Supreme Court confirms approach to construction of bond documents

It has been a long journey, albeit an expedited one, for Lloyds Banking Group (the “Bank”) to confirm its right to redeem certain contingent convertible notes (“ECNs”) issued in 2009 as part of a capital raising programme following the financial crisis of 2008.The Supreme Court, in a judgment handed down on 16 June 2016 has, by a majority of 3 to 2, ruled that the Bank was indeed entitled to redeem.

The case has generated significant public and media interest, particularly in view of the fact that a number of ECNs were held by retail investors. This in turn raised interesting questions as to what materials such holders could reasonably have been expected to have in mind and whether such materials could legitimately form part of the factual matrix when construing the relevant clause entitling the Bank to redeem the notes.

Upon issuance, the ECNs were structured as hybrid or contingent capital ('co-co') securities. This meant that, while they were issued as subordinated bonds, if the Bank was unable to meet certain capital adequacy thresholds, they would convert into ordinary shares – the highest grade of loss absorbing capital (or “Core Tier 1 Capital” as it was at the time). In particular, the ECNs were designed to help the Bank pass “stress tests” modelled by the Financial Services Authority which, at the relevant time (which is to say in the infancy of the stress testing regime), required the Bank to maintain a ratio of at least 4% of risk weighted assets to Core Tier 1 Capital.

In order to satisfy the FSA, the conversion trigger point for the ECNs was set at 5% of risk weighted assets to Core Tier 1 Capital, to allow for a degree of 'headroom', by providing for conversion before the then minimum regulatory requirement would be reached.

In 2013, following new EU regulatory legislation, the capital adequacy regime was overhauled by the new regulator, the Prudential Regulation Authority (“PRA”). In particular, the concept of Core Tier 1 Capital was replaced with that of the more restrictive Common Equity Tier 1 Capital (“CET1”). The practical effect of this change was that the conversion of the ECNs could only now trigger if the Bank’s CET1 ratio fell far below the adjusted minimum ratio required by the regulator.

As a result of these regulatory changes, the Bank argued that it was entitled to redeem the ECNs as they had “ceased to be taken into account…for the purposes of any “stress test” applied by the PRA in respect of the Consolidated Core Tier 1 Ratio”. The principal argument put forward at trial and subsequently by BNY Mellon Corporate Trustee Services Ltd, who was representing the note holders as the note trustee (the “Trustee”), was that, for the purposes of construing the wording “ceased to be taken into account”, it was not enough that the ECNs did not in practice help the Bank to pass the stress test hurdle; nor, indeed, to show also that it was now unlikely that they ever would. Rather, the ECNs must in some way be “disallowed in principle” – i.e. the subject of some sort of formal determination by the regulator that they would never be taken into account for the purposes of a stress test, regardless of the inter-relationship between their conversion trigger and the minimum regulatory capital ratio requirement.

In determining this issue, their Lordships considered to what extent, when construing the Trust Deed (which housed the clause entitling the Bank to redeem), it was right to take into account statements in the Exchange Offer Memorandum (the circular for the ECNs), the letter from the chairman of LBG which accompanied the Exchange Offer Memorandum and the details of the statements and other documents issued by the FSA in 2008 and 2009. These documents demonstrated the importance, from a regulatory perspective, of maintaining regulatory capital at a level above the minimum requirement.

The Bank had announced its intention to redeem the notes on 16 December 2014. The Trustee brought proceedings challenging this claim. After an expedited trial, Etherton C gave judgment on 3 June 2015 in favour of the Trustee. An appeal was then also expedited, resulting in judgment in favour of the Bank by the Court of Appeal on 10 December 2015. The Supreme Court then granted permission to appeal and heard the case, again on an expedited basis, in March 2016. Thus, the entire judicial process, including all levels of appeal, was completed in a year and a half.

Lord Neuberger, the President of the Supreme Court, gave the leading judgment and highlighted that the weight given to statements made in other documents available at the time of the contract in question must be “highly dependent on the facts of the particular case”. However, in cases of contracts documenting the terms on which a negotiable instrument are held, he stressed that “very considerable circumspection is appropriate before the contents of such other documents are taken into account”.

