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Class X warfare: contractual interpretation of securitisation documents


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In a recent video blog we considered how the contractual interpretation principles established in Arnold v Britton may be applied to structured finance disputes.  We noted the significant challenges in trying to apply the Supreme Court's principles to such cases.  This is particularly acute where the transaction documents predate the global financial crisis, and as such are now exposed to completely unforeseen and extreme market conditions.  The two decisions in Hayfin v Windermere and Credit Suisse v Titan provide a valuable indication of how the courts are handling such situations.

The facts in Hayfin v Windermere VII

This first case concerns certain Class X Notes issued as part of a CMBS structure known as Windermere VII, arranged by Lehman Brothers in May 2006.  Hayfin, the claimant in these proceedings, is a Class X Noteholder, and raised arguments in relation to the way in which interest payments were to be calculated.

The payments are based on “excess spread”; essentially, the difference between the interest that Windermere could expect to earn from the underlying loans and the interest payable on other classes of notes.  Interest on the loan was to be paid at a fixed rate and a margin.  However, the non-Class X notes were subject to EURIBOR fluctuations, and so Windermere entered into an interest rate swap between the fixed and EURIBOR rates (plus margin).  An intercreditor agreement was also signed to regulate cash flows between Windermere and the junior lenders.  This provided a formula to allocate the margin element and a proportionate share of the EURIBOR element between Windermere and the junior lenders.  

What went wrong?

Several subsequent events contributed to the dispute that has now arisen.  Firstly, the borrower triggered an event of default by failing to repay the principal advanced under the loan at maturity in October 2012.  The following week, the swap expired without being renewed.  Finally, EURIBOR rates dropped significantly, taking them below the loan fixed rate.  These events created a situation whereby Windermere became entitled to a significantly higher rate of fixed interest than anticipated. 

Hayfin argued that once the swap expired, references in the interest calculations to EURIBOR produced a “mismatch” between the fixed rate interest payable by the borrower, and the division of such monies between Windermere and the junior lenders by reference to a floating rate.  This led to a “build-up of surplus interest” within the loan structure, which ultimately resulted in a significant underpayment of interest and a consequential reduction to the excess spread available to Hayfin.

Hayfin argued that in order to redress this mismatch, the court should “correct” the reference to EURIBOR in the definitions of both Senior and Junior Rate in the intercreditor agreement so that it read as:

EURIBOR or (where no Hedging Arrangement remains in place) the Fixed Rate or (following an Event of Default where no Hedging Arrangement remains in place), the higher of EURIBOR and the Fixed Rate” (emphasis added).

The court’s decision on the references to EURIBOR

Mr Justice Snowden dismissed Hayfin’s argument, finding that the documentation ought to be interpreted as drafted.  In doing so, he observed that “there is a premium to be placed upon the language actually used in the instrument”.  Referring to Arnold v Britton he confirmed that the test for correcting a contract by construction or the implication of a term was strict: 

“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.  Even then, the court must be certain both that the absence of the missing words was inadvertent, and that if the omission had been drawn to the attention of the parties at the time of contracting they would have agreed the additional provision should be made.”

In coming to this decision, Mr Justice Snowdon paid particular heed to the fact that the definitions of Senior and Junior Rate were not merely boilerplate, but carefully negotiated and drafted, and central to the commercial deal being struck between the parties. He also held that it was foreseeable at the time of execution that the borrower might fail to replay the Nordostpark Loan, and that the swap agreement would then expire.  Accordingly, the court could not be confident that the absence of additional wording was the result of oversight or mistake.

Construction of “Expected Available Interest Collections”

Hayfin also made a number of other arguments regarding the construction of interest provisions, including that default interest due on the Nordostpark Loan should be accounted for when calculating the Class X Interest Rate.  Specifically, Hayfin argued that the concept of “Expected Available Interest Collections” in the note conditions, which assumed that interest payments on the underlying loans had been paid in full, should also apply to default interest, thereby increasing the excess spread.

The court disagreed with Hayfin’s arguments, finding that it was necessary to consider whether such amounts would actually become available to Windermere under the loan documentation.  Upon careful examination of the documentation, it was held that the clear intention and effect of the waterfall provisions was to subordinate the payment of default interest to the payment of principal and interest to Windermere.  Class X interest therefore did not include default interest, as even if this had been paid in full it would not have become available to Windermere until the waterfall was paid out in full, and would not have counted as part of the Expected Available Interest Collections.

Credit Suisse v Titan: an interesting comparison

The facts in Credit Suisse v Titan are broadly similar to those in Hayfin v Windermere VII.  They concern four consolidated claims in respect of Class X Notes held by Credit Suisse in the Titan series of CMBS transactions, originally documented in 2006 and 2007.  The Titan claims, however, are more limited than the Windermere claims, and the most significant issue related to whether it was necessary to take account of any default interest due on the underlying loans in order to determine the Class X interest rate. 

Interpretation of the disputed wording

Credit Suisse argued that the wording “the related per annum interest rate due on such Loan” in the note conditions should be interpreted so as to include a default rate of interest payable in circumstances where the underlying loan was in default.  This would have resulted in a greater excess spread, entitling Credit Suisse to greater payments on the Class X notes.  

As with Hayfin v Windermere, the court dismissed Credit Suisse’s arguments and held that no account should be taken of default interest.  In reaching this decision, the Chancellor acknowledged that two possible interpretations arose out of the drafting.  Accordingly, his judgment was based on “which interpretation [was] most likely to carry the commercial outcome intended by the parties”, and was particularly swayed by the following factors:

  1. It was “counter-intuitive” to create a scenario whereby the “worse the Loans perform the higher proportion of the Loan is payable to the Class X Noteholder”;
  2. The Offering Circular contained no indication that the Class X Notes would factor in default interest if it became payable;
  3. There was no direct evidence that the parties envisaged that there would ever be such defaults under the loans as would generate an excess over the specified margin between the basic annual interest rates payable on the loans and the rates payable on the notes;
  4. The calculation of the per annum Class X interest rate at any particular payment date would be overly complex if the default rate under the loan had to be taken into account, which was not likely to have been intended; and
  5. If Credit Suisse was correct in arguing that the Class X interest rate included an additional rate payable under the loans following default, then “it would be an extraordinary commercial intention for the Originator to take the benefit of additional payments referable to defaults under the Loans (resulting in the Class X Noteholder receiving a greater proportion of the Loan receipts relative to the Class A-H Noteholders) without bearing any of the cost of securing the making good of such defaults”.

Comparing the two judgments: the same but different?

Although the outcome was similar in both cases (namely that default interest on the underlying loans should not increase the excess spread) there are differences in the court’s approach. The outcome in Windermere was based upon a detailed analysis of the mechanics and wording of the actual documentation, whereas in Titan the focus was on the parties’ commercial intentions, and the commercially unlikely implications of Credit Suisse’s arguments.

Looking at the cases together, it appears that whilst the courts are adopting a strict approach to construction, they will acknowledge and support a more commercial interpretation where the documentation is genuinely ambiguous.  This should sound some caution for prospective claimants hoping to advance arguments that lack the weight of commercial common sense, unless those arguments are supported by compelling and explicit drafting.

Hayfin has been granted permission to appeal to the Court of Appeal, and the market will indoubtedly follow that appeal with interest.

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