Court of Appeal gives guidance on construction of notes and offering circular in context of a commercial mortgage-backed securitisation
A tranche of notes issued as part of a commercial mortgage-backed securitisation (the ‘Class X Notes’–) were entitled to interest calculated on the basis of the difference between amounts received by the securitisation vehicle and amounts owing to other noteholders – effectively, a measure of the profit or the excess spread retained in the structure.
A dispute arose as to the correct calculation of the interest following a default in the underlying structure that led to the payment of additional default interest. The Class X noteholders claimed that the correct construction of the terms and conditions of the Class X Notes was to include this entitlement; other noteholders argued that it should not.
The Court of Appeal held, Briggs LJ dissenting, that the Class X interest calculation did not include default interest. The majority held that use of the phrase ‘per annum’ meant that the natural construction excluded default interest. Briggs LJ put less weight on this phrase and came to the opposite view.
All members of the Court of Appeal agreed on the correct approach to construction. First, it was necessary to determine the meaning of the words in their context. The importance of respecting the bargain made by the parties even when it was imprudent was stressed both in the leading judgment of- Arden LJ and the dissent of Briggs LJ.
The Offering Circular was not merely part of the surrounding circumstances: the Class X Notes were issued on the basis of it, it would have been available to subsequent noteholders and the issuer expressly accepted responsibility for the information in it. Although the Offering Circular states that the information in it is qualified by the transaction documents, and so cannot prevail in the case of a conflict, it is nevertheless ‘an aid to construction’ (per Arden LJ).
Both Arden LJ and Briggs LJ started by considering the natural meaning of the words in context and then cross-referenced this against the commercial common sense of the provision. Although they came to opposite views on the meaning, they both decided that commercial common sense did not require any change of view. Both interpretations had commercial flaws: excluding default interest meant that some funds might flow through the waterfall and end up being paid out to charity; including default interest meant that the Class X noteholders arguably received a windfall at the expense of more junior noteholders. But these flaws were not serious enough to displace the natural construction. Briggs LJ, in particular, stressed the difficulty of displacing construction by appeal to commercial common sense:
"The detection of ambiguity does not entitle the Court to resolve it simply by reference to a balance of commercial considerations. Sometimes the words used, even if admitting some ambiguity, still point firmly towards a different answer to that which is to be derived from a balancing of commercial considerations" (para. 82).
Construction is fraught with difficulty: even though all members of the Court of Appeal agreed on the general approach, they disagreed on the plain meaning of a single phrase. As Briggs LJ put it:
"English law assumes that every question of construction has a right and a wrong answer. In reality there can often be as much scope for reasonable differences of view as there is in many questions about the exercise of a discretion" (para. 59).
Nevertheless, it is clear that commercial common sense will rarely be able to impose a particular construction. The Court of Appeal has followed the new orthodoxy of Arnold v Britton  UKSC 36 – even perhaps expanding it in making clear that a little ambiguity will still not allow recourse to commercial common sense.
The rule against penalties featured at first instance in similar cases dealing with Class X interest – as the interest on the Class X Notes is out of all proportion to the nominal principal, to the extent it is payable on default, it is arguably a penalty. It is unfortunate that this issue did not arise for consideration before the Court of Appeal.
Finally, the comments as to Offering Circulars may be relevant for future questions of construction in the capital markets. The Offering Circular has a special status, it is not just another background document. Although it cannot displace a transaction document, it may be used as an aid to construction.