Supreme court provides clarification of approach to interpretation of trust deeds governing structured notes

Under the terms of the ECNs, in the event that LBG’s CT1 ratio (i.e., its ratio of CT1 to risk weighted assets of total Tier 1 Capital (CT1 ratio)) fell below 5 percent – a ratio deliberately set 1 percent higher than the 4 percent regulatory minimum, the ECNs would be converted into fully paid up shares, increasing the Bank’s CT1 capital level. This conversion mechanism allowed LBG to count the ECNs towards to its CT1 ratio, while offering the noteholders an unusually high rate of interest – approximately 10 percent per annum, on average.

Crucially, the terms of the ECNs allowed for early redemption if a Capital Disqualification Event (CDE) occurred. Early redemption, like a conversion into equity, would deprive the noteholders of their entitlement to interest from the moment of redemption. The CDE in issue in the case was set out in paragraph 2 of the Trust Deed governing the ECNs: where the notes “[ceased] to be taken into account … for the purposes of any ‘stress test’ applied by the FSA in respect of the Consolidated [CT1 ratio]”.

In 2013, the FSA was replaced by the Prudential Regulation Authority (PRA) and the regulatory framework had developed from CRD1 (being the applicable regulation at the time the ECNs were issued) to CRD IV. Under this regime, CT1 capital was replaced by Common Equity Tier 1 capital (CET1) and the minimum core capital ratio was increased by the PRA to 4.5 percent CET1 (higher than the original minimum), effective 1 January 2015. CET1 is a significantly more restrictive category than CT1 was and excluded contingently convertible loan stock such as ECNs, save if the trigger for conversion was set at a CET1 ratio of at least 5.125 percent.

This posed a problem for LBG. The effect of the terms of the ECNs was that the conversion would only be triggered if LBG’s CET1 fell well below the new regulatory minimum, rather than at a level 1 percent above the regulatory minimum as had been their effect before the regulations were amended. In effect, if the ECNs were not considered to be CET1, and could only be converted into equity in circumstances where LBG’s CET1 fell well below the regulatory minimum, LBG was locked in to paying around GBP 940,000 per day in interest to noteholders of securities which LBG would not be in a position to call upon for the purpose of satisfying its regulatory requirements, in the way they were intended to.

Due to the regulatory changes, the PRA did not take the ECNs into account during a stress test in December 2014, which LBG passed with a CET1 ratio of 10.1 percent at the end of 2013 and a ‘minimum stressed’ ratio in the stress test of 5 percent.

As the ECNs had not been, and due to the regulatory changes could now not be taken into account for the purposes of the then current regulatory capital ratio, LBG declared that a CDE had occurred and sought to redeem the GBP 3.3bn in outstanding ECNs. The noteholders, acting through the Trustee, sought to oppose this and brought their case before the High Court, claiming that LBG was not entitled to have declared a CDE, nor therefore to have redeemed the ECNs.

In contrast, LBG sought a declaration from the High Court that a CDE had occurred on the basis that, as a result of the regulatory changes, the ECNs had not been taken into account in PRA stress tests, in particular the December 2014 stress test. LBG claimed that it was therefore entitled to redeem the outstanding GBP 3.3bn ECNs.

The High Court found in favour of the Trustee, but LBG prevailed before the Court of Appeal. The Trustee therefore appealed to the Supreme Court. The Supreme Court found by a margin of 3:2 in favour of LBG, concluding that a CDE had arisen, and thus the ECNs were redeemable. However, it was unanimous in its decision on the “proper approach to interpretation” of the terms of negotiable instruments such as these.

The proper approach to interpretation

Much of the argument before the Supreme Court focussed on whether, when construing the Trust Deed (containing the clauses in relation to redemption of the ECNs), the Court of Appeal had been entitled to take into account statements made in the substantial Exchange Offer Memorandum and in the lengthy letter from the chairman of LBG which accompanied it.

The Exchange Offer Memorandum contained factual background which the Trustee argued should provide context to interpret the terms of the ECNs. The Trustee pointed to the absence of certain pieces of information in this document regarding the regulatory thresholds applicable in a stress test or their relationship with the contractual conversion trigger (pushing the ECNs into equity). The Supreme Court rejected the Trustee’s arguments in this respect.

