Court of Appeal clarifies requirements of claims in knowing receipt in failed claim against bank

The Court of Appeal has dismissed a knowing receipt claim against a bank for receipt of shares, which were transferred to the bank in breach of trust, on the basis that the claimant did not have a continuing proprietary interest in the relevant shares: Byers & Ors v The Saudi National Bank [2022] EWCA Civ 43.

The decision provides helpful clarification as to the elements required to make good a claim in knowing receipt. It confirms that liability for knowing receipt arises from the recipient’s knowledge of the fact that it has received trust property which has been transferred in breach of trust. This includes where a recipient has received the property without knowing that it was transferred in breach of trust and only later discovers the fact. Once the recipient acquires such knowledge, it makes it unconscionable for the recipient to retain the property and imposes a duty on the recipient to treat the property as if they are a trustee of it and to restore it to the trust. This contrasts with liability for dishonest assistance, where liability is fault-based and arises from the recipient’s dishonesty in assisting a trustee to commit a breach of trust (or assisting a fiduciary to commit a breach of fiduciary duty).

A key battleground in the present case, was whether a continuing proprietary interest in the relevant property is required for a claim in knowing receipt claim. In the view of the Court of Appeal, a defendant cannot be liable for knowing receipt if it takes the property free of any interest of the claimant. In this case, given the claimant had failed to prove at trial that its beneficial interest in the shares continued under local law following transfer to the bank, the claim in knowing receipt failed.

We consider the decision in more detail below.

Background

The background to this decision is more fully set out in our blog post on the High Court decision, here.

In summary, Saad Investments Company Limited (SICL) was a Cayman Island registered company and the beneficiary of certain Cayman Island trusts. Trust property included shares in five Saudi Arabian companies (the Shares). In July 2009, SICL went into liquidation.

In breach of trust, the trustee of the Cayman Island trusts transferred the Shares to a bank based in Saudi Arabia (the Bank). The purpose of the transfer was to discharge part of a debt owed by the trustee to the Bank.

The liquidators of SICL, the claimants, subsequently brought a claim for knowing receipt against the Bank, on the basis that the Bank knew (or ought to have made / was reckless in failing to make inquiries which would have revealed) that the trustee held the Shares on trust for SICL and that the transfer was in breach of trust.

High Court decision

The High Court’s reasoning is discussed in our previous blog post.

In summary, the High Court found in favour of the Bank and dismissed the claim. It held that a claim in knowing receipt where dishonest assistance is not alleged will fail if, at the moment of receipt, the beneficiary’s equitable proprietary interest is destroyed or overridden so that the recipient holds the property as beneficial owner of it. In the absence of a formal allegation of dishonesty against the Bank, and given the claimants’ failure to prove that SICL’s beneficial interest continued under local law despite receipt of the Shares by the Bank, the claim failed.

The claimants appealed to the Court of Appeal. The claimants argued that they did not need to have a continuing proprietary interest in the Shares to succeed in their knowing receipt claim.

Court of Appeal decision

The Court of Appeal found in favour of the Bank and dismissed the appeal by the claimants. In summary, it held that a continuing proprietary interest in the relevant property is required for a knowing receipt claim to be possible. A defendant cannot be liable for knowing receipt if he took the property free of any interest of the claimant. Absent a continuing proprietary interest in the Shares at the time of the registration, the claim in knowing receipt failed.

We consider below some of the key issues considered by the Court of Appeal in relation to the knowing receipt claim.

Accessory liability and the distinction between knowing receipt and dishonest assistance

The Court of Appeal highlighted that the starting point for establishing accessory liability for breach of trust is the well-known statement of principle in Barnes v Addy (1874) LR 9 Ch App 244:

  • Strangers are not to be made constructive trustees merely because they act as the agents of trustees in transactions within their legal powers, unless those agents receive and become chargeable with some part of the trust property, or unless they assist with knowledge in a dishonest and fraudulent design on the part of the trustees.

