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.