The starting point, therefore, for construing such debt instruments is the often cited approach adopted by the House of Lords in In re Sigma Finance Corp (in administrative receivership) [2009] UKSC 2. In that case, Lord Collins observed that, where a trust deed concerned securities issued to “a variety of creditors, who hold different instruments, issued at different times and in different circumstances”, the background or matrix of fact could only be of very restricted relevance in exercises of contractual construction.

In departing from this general principle, however, Lord Neuberger later remarked that, in the Bank’s case, the Trust Deed and the relevant redemption provisions could not reasonably or properly be understood unless “one has some appreciation of the regulatory policy of the FSA at and before the time the ECNs were issued”. This chimes with Lady Justice Gloster’s judgment in the Court of Appeal that the 'reasonable addressee' of the Exchange Offer Memorandum had to be taken as “someone having an informed understanding, whether on his own or with the assistance of a financial adviser, of the working of the relevant markets, the regulatory background, the use of stress tests in the regulator’s testing of the adequacy of a bank’s capital resources and the function which the ECNs were intended to fulfil”.

Having therefore decided to admit the regulator’s statements to the relevant factual matrix (along with the other documents referred to above), the next question for the Court was whether the ECNs, in order to be “taken into account”, had to play some part in enabling the Bank to pass the stress test as opposed to merely being theoretically taken into account for some purpose in the stress test. In agreeing with the Court of Appeal's approach, Lord Neuberger said that the vital consideration was that, under the new capital adequacy regime, the ECNs could not fulfil the job for which they were designed, i.e. to convert to shares before the relevant ratio was reached. He also remarked that the wording of the clause itself suggested that the words “taken into account” more naturally connoted a dependence upon practical developments than requiring a disallowance in principle before it could cease to apply.

Lords Sumption and Clarke disagreed with the majority in both their reasoning and conclusions largely on the basis that: (i) the ECNs could still serve their function of boosting the Bank’s top tier capital by being converted to equity notwithstanding the change to the minimum relevant requirement; (ii) the concept of a stress test was broader than a simple pass/fail process and the way in which the ECNs might affect a stress test was uncertain; (iii) the most natural reading of the redemption trigger under consideration was that it required the express regulatory disqualification of the ECNs before it could be engaged; and (iv) the ECNs were long dated securities, which cannot have been intended to be redeemed early except in some extreme event.

The Supreme Court were faced with two rival interpretations, both of which were consistent with the wording of the clause. In that sense, it was not a contest between a literal interpretation and a non-literal purposive interpretation and the Supreme Court did not try to add further fuel to the debate as to when purposive interpretation is permissible. In fact, Lord Neuberger commented that the Supreme Court had perhaps given too much guidance on contractual interpretation in recent years and his approach is notably free from extensive citation of previous authority. Nevertheless, the decision is an example of a commercial interpretation, taking into account the intention behind the document.

The guidance on taking account of extraneous materials will be helpful in future cases, especially in the case of financial instruments. The Court stressed the importance of starting within the four corners of the document. But when the construction of a clause requires consideration of contemporaneous but extraneous materials in order to be readily understood, these may be admitted for the purposes of the factual matrix. While parties should always aim to include important information in the agreement itself, this shows a commercial awareness by the Supreme Court that was critical in allowing them to determine which interpretation was correct.

There has also been some helpful clarification with regard to what retail investors could have reasonably expected to have understood and financial institutions will be relieved that the wording contained in circulars stipulating that any decision to invest should only be taken after informed and detailed consideration of the risks surrounding the investment (with the assistance of financial advisors) will be taken at face value by the Courts.

Finally, the narrow majority in favour of the Bank (and indeed the difference of opinion between the court at first instance and the Court of Appeal) shows that these types of contractual construction disputes are not without complexity and consequently capable of dividing opinion at the highest judicial level.