The Court of Appeal then went on to note the distinction between knowing receipt and dishonest assistance:

  • Liability for dishonest assistance arises where a person dishonestly procures or assists in a breach of trust or fiduciary duty. While the standard by which the law determines whether a mental state is objective, negligence does not suffice. For a defendant to be liable for dishonest assistance, his mental state has to have been such as by ordinary standards would be characterised as dishonest (as per Barlow Clowes International Ltd v Eurotrust International Ltd [2005] UKPC 37 and Ivey v Genting Casinos (UK) Ltd [2017] UKSC 67). However, there is no requirement that the defendant should have received property to which the trust or fiduciary obligation has ever attached.
  • To establish a claim for knowing receipt, a claimant must show: first, a disposal of his assets in breach of fiduciary duty; secondly, the beneficial receipt by the defendant of assets which are traceable as representing the assets of the plaintiffs; and thirdly, knowledge on the part of the defendant that the assets he received are traceable to a breach of fiduciary duty (as per El Ajou v Dollar Land Holdings plc [1994] 2 All ER 685).
  • The recipient’s state of knowledge must be such as to make it unconscionable for him to retain the benefit of the receipt. While a knowing recipient will often be found to have acted dishonestly, it has never been a prerequisite of the liability that he should (as per Bank of Credit and Commerce International (Overseas) Ltd v Akindele [2001] Ch 437).
  • A recipient need not necessarily have had any knowledge or even notice of any breach of duty at the point of receipt to be liable for knowing receipt. A person who has received trust property transferred to him in breach of trust can incur liability either if he received it with notice that it was trust property and that the transfer to him was a breach of trust or if he received it without such notice but subsequently discovered the facts. What matters is that the recipient’s state of knowledge should have become such as to make it unconscionable for him to retain the benefit of the receipt (as per Agip (Africa) Ltd v Jackson [1990] 1 Ch 265).

Mental element for establishing knowing receipt

The Court of Appeal noted that, as per Akindele, the mental element to establish liability for knowing receipt arises from the recipient’s knowledge of the fact that it has received trust property which has been transferred in breach of trust. This makes it unconscionable for the recipient to retain the property. Knowing receipt is not concerned with unconscionability of receipt, but with unconscionability of retention.

In the Court of Appeal’s view, liability for knowing receipt may arise where there has been no unconscionable conduct by the recipient. Indeed, a recipient could receive the property without knowing that it has been transferred in breach of trust and only later be informed of the fact. If the property is still in the recipient’s possession when they become aware of its provenance, the duty to deal with it as a constructive trustee immediately arises. Failure to do so will give rise to liability for knowing receipt, even where – up until the moment of knowledge – the recipient has done nothing unconscionable.

The requirement for a continuing proprietary interest

The Court of Appeal said that a continuing proprietary interest in the relevant property is required for a knowing receipt claim to be possible. A defendant cannot be liable for knowing receipt if he took the property free of any interest of the claimant. Absent a continuing proprietary interest in the Shares at the time of the registration, the claim in knowing receipt failed.

The Court of Appeal agreed with the High Court that such a conclusion was borne out by a consistent line of case law in which it has either been decided that a claim in knowing receipt cannot succeed unless the claimant has a continuing proprietary interest following the impugned transfer or that has been assumed to be correct. As per Lightning Electrical Contractors Ltd (2009) 1 TLI 35 the court could not grant relief against a transferee if under the lex situs the claimant’s equity was extinguished by the transfer. Also, as per Akers v Samba Financial Group [2017] UKSC 6, where under the lex situs of the relevant trust property the effect of a transfer of the property by the trustee to a third party is to override any equitable interest which would otherwise subsist, that effect should be recognised as giving the transferee a defence to any claim by the beneficiary. Also, as per Courtwood Holdings SA v Woodley Properties Ltd [2018] EWHC 2163, the foundation of a knowing receipt claim is that the assets do not belong in equity to the recipient and that what gives the equity to the claimants is the fact that the transaction which is impugned is not one which transfers a good title to the recipient.

