The unusual facts of a recent dispute between interested parties in the Theatre CMBS transactions have highlighted some important issues in complex structured finance transactions, and in particular the responsibilities of corporate trustees to protect the interests of otherwise unrepresented creditors. The decision also considers the disenfranchisement provisions that are common in securitisation transactions, and looks at how orthodox concepts of beneficial ownership should be applied to modern synthetic risk transfer structures.
In Citicorp Trustee Company Ltd v Barclays Bank Plc and others  EWHC 2608 (Ch), Mr Justice Peter Smith was asked by Citicorp as trustee to determine whether Barclays and Rabobank as the holders of senior notes under two CMBS transactions were able to vote those notes on restructuring proposals.
The situation was complicated by the fact that Barclays had numerous roles in the context of the securitisations and that Barclays and other parties had entered into complex synthetic risk transfer structures behind the scenes. Under these swap arrangements, which operated outside the CMBS structure, Barclays had control over Rabobank’s notes, and in turn Ambac had control over Barclays’ holdings in both sets of notes, meaning that Barclays and Rabobank as the holders of the senior notes did not have the economic interest in them or control the voting rights with respect to the notes. Further, Barclays was a hedge counterparty to the securitisation structure under interest rate swap agreements. A default and early termination of those swaps would entail payments of up to £475 million becoming due to the hedge counterparties, and having priority over payments to noteholders.
These interests led Barclays, which had initially argued to the trustee that it was entitled to vote its notes, to change tack and argue before the court that the notes it held (but not Rabobank’s notes) were disenfranchised. In doing so Barclays relied on an apparent prohibition on it voting as a noteholder because it had been a seller of loans to the securitisation structure. Ambac was forced to step forward to protect its financial interest in the notes and argue in court for Barclays’ right to vote the notes (on Ambac’s direction).
Junior noteholders that had previously sought to persuade the trustee that neither Barclays nor Rabobank should be allowed to vote the senior notes they held opted not to be parties to the proceedings and advance their position to the court. Indeed, no junior noteholder could readily be identified to be joined to the proceedings, as the notes were held in dematerialised form through the clearing systems and therefore only the servicer under the CMBS knew who they were. Barclays had been the servicer but had transferred the role, and the new servicer was not initially a party to the proceedings.
Representing all interests
The court took steps to address two perceived problems that arose from these convolutions. First, the judge was concerned to ensure the interests and arguments of all creditors were advanced despite no junior noteholder being willing to take part. To achieve this he relied on the decision in State Street Bank & Trust Co v Sompo Japan Insurance Inc and others  EWHC 1461, which emphasised the importance of a trustee bringing all relevant propositions and arguments to the court’s attention.
So the trustee’s counsel was called on to make arguments on behalf of the absent junior noteholders. In addition, the judge took steps to ensure his judgment would bind all the relevant parties to the structure. In addition to the trustee, Barclays, Rabobank and Ambac, the court joined the servicer to the proceedings and ordered it to disclose on a confidential basis to the lawyers for the other parties the identity of one junior noteholder. That noteholder was joined to the proceedings as “Defendant XY”, served with all the documents, and given liberty to apply for a limited period to vary the order joining it. Defendant XY was made a representative defendant under CPR 19 so that all the junior noteholders would be bound by the judgment.
These arrangements were designed to avoid any risk that a junior noteholder might sit out the proceedings and, if the judgment was unfavourable, commence its own proceedings. This was of particular concern given the fast approaching maturity date and the risk that proceedings may be brought by junior noteholders as a delay tactic. The judge acknowledged that a junior noteholder adopting this tactic having been aware of the trustee’s proceedings might expect to be accused of an abuse of process, but sought to avoid any risk in advance nonetheless.
Voting the notes
Having ensured that all interests would be represented and bound in this way, the judge went on to determine that the Barclays and Rabobank senior notes were not disenfranchised. In doing so, he held that the restriction on voting notes applied only to notes held by or for Barclays in its capacity as a seller of loans to the CMBS structure and not in any other capacity. He accepted that Barclays never would in any circumstances hold notes in its capacity as seller. Nonetheless he considered this interpretation was to be preferred. The alternative was to deprive Barclays (and perhaps more importantly, Ambac) of important voting rights on valuable senior notes in circumstances where there appeared to be no good explanation for why those rights should be given up.
The judge also rejected the argument that Barclays was beneficially entitled to the Rabobank notes by virtue of the control it had over them under the swap arrangements between Rabobank, Barclays, and Ambac. That argument had been advanced by the trustee on behalf of the absent junior noteholders, with the aim of showing that those notes were also caught by the restriction on Barclays as a Seller voting notes.
The court’s decision provides some guidance on how the courts will approach disenfranchisement provisions typically included in securitisation transactions to prevent noteholders with conflicting interests misusing their voting rights. The case confirms that where disenfranchisement provisions are aimed at a party acting in a specified capacity, they will not apply where that party holds notes in a different capacity. In practice it may often be difficult to identify in what capacity a holder holds notes. This will be of particular concern to corporate trustees, who need to know that instructions from noteholders are validly given. Care needs to be taken when drafting disenfranchisement provisions to ensure they operate as intended.
In dealing with the argument that the synthetic swap arrangements behind the notes transferred their beneficial ownership, the judge suggested that it “might be possible in certain unusual circumstances to stretch the traditional and well understood meaning of the words beneficial ownership beyond a proprietary nature”. But he conceded that he could not conceive of any circumstances where it would. This adds an element of uncertainty as to whether the traditional meaning of beneficial ownership will continue to apply in future cases.
Also of concern is the way in which the case reinforces the emphasis since State Street on the duty of trustees to act as a “watchdog” for unrepresented classes of creditors who are beneficiaries of the trust. Pleas by a trustee that it should be able to maintain “complete neutrality” (as the trustee asked to do in State Street) are currently finding no favour from the courts.
This duty has potentially wide reaching implications for trustees. When seeking directions from the court, trustees could be expected to survey all the varied interests of the many creditors on whose behalf a trustee may take enforcement or other action, and represent the interests of any who choose not to represent themselves. It is not hard to see how difficult this could be in a structure involving multiple tranches of notes, multiple loans, hedging arrangements of various types, and numerous servicers and other administrative parties, all of whom could be creditors in an enforcement scenario. This is particularly onerous for trustees given that in capital markets transactions many of these parties will not wish to be represented, and it is often not even possible to identify all of the beneficiaries.
Worse still is the risk that a disgruntled creditor could pursue action against the trustee for failing to represent its interests when seeking directions. Whether such claims would succeed is another matter, but trustees will need to be increasingly alive to the possibility, and take proactive steps to protect themselves when pursuing directions applications. Further developments in this area may well follow, as trustees focus on whether standard form indemnities protect them sufficiently from such claims, and seek at the case management stages of future cases to define and limit as far as possible their “watchdog” role.