In BNY Mellon Corporate Trustee Services Limited v LBG Capital No 1 Plc & Anor  UKSC 29 the Supreme Court has given further guidance on how far background materials should be taken into account when interpreting a contract or trust deed which governs the terms on which a negotiable instrument is held.
The litigation concerned contingent convertible notes issued in late 2009 to increase the core tier 1 ("CT1") capital of Lloyds Banking Group ("LBG"), as part of a series of steps taken after the FSA identified a capital shortfall during a stress test undertaken in March 2009.
The trust deed provided that notes would convert into ordinary shares if LBG's consolidated CT1 capital ratio fell below 5% of its risk-weighted assets, which was 1% higher than the 4% ratio required by the FSA when the notes were issued, and which allowed them to be counted as CT1 capital for stress testing purposes.
As Lord Neuberger explains in the leading judgment, the issue before the Supreme Court was whether those notes, which entitled holders to interest at a rate of more than 10%, could be redeemed by LBG.
The notes could be redeemed early by LBG on the occurrence of a "Capital Disqualification Event" ("CDE") which, as Clause 19.2 provided, included circumstances where the notes had:
"ceased to be taken into account ... for the purposes of any `stress test' applied by the FSA in respect of the Consolidated Core Tier 1 Ratio".
The definition of "Core Tier 1 Capital" applied the definition used by the FSA in effect as at May 2009 but it did not seem, at least on a literal reading, to accommodate any changes to the regulatory requirements that might be made from time to time thereafter.
The regulatory landscape subsequently changed. In particular, CT1 capital was replaced by common equity tier 1 ("CET1") capital and LBG became subject to a new CET1 capital ratio standard of 7% of its risk-weighted assets. Also, convertible instruments would only be counted as Tier 1 capital for stress testing purposes if their conversion trigger was at least 5.125%, but the conversion trigger in the notes would only be reached if LBG's capital ratio (measured using CET1) fell below 1%.
When a further stress test was undertaken in December 2014, LBG achieved the capital ratio standard without the need to take the notes into account. It said that this constituted a CDE and that it could therefore redeem the notes. The noteholders disagreed and directed the note trustee to apply to the Court for a declaration that a CDE had not occurred.
By the time the case reached the Supreme Court there were two issues regarding whether a CDE has occurred.
- did the change from CT1 to CET1 mean that, applying the definition of "Core Tier 1 Capital", a CDE could not occur?
- had the notes ceased to be taken into account, as required by Clause 19.2?
Before answering these specific questions, the Supreme Court gave further consideration to the proper approach to interpretation, in particular when looking at a contract or trust deed which governs the terms on which a negotiable instrument is held.
Approach to interpretation of the trust deed
Having regard to the considerable guidance already given in other cases, the Supreme Court limited itself to considering only the specific point that had arisen in this case: what, if any, weight should be given to other documents that were available at the time the trust deed took effect, notably the offer memorandum, the accompanying letter from LBG's chairman and various materials published by the FSA.
Lord Neuberger acknowledged that the weight to be given to such surrounding documents is highly dependent on the facts of each individual case, but that:
"when construing a contract or Trust Deed which governs the terms upon which a negotiable instrument is held ... very considerable circumspection is appropriate before the contents of such other documents are taken into account.
In reaching this view, he endorsed the conclusion reached by Lord Collins in Re Sigma Finance Corp (in administrative receivership)  1 All ER 571 that, when looking at this sort of document, the background or factual matrix should not be relevant except in the most generalised way.
Lord Neuberger nonetheless concluded that the relevant provisions of the trust deed did require some appreciation of the regulatory policy of the FSA at and before the notes were issued. He considered it appropriate to assume that most noteholders would have had advice from reasonably sophisticated advisers and that it accorded with good sense that the FSA regulatory material published in 2008 and 2009 could be taken into account as an aid to interpreting the trust deed. However, it is noteworthy that he referred to "at least the general thrust and effect" of that material being taken into account, i.e. the regulatory environment in which the notes were issued, rather than the detailed wording of the FSA documents.
He did not consider that the memorandum and letter took matters any further and concluded that it was unhelpful to consider them. He did not therefore need to address the difficulty that frequently arises with negotiable instruments, where background documents might have been available to original purchasers but not necessarily seen by subsequent purchasers.
First Issue: Did the change from CT1 to CET1 mean that a CDE could not occur?
It was argued on behalf of the noteholders that a CDE could not have occurred as the definition required the stress test to be in respect of the "Consolidated Core Tier 1 Ratio" but the December 2014 stress was in respect of the CET1 capital ratio.
The trial Judge and the Court of Appeal rejected this argument, concluding that a departure from the strict literal meaning of the "Core Tier 1 Capital" definition was justified on the basis of the test set out by Lord Hoffmann in Chartbook v Persimmon, namely that it was clear that something had gone wrong with the language and it was clear what a reasonable person would have understood it to have meant.
Lord Neuberger agreed, subject to only expressing doubt as to whether reading the reference to "Consolidated Core Tier 1 Ratio" in Clause 19.2 as extending to its later regulatory equivalent really did require a departure from the literal meaning unless (he said) a rather pedantic approach was being taken to interpretation. He did not expand upon this, but it does bring into question whether commentators who took Lord Neuberger's judgment in Arnold v Britton  UKSC 36 to mark a shift to a much more literal approach to construction may have overstated the impact of the guidance given in that case.
Second Issue: Had the notes ceased to be taken into account?
The Supreme Court had to decide whether the "ceased to be taken into account" wording in the definition of CDE meant that (i) they no longer played a part in enabling LBG to pass stress tests; or (ii) they were disallowed in principle and therefore no longer capable of being taken into account.
The noteholders relied on notes continuing to be taken into account for some purposes in the stress tests applied by the PRA, together with it remaining the case that they would convert if the CET1 capital fell sufficiently to meet the notes' conversion trigger.
LBG argued that the effect of the regulatory changes was that the notes could no longer assist it to pass the stress test the 5% conversion trigger in the notes was
lower than the minimum required by the PRA and the PRA had not in fact relied on the notes when undertaking the December 2014 stress test. It was submitted that this was sufficient to constitute a CDE.
By a 3:2 majority, the Supreme Court agreed with LBG. Lord Neuberger accepted that the relevant determining factor was whether the notes played a part in enabling LBG to pass the stress test. He saw the vital point as being that they could not be taken into account to do the very job for which they were designed, namely to enable their conversion before the minimum tier 1 ratio was reached. He added that support for this interpretation of "ceased to be taken into account" could be found by comparing that expression with the words "no longer eligible to qualify" which appeared elsewhere in the CDE definition the latter depends on what the regulations say, but the former depends more on what happens in practice.
In a brief dissenting judgment, Lord Sumption (with
whom Lord Clarke agreed) preferred the view taken by the trial Judge and disagreed with the Court of Appeal.
This divergence of opinion underlines the difficulty in predicting how a provision will be interpreted and why questions of interpretation feature so regularly in the appellate courts.