The Court of Appeal also underlined that as per Macmillan Inc v Bishopsgate Investment Trust plc (No 3) [1995] 1 WLR 978, a bona fide purchaser without notice can defeat a continuing proprietary interest claim as it will have taken free of the claimant’s interest.

Accordingly, for the reasons above, the Court of Appeal found in favour of the Bank and dismissed the appeal by the claimants.

Permission to Appeal

The Court of Appeal refused the claimants’ application for permission to appeal to the Supreme Court.

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High Court considers distinction between liability for dishonest assistance and knowing receipt in failed claim against bank

The High Court has dismissed a claim brought by the liquidators of an investment company against a bank for knowing receipt, in circumstances where the investment company’s shares were transferred by a trustee (in breach of trust) to the bank, and used by the bank to discharge part of a debt owed by the trustee to the bank: Byers & Ors v Samba Financial Group [2021] EWHC 60 (Ch).

One of the key issues before the court was whether the claimants’ claim in knowing receipt must fail, where the beneficiary’s interest in the shares was extinguished by the transfer (as per local Saudi Arabian law, which was applicable to the property). Such a question does not arise in relation to English property under the general law of England and Wales, but may arise (as in this case) where under the foreign law applicable to the property, the transferee’s title may trump the interest of the beneficial owner and knowledge of that interest is irrelevant.

In summary, the court found that a claim in knowing receipt where dishonest assistance is not alleged, will fail if, at the moment of receipt, the beneficiary’s equitable proprietary interest is destroyed or overridden so that the recipient holds the property as beneficial owner of it. In the absence of a formal allegation of dishonesty against the bank, and given the claimants’ failure to prove that the investment company’s beneficial interest continued under local law despite receipt of the shares by the bank, the claim failed.

The judgment is noteworthy for its analysis of the distinction between liability for dishonest assistance and knowing receipt, both of which are common types of claim made against financial institutions. Historically, there has been some blurring of the line between the two causes of action, further complicated by references to “dishonest receipt” in certain judgments. The decision provides the following helpful clarification:

  1. Dishonest assistance is truly fault-based. It arises from the dishonesty of the defendant in assisting a trustee to commit a breach of trust (or assisting a fiduciary to commit a breach of fiduciary duty). From the perspective of financial institutions, it is important to note that such liability, if established, may result in vicarious liability for the employer of the individual defendant. For example, in Bilta (UK) Ltd (in Liquidation) v Natwest Markets plc & Anor [2020] EWHC 546 (Ch), the parent bank and its indirect subsidiary were found vicariously liable for the dishonest assistance of carbon credit traders employed by the subsidiary).
  2. Knowing receipt unconnected with dishonesty is different, at least at the moment of receipt. The recipient is not liable in such a claim for wrongly agreeing to receive the property. The knowing recipient’s liability depends on their knowledge that the property they receive is trust property and is to be dealt in that way. The principal duty of a knowing recipient is to deal with the property once received as if they are a trustee of it and to restore it to the trust; it would be unconscionable for them to do otherwise.

The decision is considered in more detail below.

Background

Saad Investments Company Limited (SICL) was a Cayman Island registered company and the beneficiary of certain Cayman Island trusts. Trust property included shares in five Saudi Arabian companies (the Shares). In July 2009 SICL went into liquidation.

In September 2009, Mr Al Sanea (the trustee) in breach of trust transferred the Shares to a bank, based in Saudi Arabia (the Bank). The purpose of the transfer was to discharge part of a debt which Mr Al Sanea owed to the Bank. Mr Al Sanea’s account was then credited by the Bank with the market value of the Shares on the day of the transfer; in the region of 801 Saudi Riyals (USD $318 million).