The Supreme Court acknowledged that the exact weight to be placed on contemporaneous documents in the interpretation of the terms of a trust deed is highly dependent upon the facts of the case, but it said that very considerable circumspection is appropriate before the content of such other documents are taken into account. Further, the majority affirmed the view of Lord Collins in Re Sigma Finance Corporation [2009] UKSC 2 that “it is the wording of the instrument which is paramount”.” In light of this, it was determined that the only knowledge necessary to understand the terms and conditions was the FSA regulatory material published in 2008 and 2009, and the other documents were not taken into account.

Did the possibility of a CDE fall away following CRD IV?

The Supreme Court rejected the Trustee’s first argument that the CT1 ratio applicable at the time the ECNs were issued was a different ratio to the CET1 ratio measured by the 2014 stress test. The Supreme Court concluded that the reference to the CT1 Capital in the CDE definition of the trust instrument should be treated as a reference to “its then regulatory equivalent”, the CET1 Capital.

The Supreme Court adopted the analysis of Gloster LJ in the Court of Appeal, who reasoned that although this might be a departure from what she considered to be the literal meaning of the words, the approach was in line with Lord Collins’ observations in Sigma where he warned against an “over-literal interpretation of one provision without regard to the whole”, which may “distort or frustrate the commercial purpose”. Indeed, Lord Neuberger was frank in doubting whether such a view was departure at all, dismissing the literal meaning which the Trustee argued for as a “rather pedantic approach to interpretation”.

Had a CDE occurred?

The Trustee argued that a CDE could only have arisen if the ECNs had been disallowed in principle as part of the December 2014 stress test.

Lord Neuberger, delivering the leading judgment on behalf of the majority, preferred LBG’s approach and concluded that a CDE had occurred for three reasons.

First, and most importantly, the ECNs were meant to be converted to “increase the Tier 1 Ratio [i.e., the regulator-imposed capital ratio in force at the time] before that ratio had fallen below the minimum [of 4 percent]”. As the trigger for the convertibility of the ECNs was below the regulatory minimum, they would not be converted into equity in time to be taken into account in calculating the applicable capital ratio, which by this time was CET1. Therefore, Lord Neuberger concluded, the ECNs could not be taken into account because they could not do “the very job for which their convertibility was plainly designed”.

Secondly, Lord Neuberger contrasted the two paragraphs of the CDE definition in the Trust Deed where paragraph 1 considered the question of whether the ECNs were “no longer eligible to qualify”, and paragraph two (the paragraph in issue) referred to an event where the ECNs “cease to be taken into account”. The former, his Lordship held, referred to what the Regulations say, whereas the latter referred to what occurred in practice. LBG relied, correctly in his view, on the fact that the ECNs had not, as a matter of fact, been taken into account for the purpose described in paragraph two.

Lastly, Lord Neuberger noted that if the court favoured the Trustee’s interpretation, it would be difficult to envisage a situation in which the CDE definition could ever be invoked and this would be at odds with the parties’ commercial intentions.

Comment

Inevitably, the drafting can never comprehensively deal with every scenario, and issues of interpretation will continue to go before the courts, often meaning that significant financial matters are determined by the court. The views of the court regarding the construction of negotiable instruments such as these are helpful guidance.

The majority of the Supreme Court clearly supported a pragmatic and purposive approach to interpreting whether a CDE had occurred, relying on whether the ECNs were fit for their intended purpose. In this light, the court’s conclusion is defensible. Nonetheless, Lord Sumption offered a cogent dissent that, irrespective of whether the terms of the trust deed were commercially advantageous to LBG, there had been no CDE as the ECNs continued to serve the function of boosting its CET1 capital in the event that the applicable regulator-imposed capital ratio fell to 1 percent. The 3:2 division of the court, coupled with the case’s appellate history, demonstrates that matters of interpretation are very fact specific, and that it is difficult to predict which interpretation will ultimately find favour.