The High Court has recently considered the contractual interpretation of documentation in a collateralised loan obligation ("CLO") transaction: Deutsche Trustee Company Ltd v Duchess VI CLO B.V. & Ors [2019] EWHC 778 (Ch). Applying established principles of contractual interpretation, the court held that an incentive fee was not payable to the collateral manager of the CLO, following the exercise of a right of early redemption by the holders of the equity notes.

The court found that the documentation read as a whole was clear in the context of the transaction. It emphasised the "particular, even paramount" importance of the words used when the court is construing the terms of a traded instrument which will exist for a long time and pass through many hands (Re Sigma Finance Corp [2009] UKSC 2). Having considered the specific language used, the court concluded the parties to the notes were entitled and would expect to be bound by the language used.

In the latter context, the most interesting issue on rival commercial constructions was what the court described as the "supposedly perverse incentive" for the relevant noteholders to exercise their right of early redemption in order to avoid paying the incentive fee to the collateral manager. The court's pragmatic response to this argument was that, if the notes were performing sufficiently well that the incentive fee was triggered, it would be in the interests of the relevant noteholders to "stick with it" and pay the incentive fee from quarter to quarter, rather than redeeming the notes purely to deprive the collateral manager of the incentive fee.

It is understood that the High Court has granted permission to appeal.

Background

The parties entered into a CLO securitisation transaction in August 2006 pursuant to which Duchess VI CLO B.V. (the "Issuer") issued various classes of notes (the "Transaction"). Deutsche Bank Trustee Company Limited acted as trustee (the "Trustee"). Napier Park Global Capital Limited held Class F Notes (the equity tranche of the CLO). Barings (U.K.) Limited acted as the collateral manager (the "Collateral Manager").

The Collateral Manager was appointed pursuant to a collateral management agreement (the "CMA"), under which it was responsible for the investment decisions which determined the performance of the Transaction as a whole. In addition to receiving an ongoing base collateral management fee, a separate incentive collateral management fee (the "ICM Fee") was payable, in certain circumstances, to the Collateral Manager to incentivise its management of the portfolio.

The Transaction did not perform as hoped, at least in part due to the global financial crisis. In January 2018, the Class F Noteholders exercised their right to an Optional Redemption under Condition 7 of the Conditions of the Notes, requiring the Collateral Manager to liquidate the portfolio and make a distribution of principal according to the applicable waterfall.

The Collateral Manager duly liquidated the portfolio, but it also claimed that an ICM Fee was due on redemption of the principal (which was said to have triggered the threshold of return which would lead to the ICM Fee being payable).

The Trustee, who took a neutral position, brought proceedings under CPR Part 8 which focused on the entitlement of Collateral Manager to payment of an ICM Fee in relation to the redemption.

Decision

General approach to interpretation

The court summarised the (well-established) approach to the interpretation of contracts as set out in the Supreme Court's recent decisions in Rainy Sky v Kookmin Bank [2011] 1 W.L.R. 2900Arnold v Britton [2015] A.C. 1619 and Wood v Capita Insurance Services Limited [2017] 2 WLR 1095.

In the context of interpreting the CMA (and other Transaction documents), the parties agreed that construction was an iterative process which involved the court checking the rival meanings against other provisions and investigating their commercial consequences. This followed the approach taken in Re Sigma (and in Rainy Sky). The court emphasised commentary in Re Sigma as to the "particular, even paramount" importance of the words used when the court is construing the terms of a long term, transferable instrument and that the matrix of fact ought only to be relevant in the most generalised way. As was explained by Lord Collins, the commercial intention which could be inferred from the face of the document, and the nature of the parties' business, could be used as an aid to construction, but no more.

Interpretation of the Transaction documents

The key issue considered by the court was the Collateral Manager's entitlement to an ICM Fee under Clause 14.1 of the CMA when the Class F Noteholders exercised their Optional Redemption rights under Condition 7. Commenting that the Transaction documentation read as a whole was unambiguous, it held that the Collateral Manager was not entitled to an ICM Fee in such circumstances.

The court started its analysis by looking to Clause 14.1 of the CMA, which provided that the ICM Fee would be paid "on each Payment Date, subject to Condition 4(d) (Limited Recourse) of the Conditions and in accordance with the Priorities of Payment". It said that this was simply governing the timing of payment and that, to see in what circumstances such a fee would be payable, it was necessary to look at the definition of the ICM Fee. The definition made clear "in no uncertain terms" that it was a fee which was only payable to the Collateral Manager in accordance with the payment waterfalls which applied during the on-going lifetime of the Transaction, not those that applied following an Optional Redemption under Condition 7.

The court held that the reference to the specific waterfalls could not be ignored; if the draftsman had intended that an ICM Fee would accrue when different waterfall provisions were triggered, there would have been a reference to the that waterfall in the ICM definition.

Rival commercial constructions

The Collateral Manager argued that the result of an interpretation which led to the ICM Fee not being payable upon an Optional Redemption was that there would be a "perverse incentive" for the Class F Noteholders to trigger an Optional Redemption to avoid the ICM Fee. The court's pragmatic response to this argument was that, if the issue was performing sufficiently well that the ICM Fee would be triggered by the returns being generated, it would be in the interests of the Class F Noteholders to "stick with it" and pay the ICM Fee, rather than redeeming the notes purely to deprive the Collateral Manager of the ICM Fee.

Accordingly, having considered the specific language used, the court concluded that the commercial background and relevant factual matrix known to the parties at the date of the Transaction did not point to a different interpretation.