The liquidators of SICL, the claimants, subsequently brought a claim for knowing receipt against the Bank seeking compensation for the value of the Shares transferred to it. The claimants’ case was that the Bank received trust property with knowledge of a breach of trust. Alternatively, the Bank ought to have made (or was reckless in failing to make) inquiries, which would have revealed that the Shares were held by Mr Al Sanea on trust for SICL and that the transfer was in breach of trust.

One of the key issues before the court (which is the focus of this blog post) was whether – if SICL’s interest in the Shares was extinguished by the transfer (as per Saudi Arabian law) – the claimants’ claim in knowing receipt must fail (as per English/Cayman Islands law). This involved the important question of whether a transferee, who upon receipt obtains title to the property free from a beneficiary’s equitable proprietary interest, can nonetheless be personally liable in equity for knowing receipt because they received the property with sufficient knowledge that the transfer was a breach of trust.

Such a question does not arise in relation to English property under the general law of England and Wales, but may arise (as in this case) where under the foreign law applicable to the property, the transferee’s title may trump the interest of the beneficial owner and knowledge of that interest is irrelevant.

Decision

The High Court found in favour of the Bank and dismissed the claim. In summary, the court held that a claim in knowing receipt where dishonest assistance is not alleged will fail if, at the moment of receipt, the beneficiary’s equitable proprietary interest is destroyed or overridden so that the recipient holds the property as beneficial owner of it.

We consider below some of key issues considered by the court in relation to the knowing receipt claim.

The claimants’ arguments

The key arguments articulated by the claimants were as follows:

  • There should in principle be a personal remedy and it was irrelevant whether under Saudi Arabian law the transfer of the Shares to the Bank extinguished SICL’s proprietary interest in them, as the Bank received the Shares for its own purposes with sufficient knowledge that they had been transferred in breach of trust.
  • Under Saudi Arabian law the effect of the registration of the Bank as the owner of the Shares did not deprive SICL of the ability to assert its equitable interest against the Bank.
  • That liability in knowing receipt arises from the wrongful receipt of property by the transferee, i.e. it is a fault-based liability. The transferee knows (sufficiently) that the property belongs to another and that it has been wrongly transferred to them. The transferee therefore is not entitled, as against the beneficiary to receive and retain the property for itself.

No allegation of dishonesty

The court said that although the claimants at times came close to alleging the Bank was an accessory to the theft of the Shares, they did not allege dishonesty as would be required to establish liability as a constructive trustee for dishonest assistance in a breach of trust. Also, the court noted that an allegation that a person has failed recklessly to make the enquiries that an honest person would have made is not an allegation of dishonesty. The fact that there was no allegation of dishonesty underpinned the rest of the court’s analysis of the claim.

Distinction between liability for dishonest assistance and knowing receipt

The court commented that the claimants’ arguments failed to draw a sufficiently clear distinction between liability for dishonest assistance and knowing receipt.

The court underlined that a defendant can be liable for both dishonest assistance and knowing receipt, but as a matter of law the distinction is clear. In the court’s view, dishonest assistance is truly fault-based – the equity arises from the dishonesty of the defendant in assisting a trustee to commit a breach of trust.

Knowing receipt unconnected with dishonesty is different, at least at the moment of receipt. The recipient is not liable in such a claim for wrongly agreeing to receive the property. The knowing recipient’s liability depends on their knowledge that the property they receive is trust property and is to be dealt in that way. The principal duty of a knowing recipient is to deal with the property once received as if they were a trustee of it and to restore it to the trust; it would be unconscionable for the recipient to do otherwise.

Approach to knowing receipt claim where there is no dishonesty

The court explained that a knowing receipt claim that does not allege dishonesty requires the claimant to have a continuing proprietary basis for it (as per Macmillan Inc v Bishopsgate Investment Trust plc (No.3) [1995] 1 WLR 978).

