themselves capable of applying those principles very differently to the same provisions. Whilst the contract in this case may have been sufficiently ambiguous to permit recourse to commercial common sense (particularly given the absence of critical defined terms), it remains to be seen whether this decision will also be the subject of an appeal.

Harry Edwards
Harry Edwards
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Sarah Boland
Sarah Boland
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Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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