Key Points

  • If a suite of finance documents does not specify whether realisations should be treated as principal or interest a Court will make the decision for the parties; and
  • The receipts should be characterised as principal or interest depending on their source, and the role which they play in the context of the Loan and its security, viewed as a matter of commercial common sense.

Facts

There was a securitisation of some real estate loans. Different categories of noteholder were ranked as senior or junior in terms of the payment waterfall. When there were defaults in some of the portfolio loans and receivers realised assets the servicer had to make a payment based upon the following provision:

“The Master Servicer will on or before each Calculation Date identify funds paid under the Credit Agreement and any Related Security, as principal, interest and other amounts on the relevant ledger in accordance with the respective interests of the Issuer and the Seller (if any) in the Loan.”

Broadly speaking whether a receipt was to be categorised as principal or interest was a live issue because junior noteholders were more likely to receive something if the relevant realisation was allocated against interest rather than principal.

The servicer received sums from the receivers appointed to enforce recovery of the underlying loan that included rents paid by tenants, surrender premiums paid by tenants who wanted to terminate the lease and sale proceeds. The Court was asked to decide what should be regarded as interest and what principal.

Decision

The Court decided that the receipts should be characterised as principal or interest depending on their source, and the role which they play in the context of the loans and its security, viewed as a matter of commercial common sense. They did not think the tax cases on whether something was capital or income were of much assistance to them in answering this question which was one of applying the normal rules of contractual construction. It was obvious that rent was equated with revenue which in the context of this financing structure meant interest. After applying the rules of construction the Court considered that surrender premiums and sale proceeds were to be classified as principal as this made the most commercial sense of the documentation when tested against the structure of the financing as a whole.

Comment

The junior noteholders had argued that the common law rules of appropriation of payments should be applied to this structured financing in arriving at a proper construction of the waterfall provisions. The common law rule is concisely stated in Chitty on Contracts 31st edition, Vol. 1, para 21-068:

“Where there is no appropriation by either debtor or creditor in the case of a debt bearing interest, the law will (unless a contrary intention appears) apply the payment to discharge any interest due before applying it to the earliest items of principal.”

Here the judge pointed out that the correct result depended on the construction of the complex suite of documents agreed by the parties and in this context the common law rules of appropriation of payments were irrelevant.

Although most simple loan financings will not need to go any further than the current Loan Market Association drafting when it comes to waterfall payments if you are engaged in something more bespoke involving several layers of debt spelling out how different types of realisations are to be treated is the safest course.

CBRE Loan Servicing Limited v Gemini (Eclipse 2006-3) PLC