Early redemption of convertible securities

Early redemption of convertible securities

How did the court approach the question of whether a capital disqualification event had occurred so as to allow the early redemption of convertible securities? Laura Davis, associate at DAC Beachcroft, says the court’s focus in BNY Mellon v LBG Capital was on bringing commercial sense to the contract.

Original news

BNY Mellon Corporate Ltd v LBG Capital No. 1 plc and another [2015] EWCA Civ 1257, [2015] All ER (D) 112 (Dec)

The Court of Appeal, Civil Division, in allowing the defendant issuers’ appeal, granted a declaration that a ‘Capital Disqualification Event’ (CDE) had occurred, thereby entitling the issuers to redeem enhanced capital notes in accordance with their terms.

Briefly, what was the background to the appeal?

This case relates to £3.3bn of enhanced capital notes (ECNs) issued by Lloyds Bank subsidiaries (LBG) in 2009. The ECNs were designed to increase Lloyds’ core tier 1 capital (CT1 Capital) after the Financial Services Authority (FSA) found that it had a shortfall.

The ECNs would convert to CT1 Capital only if the bank’s capital position deteriorated below requisite levels. They had maturity dates from 2019–2032 and a very high interest rate. The trust deed constituting them allowed for early redemption on a CDE. The definition of a CDE (the CDE definition) included a situation where the ECNs ceased to be ‘taken into account’ for the purposes of a stress test.

In carrying out a stress test in December 2014 (the December stress test), the Prudential Regulation Authority did not take the ECNs into account. LBG announced that a CDE had occurred and it intended to redeem them. BNY Mellon, the trustee of the ECNs, issued proceedings to prevent an early redemption.

In June 2015 the High Court found that no CDE had occurred. LBG appealed.

What were the legal issues that the judge had to decide in this appeal?

The primary legal issues on appeal were:

  • whether the December stress test was a relevant stress test for the purposes of the CDE definition (the preliminary issue)
  • whether the first instance judge was correct to conclude that a CDE would only occur where there was a ‘disallowance in principle’ of the use of ECNs in connection with stress testing (the main construction issue)

Why did these issues arise?

The preliminary issue arose because the December stress test was in respect of Common Equity Tier 1 Capital, whereas the CDE definition referred to stress tests in respect of Consolidated CT1 Capital only. By the time of the December stress test, due to regulatory changes, CT1 Capital was a historical concept. A literal reading would mean that, for all practical purposes, the CDE definition would never be met. The court therefore considered whether the wording of the definition constituted an obvious mistake which it was appropriate to correct by interpretation.

As to the main construction issue, at first instance it had been common ground that the ECNs were not taken into account in the December stress test because LBG’s capital position was strong enough for it to pass the test without them. The High Court held that the CDE definition was not aimed at that situation. Rather, it envisaged circumstances where ECNs were no longer taken into account in stress testing in general. LBG appealed this decision, making the arguments below.

What were the main legal arguments put forward?

On the preliminary issue, LBG argued that there had been an obvious mistake in the drafting of the CDE definition, which should be corrected to avoid an interpretation that did not make commercial sense. BNY Mellon submitted that the mistake would not have been obvious to individual holders of the ECNs (many of whom were retail investors), so the court should not correct it.

BNY Mellon’s position on the main construction issue was that, as held at first instance, a CDE could only occur where the use of ECNs in the stress test was disallowed in principle. LBG argued that there would be a CDE where, because of changes to regulatory capital requirements, the ECNs no longer assisted LBG to remain above minimum ratio requirements, even if there had been no ‘disallowance in principle’. Since the ECNs were first issued, their conversion trigger point had fallen below the regulatory minimum ratio. This meant that they could not assist LBG in meeting capital requirements, were not taken into account in the December stress test and would not be taken into account in future stress tests.

What did the judge decide, and why?

The judge held that the reference to CT1 Capital in the CDE definition was an obvious mistake which could be corrected as a matter of interpretation, as discussed further in the next question.

LBG’s appeal was allowed as regards the main construction issue. The judge held that the ECNs would cease to be ‘taken into account’ for the purpose of the CDE definition if they were no longer capable of contributing to LBG’s ability to meet the stress test’s requirements. Changes in the regulatory regime meant this was the case. A CDE had occurred and the ECNs could be redeemed.

How did the court approach the construction of contractual mistakes?

In finding that it was appropriate to correct the mistake, the court relied on (i) the obvious nature of the mistake, and (ii) the fact that the reasonable addressee of the notes would have known what the parties intended:

  • (i) It was clear that ‘something has gone wrong’ with the CDE definition. A literal construction would mean that a CDE could never occur after the concept of CT1 Capital stopped being used in stress testing. When the ECNs were issued, it was expected that there would be an amendment to the definition of CT1 Capital in the near future. It would make no commercial sense if the ECNs were capable of redemption only during the limited window before the definition was amended.
  • (ii) The fact that many of the ECN investors were retail investors was irrelevant to assessing what the ‘reasonable addressee’ would have understood. The ECNs were highly complex instruments, and their offer memorandum made it clear that the decision to invest should only be taken after informed and detailed consideration. The reasonable addressee must therefore be taken to be someone with an informed understanding of the working of financial markets, the regulatory background and the use of stress tests. That person would recognise the mistake.

To what extent is the judgment helpful in clarifying the law in this area?

There was no dispute regarding the legal principles to be applied to the construction of the CDE definition. The judge referred to Lord Hoffman’s statement in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, [2009] 4 All ER 677:

‘All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant.’

This decision is an important demonstration of the difficulties that can arise in interpreting complex financial documentation, even where legal principles are undisputed.

What practical lessons can those advising take away from the case?

The detail of this case relates to a very specific type of financial instrument, and there are limited practical lessons of general application to be taken away. However, the court’s approach to the issue of contractual interpretation is of interest as it demonstrated very clearly that it was less interested in the strict technicalities of drafting and more interested in a purposive approach bringing commercial sense to the contract.

The court’s finding in respect of the reasonable addressee’s understanding of the ECNs is also of practical interest. The court was unsympathetic to retail investors arguing that they would not have understood an obvious error in the drafting of documents in circumstances where clear warnings had been given, pre-investment, regarding the complexity of the transaction and the need for a detailed risk assessment to be carried out.

Interviewed by Anne Bruce.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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About the author:

Emma is head of the Banking and Finance team and the Finance Group at LexisNexis®UK.

Emma has wide-ranging experience in derivatives and capital markets with a particular emphasis on credit derivatives and structured products. Emma qualified as a solicitor with Allen & Overy LLP, working in the derivatives and structured finance teams in both their London and Paris offices before gaining experience with Deutsche Bank AG (advising the foreign exchange prime brokerage desk) and Crédit Agricole CIB (advising the fixed income and derivatives desk) before joining LexisNexis®.