How have the courts interpreted a downgrade of AAA Notes and a subsequent upgrade as a trigger in a CLO deal?

How have the courts interpreted a downgrade of AAA Notes and a subsequent upgrade as a trigger in a CLO deal?

What does the recent case of Napier Park European Credit Opportunities Fund Ltd v Harbourmaster Pro-Rata CLO 2 BV [2014] EWCA Civ 984 tell us about the court’s approach to interpretation of contracts in collateralised loan obligation (CLO) structures?

Original news

The Court of Appeal adopted the iterative approach to interpretation of contracts in a CLO structure. The court looked not just at the textual analysis and comparison but also placed rival interpretations within their commercial setting and evaluated their commercial consequences.

What was the crux of the case?

The crux of the case lay in the interpretation of wording in the collateral management agreement in the CLO structure—in particular para 4(i) of the definition of 'Reinvestment Criteria'. This included a condition that if ‘the ratings of the Class A1 Notes have not been downgraded below their Initial Ratings’ certain sums repaid early by borrowers under the underlying loan obligations would be used to redeem Senior Notes rather than be used for reinvestment by acquiring more loan obligations. Senior Notes in the CLO structure had initially been rated as AAA but had been downgraded to AA for over two years and nine months after which time they were upgraded back to AAA rating.

There were two possible interpretations:

  • the Notes would be considered to have been downgraded, any payments received into the structure as unscheduled principal proceeds (UPP) had to be used to redeem the Notes, by paying Senior Notes according to the payment waterfall (this approach was favoured by the High Court Napier Park European Credit Opportunities Fund Ltd v Harbourmaster Pro-Rate CLO 2 BV [2014] EWHC 1083 (Ch), [2014] All ER (D) 96 (Jun))
  • the Notes were not considered as downgraded, then the UPP had to be used for reinvestment by the collateral manager according to specific criteria—this route favoured Junior Noteholders as reinvestment would mean the issuer would acquire more loan obligations fitting specified criteria which

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