A claimant must be able to assert that the defendant received the property and was obliged to deal with it as if they were a trustee of it. If the recipient was from the outset entitled to deal with the property as their own, the claim cannot succeed. In the present case, the claimants needed to prove that SICL’s proprietary interest in the Shares was not extinguished at the moment of receipt by the Bank; but the claimants failed to do so. The knowing receipt claim therefore failed.

Permission to Appeal

The court granted the claimants permission to appeal to the Court of Appeal on the knowing receipt issue.

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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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High Court refuses declarations sought by trustee of unsecured notes as to amounts due and payable by issuer

In Part 8 proceedings brought by the trustee of certain unsecured notes, the High Court has refused to exercise its discretion to grant declarations as to the amounts due and payable by the issuer of the notes: The Bank of New York Mellon, London Branch v Essar Steel India Ltd [2018] EWHC 3177 (Ch). The court reached this conclusion notwithstanding the fact that the issuer was clearly in default under the notes, did not take any steps in the proceedings and was not represented before the court.

The decision offers some cautionary guidance as to the steps that those exercising corporate trustee functions might consider taking when applying for declaratory relief in relation to non-payment by the issuer of notes or other debt instruments. In particular, the court in this case found that:

  • In the absence of any evidence to confirm that other proceedings involving the issuer (an insolvency process in India) would not be affected by declarations made by the English court, the potential for those foreign proceedings to be affected was a factor that pointed clearly against the making of the declarations.
  • In circumstances where a third party who might be affected by the declarations (the insolvency professional in India) was not before the court and had been unable to make submissions, granting the declarations would amount to an “improper interference” in a foreign process being conducted by another party if the declarations were to affect the foreign process.

To the extent that the court appears to have taken a strict approach to the exercise of its discretion in this case, this may be explained by the court’s decision to adopt a “conservative mindset” against granting the declaration, because of the issuer’s non-participation in the proceedings. It is noteworthy that the court adopted this approach even though the issuer’s non-participation was not the fault of the claimant, and the claim was made under Part 8 and therefore did not turn on a factual dispute.

Background

The defendant (the “Issuer”) issued certain US Dollar 0.25% unsecured notes (the “Notes”), which were constituted under the terms of a trust deed dated 5 December 2003 (the “Trust Deed”). The claimant was the trustee (the “Trustee”) of the Notes.

The Trustee issued a Part 8 Claim in July 2018 seeking declarations against the Issuer as to the amounts due and payable in respect of the Notes. The Issuer took no step in the proceedings and was not represented at the hearing.

To determine whether the declarations sought should be made, the court said there were three questions to resolve:

  1. Did the Trustee have standing to bring the claim?
  2. Was the Defendant properly before the court, so that it could properly determine the substance of the Part 8 Claim?
  3. Was it appropriate to make the declarations sought by the Trustee?

Decision

Having found that the Trustee had standing to bring the claim and the Issuer was properly before the court (by service of the claim form on a service agent appointed under the Trust Deed), the court held that it would be inappropriate to make the declarations sought by the Trustee.

The court noted that the power to grant declaratory relief is discretionary (Rolls Royce plc v Unite the Union [2009] EWCA Civ 387). In exercising that discretion, the court said it was required to take into account justice to the claimant, justice to the defendant, whether the declaration would serve a useful purpose and whether there were other special reasons why or why not the court should grant the declaration (Finance Services Authority v Rourke  [2002] CP Rep 14).

The key reasons given by the court for finding that the declarations sought by the Trustee should not be made were as follows:

Both sides of the argument will not be put

The court said it was required to ensure that all those affected were either before the court or would have their arguments put before the court (Rolls Royce at [120](6)).

The court accepted that it would be “invidious and wrong” to allow a defendant’s non-participation in proceedings to prevent the making of declarations (particularly where this was not the fault of the claimant, and where the claim was made under Part 8 and did not turn on substantial disputes of fact – as here). However, where the defendant was absent, the court considered that it was required to approach the exercise of its discretion with “something of a conservative mindset against the granting of a declaration“.

