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 would pay down to meet Notes falling lower down the waterfall of payments (this was the interpretation on which Napier, a Junior Noteholder, was basing its appeal before the Court of Appeal)

The Court of Appeal adopted an iterative approach to interpretation. It decided that the wording in para 4(i) in the context of the commercial transaction meant that the ratings of the Class A1 Notes was not considered to be downgraded at the time the test arose for deciding how UPP should be applied. This was despite the fact that they had been downgraded in the past to AA from AAA, but had been reinstated to the initial rating of AAA. Therefore, the UPP would be reinvested rather than used to repay the Senior Notes.

What documents in the CLO deal did the Court of Appeal review?

The CLO structure involved Harbourmaster Pro-Rata CLO 2 BV, as issuer acquiring loan obligations to issue 14 classes of Notes from Senior, Mezzanine and Junior Notes due 2022. The Class A1 Senior Notes had an initial rating of AAA from Standard & Poors (S&P) at closing on 23 August 2006.

The main documents examined by the court were:

  • the trust deed which included the Notes
  • the collateral management agreement, and
  • the collateral administration agreement

What happened in this case?

The appeal was brought by one of the Junior Noteholders, Napier, which claimed that the High Court had misinterpreted a provision in the collateral management agreement which meant that UPP had been directed to repay Senior Class A1 Notes rather than being reinvested.

During the CLO deal from 23 August 2006 to 15 October 2015 (the reinvestment period), the collateral manager had to use UPP to acquire more loan obligations for the issuer according to certain conditions and according to specific criteria. One of the conditions was that the 'ratings of the Class A1 Notes have not been downgraded below their initial ratings'.

The Class A1 Notes were downgraded by S&P on 5 February 2010 to AA. However, on 30 November 2012, S&P reinstated its AAA rating for those Notes. The collateral manager, having received over £7m in UPP, considered that as there had been a downgrade the condition could not be met. Therefore, UPP had to be directed to redeem Senior Notes.

Napier disputed this interpretation which the High Court confirmed. However, the Court of Appeal looked at the method of interpretation used by the High Court to reach the contrary position.

What method of interpretation of contracts did the court employ in this structured transaction?

LJ Lewison quoted authority to support his conclusion that the court should use an iterative interpretation by looking at the commercial context and commercial consequences to assist interpretation.

He disagreed with the Chancellor of the High Court and thought that the wording in para 4(i) could be open to different interpretations, and was not unambiguous.

The court, he said, should test any interpretation against the commercial consequences. He went on to say that he did not agree with counsel for the trustee that commercial considerations had no part to play in deciding whether a particular interpretation is or is not ambiguous.

While the High Court had looked at the grammatical structure of this condition and similar conditions in other parts of the documents which used the phrase ‘has occurred and is continuing’, the Court of Appeal thought that even though a present perfect tense had been used, it did not mean it would only relate to a historic event (eg the downgrade). It could relate to a test at a particular time and a description of whether the Notes had been downgraded but looking at it at a point in time—ie immediately before the collateral manager made the decision whether to reinvest or redeem.

What were the consequences in this CLO transaction?

Within the terms of the CLO documentation and the commercial context the Court of Appeal concluded that when the decision was to be made by the collateral manager, the Notes had been reinstated to AAA credit rating by S&P. Therefore, the condition at that point had not been breached so there was an obligation on the collateral manager to reinvest the UPP.

The downgrade had had no contractual effect on the deal during the reinvestment period. All the scheduled payments were used to pay down the Notes according to the waterfall. There was no guarantee of any UPP coming into the structure which was all due to the borrowers to the underlying loan obligations deciding to repay early. The borrowers were not party to the CLO documentation.

The collateral manager did not have a discretion on reinvestment and the Senior Noteholders did not have a right to redemption of the Notes. If the conditions were met, an obligation arose for the collateral manager to reinvest the UPP.

Is a downgrade a trigger?

As in this case, where there has been a ratings downgrade which is subsequently reinstated, the interpretation of any conditions or triggers linked to a downgrade may lead to different commercial consequences so drafting has to be as clear as possible.

By following the iterative and commercial approach of the Court of Appeal in this case, the wording meant that a downgrade which is not still in existence at the date a relevant test or when a decision has to be made, should be made on the basis of the rating at that time. Quite rightly, the Court of Appeal highlighted the meaning of a AAA rating—to be paid in full and on time—which is a forward looking analysis taking into account projections relating to the underlying loan obligations. Using a previous historic downgrade as a trigger which had been resolved by the time of the test did not fall within the commercial context of the CLO transaction.

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

Filed Under: Case analysis

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