FML Timeline: Napier Park European Credit Opportunities Fund v Harbourmaster Pro-Rata CLO 2 B.V.

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This case involved a collateralised loan obligation (CLO) structure where an issuer had issued 14 classes of notes which were divided into the following categories:

1. two sets of senior notes
2. seven sets of mezzanine notes, and
3. five sets of subordinated junior notes.

The monies raised by the issuance of the notes were used to purchase a portfolio of loans and participations in loans. Each of the classes of notes had different rates of interest and priorities for redemption under the waterfall provisions of the CLO structure.

A dispute arose between senior and junior noteholders relating to whether certain Unscheduled Principal Proceeds (UPP) (arising where an underlying borrower repays a collateral obligation early) were available to be reinvested or whether they should be paid out to the noteholders.

The contractual documentation indicated that UPP were only available for reinvestment if they met certain criteria. This included: “the ratings of the class A1 Notes have not been downgraded below their Initial Ratings”.

In this case, the notes in question were downgraded by a ratings agency before being upgraded again, back to their initial rating. As a consequence of downgrade (and despite the subsequent upgrade), the collateral administrator decided that the criteria were not met and the UPP was applied towards the redemption of the notes rather than being reinvested.

Under the terms of the waterfall, it was in the junior noteholders’ interests for the UPP to be reinvested whilst it was in the senior noteholders’ interests for the UPP to be redeemed.

At first instance, the High Court decided in favour of the senior noteholders and held that the language was unambiguous and that the UPP were not available for reinvestment. One of the junior noteholders appealed this decision.

Decision

The Court of Appeal reversed the High Court’s decision, with Lord Justice Lewison giving the leading judgment.
The Court noted that approach to the interpretation of a tradeable financial instrument of this kind was previously considered by the Supreme Court in Re Sigma Finance Corp [2009] UKSC 2.

In Re Sigma, Lord Mance stated that (echoing Lord Neuberger’s dissenting judgment in the Court of Appeal on the same case): “the resolution of an issue of interpretation in a case like the present is an iterative process, involving “checking each of the rival meanings against other provisions of the document and investigating its commercial consequences”.”

In the present case, the Court of Appeal determined that the iterative approach to contractual interpretation extended to placing the competing interpretations within their commercial setting and investigating the commercial consequences. The court clarified that this did not mean that the commercial setting should be derived from considerations outside of the four corners of the contract.

Turning to the specifics of the contractual interpretation in question, Lewison LJ held that the language of the disputed phrase was not unambiguous (as the High Court had thought). On this basis, Lewison LJ went through the iterative process and considered the disputed language in light of the overall structure of the transaction.
Looking at the overall structure of the transaction, including a number of other provisions, such as:

1. when dealing with an “Effective Date Rating Event”, the parties did not treat a downgrade of the initial ratings as an irreversible event with continuing consequences
2. that a downgrade had no contractual effect during the “Reinvestment Period”
3. if at the date when the UPP arises, the rating agencies are sure that the senior noteholders will be paid in full and on time (signified by a AAA rating), why should reinvestment of the UPP be absolutely prohibited because of an event that may have taken place years ago and, as set out in (1), in circumstances where the parties had agreed that the slate should be wiped clean, and
4. the obligation in the contractual documentation to reinvest UPP did not support the notion that a sea-change takes place at the end of the “Reinvestment Period” (see (2), above).

The court allowed the appeal.

Noteworthy/ Novel points

This case illustrates the necessity of careful drafting to ensure contractual certainty when entering into complex financial transactions.

In addition, the decision of the Court of Appeal shows that, whilst the Court is prepared to examine commercial issues when interpreting contracts, it does so within the four corners of the contract.