Potential effect on a third party not before the court

The court noted that the Issuer was the subject of an insolvency process in India, but the effect of the instant proceedings on that insolvency process (and on the insolvency professional appointed in India) was unclear. There was no Indian law before the court to confirm the position.

The court found that the possibility of the insolvency professional being affected by declarations made in English court proceedings to which he/she was not a party was a factor that pointed clearly against the making of declarations.

The existence of a real and present dispute and the potential for interference in a foreign process

The court emphasised the need for a real and present dispute between the parties, which would be resolved by the making of the declaration.

The court found that it was “difficult to identify such a dispute as between the Trustee and the [d]efendant“, because although the Issuer was in default under the Notes, there was not a discernible dispute as to terms of the Notes or the Issuer’s obligations and it was not a case where the Issuer would pay if the declarations sought were made. It appeared to be a case where the Issuer simply could not pay and the granting of a declaration would not resolve the position in respect of the Issuer.

Further, the court understood that there were some points of dispute between the insolvency professional in India and the Trustee. As noted above, the court did not have evidence as to whether the declarations sought would affect the Indian insolvency process. However, if they did, then in the court’s view such declarations would amount to an “improper interference” in a foreign process being conducted by a party (the insolvency professional in India) who was not before the court and had been unable to make submissions. The court said this was not cured by the fact that the Indian insolvency process did not preclude claims for declaratory relief; and/or that the insolvency proceedings had not been recognised in this jurisdiction.

In light of the above, the court considered that it would be inappropriate to make the declarations sought by the Trustee and declined to do so.

 

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

Court of Appeal resolves redemption dispute concerning £3.3bn “coco” notes by reference to their commercial purpose

LBG Capital No. 1 plc & Anor v BNY Mellon Corporate Trustee Services Limited [2015] EWCA Civ 1257: In an interesting contractual interpretation decision relating to contingent convertible (or better known as “CoCo“) capital notes, the Court of Appeal has overturned the decision of the High Court and held that a series of such notes (referred to as Enhanced Capital Notes or “ECNs“) issued by members of Lloyds Banking Group (“LBG“) could be redeemed because they no longer assisted LBG in passing its core regulatory capital stress tests. In doing so, the Court paid particular attention to LBG’s commercial purpose in issuing the ECNs (in the context of its regulatory capital requirements).

The construction of the ECNs was complicated by the fact that the ECNs were issued in 2009, and the Court had to construe the relevant provisions whilst taking into account the substantial changes to the regulatory environment since 2009. This included, in particular, the fact that the concept of Core Tier 1 (“CT1“) capital, which was referenced in the definitions of both the conversion and redemption provisions of the ECNs, had fallen out of use by the time of the dispute.

Aside from the interesting factual context, the legal analysis is also noteworthy since the case also provides an example of the Court’s approach to arguments of mistake in complex financial transactions such as this. The Court accepted LBG’s argument that the wording of the redemption trigger contained a mistake (by failing to allow for changes in the regulatory environment regarding core capital) which was apt to be corrected by construction. The Court held that there might be slightly different views as to the precise wording of any potential replacement text, but the result to be achieved was clear and it was irrelevant how as a matter of drafting that result might have been achieved. The Court was thus willing to accept that, even in high-profile transactions undertaken with the help of sophisticated advisers, there can be “infelicities” in the drafting and the Court should look beyond these to discover the true meaning of the parties’ agreement.

The Supreme Court has granted an application by the Claimant, BNY Mellon Corporate Trustees (“BNY Mellon“) for permission to appeal. The appeal will be listed to be heard in the Supreme Court in the near future.

Background

In March 2009, the Financial Services Authority (“FSA“) stress-tested LBG and concluded that, if it wished to avoid participating in the Government’s Asset Protection Scheme (which carried substantial costs), it would have to raise a further £21 billion in CT1 capital.

Accordingly, in late 2009 LBG undertook to do so, principally by two routes: (1) a £13.5 billion rights issue; and (2) a series of exchange offers to convert existing lower tier capital securities into ECNs. The ECNs were to be issued by two LBG subsidiaries (the “Issuers“) and the key terms and rationale of the ECNs included the following:

  • The ECNs would initially count as lower tier 2 capital, but they would automatically convert into ordinary shares (and therefore qualify as CT1 capital) if at any time LBG’s consolidated CT1 capital ratio (i.e. the ratio of its CT1 capital to its risk weighted assets) fell below a certain threshold.
  • Thus, for the purposes of the FSA’s stress tests, if in any projected scenario LBG’s CT1 capital ratio fell below that threshold, the FSA would assume the conversion trigger to be met, and would treat the ECNs as CT1 capital in such scenarios.
  • The terms and conditions of the ECNs provided that the Issuers had the option to redeem the ECNs if a Capital Disqualification Event (“CDE“) had occurred and was continuing. A CDE was defined as having occurred if (inter alia) “as a result of any changes to the Regulatory Capital Requirements or any change in the interpretation or application thereof by the FSA, the ECNs shall cease to be taken into account … for the purposes of any ‘stress test’ applied by the FSA in respect of the Consolidated Core Tier 1 Ratio“.
  • Whilst “Regulatory Capital Requirements” was defined more broadly as meaning “any applicable requirement specified by the FSA in relation to minimum margin of solvency or minimum capital resources or capital“, the Core Tier 1 Capital definition (which was incorporated into the definition of “Consolidated Core Tier 1 Ratio”) was more statically defined as meaning “core tier one capital as defined by the FSA as in effect and applied… as at 1 May 2009“.

In December 2009, some £8.3 billion of ECNs were issued. The coupons on these notes were relatively high (averaging over 10% p.a.) so that by the time of the proceedings in 2015, even though only about £3.3 billion of the ECNs were still outstanding, the total interest cost of the ECNs was about £940,000 per day.

As the regulatory regime developed after 2009, the core regulatory capital stress test applicable to LBG evolved in such a way that in November 2013 the Prudential Regulatory Authority (“PRA“, the FSA’s successor as the UK’s prudential regulator) announced that from January 2014, it would no longer monitor the capital of banks by reference to the May 2009 definition of CT1 capital, instead focussing on the concept of Common Equity Tier 1 (“CET1“) capital.

LBG passed its December 2014 stress test. The PRA confirmed (in a letter dated 17 March 2015) that whilst the ECNs were treated as part of LBG’s total capital, they did not count towards LBG’s CET1 capital ratio in the stress tests. The PRA also noted that given the differences between CT1 capital and CET1 capital, the ECNs would likely “only reach the contractual conversion trigger at a point materially below [the CET1 threshold in the stress testing exercise]“.

Accordingly, the Issuers contended that the ECNs no longer assisted LBG in passing its regulatory stress tests, and that a CDE had therefore occurred, entitling them to exercise their redemption rights. BNY Mellon (as trustee for the ECN noteholders under the relevant Deed of Trust) issued Part 8 proceedings for declaratory relief to the effect that a CDE had not occurred.

High Court decision

The two key questions on the interpretation of the CDE clause were:

  1. The preliminary issue: BNY Mellon argued that the December 2014 stress test was not a relevant stress test for the purposes of the definition of a CDE. That definition referred expressly to stress tests “applied by the FSA in respect of the Consolidated Core Tier 1 Ratio“, whereas the December 2014 stress test was in respect of CET1 capital, not CT1 capital. Because the definition of “Core Tier 1 Capital” was expressly linked to the FSA’s definition as at May 2009 it was submitted that any stress test that did not focus on CT1 capital could not be relevant to the redemption trigger. The trial judge rejected this argument because, whilst that was the “literally correct reading” of the relevant provisions, it “produced such an extraordinary result that it cannot have been intended“; there had been an “obvious mistake in the drafting“.
  2. The main construction issue: BNY Mellon’s second key argument was that, even if the December 2014 stress test was relevant (and should be read as referring to the CET1 capital test in the current regime), the ECNs had not “ceased to be taken into account” for those purposes, because they would still be treated as ordinary shares in any stress scenario where the conversion trigger had been met. In the new regulatory environment, it was clear that the stress tests were not to be treated as mere pass/fail tests and the margin of any pass or fail would be relevant in determining consequential actions following the test. The judge at first instance accepted this argument, holding that “shall cease to be taken into account” in the definition of a CDE suggested “a disallowance in principle” of the ECNs for stress testing “with continuing effect in the foreseeable future“. In his view, that had not happened because, if in any stress scenario the CT1 threshold were breached, the ECNs would convert into ordinary shares, which would still rank as core capital. He went on to say that “the ECNs will still be relevant, if LBG were to fail the stress test, in ascertaining the extent of any shortfall in capital and the kind and extent of remedial action required“.

LBG appealed, and by a Respondent’s Notice, BNY Mellon argued that the trial judge had been wrong to reject its arguments on the preliminary issue. Both issues were thus live before the Court of Appeal.

Court of Appeal decision

The preliminary issue

The Court of Appeal agreed with the trial judge that the literal meaning was not the correct interpretation of the CDE provision. The Court noted that the need for certainty meant that the conversion trigger should be defined by reference to a static (May 2009) definition of CT1 capital. However, it would make no commercial sense for the redemption trigger to be frozen in time in this way. It was unrealistic to say that the redemption right should last only for so long as the regulator did not revise the definition of core capital. There was no commercial justification for creating an option which lasted only as long as the regulator happened to use the then current concept of CT1 capital, particularly given the ECNs were long-dated instruments, with final maturities in some cases as late as 2032.

Interestingly, the Court found unpersuasive the argument that many recipients of the offer documentation were retail investors, who would assume that the documents had been drafted by sophisticated lawyers and therefore should be taken to have meant exactly what they said. The Court found it irrelevant that the body of investors included retail investors; what mattered was the “reasonable addressee“. In a case such as this, such a person would either have understood the relevant markets and regulatory environment, or would have had the assistance of suitable financial advisers. The Court relied on the statement by Lord Collins in In Re Sigma Finance Corporation [2009] UKSC 2 that, in complex documents of this kind: “there are bound to be ambiguities, infelicities and inconsistencies. An over-literal interpretation of one provision without regard to the whole may distort or frustrate the commercial purpose.”

The main construction issue

The Court also accepted the Issuers’ argument (and therefore reversed the outcome at first instance) that a CDE had occurred because the ECNs had ceased to be taken into account for the purpose of the December 2014 stress test. The Court held that the natural meaning of the provision was that the ECNs had to be capable of contributing to LBG’s ability to meet the relevant stress test in respect of its core capital ratio (rather than merely remaining in some way relevant to the exercise).

Comment

The case provides a useful example of the Court’s ability to take account of the commercial objectives of complex financial instruments such as CoCos as an aid to their construction. The Court appears to have been sensitive to the fact that regulated entities have been (and continue to be) subject to an environment of ongoing change, and that where documents have been drafted with the intention of (a) helping them to meet their regulatory obligations and (b) being responsive to changes in the regulatory environment, those intentions should be respected.

The decision is also likely to be a useful authority for parties seeking to argue that there has been a mistake in the wording of contractual documents, even where such documents have been drafted with the benefit of legal advice. The Court demonstrated a willingness to accept that even in a high value transaction where the documents were drafted by highly skilled legal teams, there was always the possibility of an “infelicity” in the wording which, if obviously incompatible with the commercial purpose of the transaction, could be corrected.

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
Donny Surtani
Donny Surtani
Senior Associate
+44 20 7466 2216
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948