At the height of the European leverage market, the emphasis in transactions was on speed of execution. Tax and commercial issues dominated negotiations and the security enforcement mechanics were often seen as a lesser priority. The recent decision of Mrs Justice Proudman in HHY Luxembourg Sarl v Barclays Bank Plc (‘HHY Luxembourg’) sheds a harsh light on one aspect of certain Intercreditor Agreements which, being a provision common to many agreements, may have a profound commercial effect. The key clause which was the subject of this case relates to the ability of the Security Trustee to release or transfer (on the instructions of the Senior Lenders) the liabilities of the junior lenders on a pledge enforcement process thereby maximising the amount any third party purchaser would pay. Such releases or transfers have occurred on a number of occasions since the occurrence of the credit crunch, and so the judgment has more than an academic impact on the European leverage market. The case is currently on appeal to the Court of Appeal.
European Directories began attempts to restructure its debt in late 2009. Under the restructuring plan, the Centre of Main Interests (COMI) of European Directories (DH6) B.V. was shifted to the United Kingdom, where a pre-pack administration would sell the operating company to a new HoldCo vehicle. The senior debt would then convert into a hybrid instrument issuing out of a newly established HoldCo, while the second lien and mezzanine lenders would be wiped out.
In HHY Luxembourg, the claimant second lien lenders sought declaratory relief on two issues of construction arising under the release clause of an Intercreditor Agreement, relating to the point in the restructuring when the Security Trustee exercises its powers under clause 15.2 of the Intercreditor Agreement to (i) transfer, and (ii) release guarantees and security granted by those Obligors that are subsidiaries of DH7 (which we will label “DH8”). Click here to see a diagram illustrating the structure.
The Intercreditor Agreement
Clause 15 of the Intercreditor Agreement contained the release mechanism. The release purported to allow the Security Agent or an insolvency administrator to sell the group free and clear of the security or the junior claims, thereby maximising the amount any third party purchaser would pay. If junior claims were left behind in respect of some group Obligors the purpose of the release provision would be defeated or at least significantly impaired.
Clause 15.2 (Disposal after enforcement action) of the Intercreditor Agreement provided:
If any assets are sold or otherwise disposed of by (or on behalf of) the Security Trustee..... as a result of the enforcement of the Transaction Security.... the Security Trustee shall be authorised.... to release those assets from the Transaction Security and is authorised to execute or enter into, on behalf of and, without the need for any further authority from any of the Lenders, Subordinated Creditors or Obligors:
(b) if the asset which is disposed of consists of all of the shares (which are held by an Obligor or European Directories (DH5) BV…) in the capital of an Obligor or any holding company of that Obligor, any release of the Obligor or holding company from all liabilities it may have to any Lender, Subordinated Creditor or other Obligor, both actual and contingent in its capacity as a guarantor or borrower and a release of any Transaction Security granted by that Obligor or holding company over any of its assets under any of the Security Documents; and
(c) if the asset disposed of consists of all of the shares held by an Obligor or the Parent in the capital of an Obligor or any holding company of that Obligor and if the Security Trustee wishes to dispose of any liabilities owed by that Obligor or Holding Company, any agreement to dispose of all or any part of those liabilities on behalf of the relevant Lenders, Subordinated Creditors, Obligors and Facility Agents..... [Emphasis added.]
The first half of each clause determines in which situations the clause shall apply: where “an Obligor sells the entire shareholding of another Obligor or any holding company of that Obligor.” In the present case, where DH6 (an Obligor) sells its shares in DH7 (an Obligor and also a holding company of DH8 (every direct and indirect subsidiary Obligor)), the clause clearly applies.
However, the second part of the clause is key. Does the “release of the Obligor or holding company from all liabilities” operate to release the liabilities of (a) DH7 alone, or (b) DH7 (the holding company) and DH8 (as the actual Obligor)?
The defendants argued that the release should be read as permitting the release of not only the liabilities and security of the Obligor or holding company whose shares are being sold (DH7), but also of “other Obligors whose shares are not being sold but are subsidiaries, direct or indirect of DH7” (DH8). The claimants, on the other hand, contended that the clause only provided for one layer of release, that is the liabilities of DH7 alone, whose shares were being disposed of. Click here to see a diagram which sets out the effect of the parties’ arguments on the scope of the release.
Proudman J. adopted a strict approach to the language used in clause 15.2(b), accepting the argument of Robin Knowles QC that the “purpose ought not to be enlarged beyond the ambit of the clause itself, provided of course that the words do not lead to an absurd result without commercial purpose or sense.” Reading the clause literally, Proudman J. stated that the reference to an “Obligor or any holding company” was to the Obligor or holding company whose shares were being disposed of (DH7), and not to any other Obligors. In other words, the Security Trustee could only release the liabilities of an Obligor where the shares of that particular Obligor were being disposed of. In support of this interpretation, Proudman J noted that the Intercreditor Agreement contained a defined term of “Subsidiary” which could have been used had the intention been to release the liabilities of subsidiaries.
This approach sits in stark contrast to the broad, commercial approach to contractual interpretation adopted by the Supreme Court last year in In Re Sigma Finance Corporation  UKSC 2. In Sigma, the Court interpreted a specific clause of the Security Trust Deed relating to the assets of a structured investment vehicle. Certain creditors sought to argue that a particular clause of the Deed effectively gave them priority. The language in question read: “During the Realisation Period the Security Trustee shall so far as possible discharge on the due dates therefor any Short Term Liabilities falling due for payment during such period, using cash or other realisable or maturing Assets of the Issuer.” The creditors argued that this language meant any debts falling due within the Realisation Period should be paid during the Realisation Period as they fell due.
On a purely literal interpretation, this appeared to be the end result of the language. However, the Court held that the underlying commercial intention of the clause was that Sigma would retain sufficient assets to cover the liabilities of all Secured Creditors, with assets to be distributed pari passu among short term creditors. In their view, priority was not to be determined in an arbitrary manner based upon when debts fell due during a Realisation Period which commenced upon enforcement. For our purposes, the Supreme Court’s analysis of the correct approach to interpretation is instructive. Lord Mance (for the majority) in the Supreme Court stated:
In my opinion, the conclusion reached [in the Court of Appeal] attaches too much weight to what the courts perceived as the natural meaning of the words of the third sentence of clause 7.6, and too little weight to the context in which that sentence appears and to the scheme of the Security Trust Deed as a whole.
In a similar vein, Lord Collins in his judgment preferred to consider the wider commercial intention which one can infer from the face of the instrument in question and recognised that:
An over-literal interpretation of one provision without regard to the whole may distort or frustrate the commercial purpose.
In HHY Luxembourg, counsel for the Security Trustee argued that the commercial purpose of a release clause is to enable a purchaser to acquire the company unburdened by guarantees or security over its assets. Equally, it was argued that a release clause which applied to subsidiaries should be seen as for the benefit of all lenders; had the value broken in favour of the second lien lenders, a wider interpretation would work in their favour by maximising the value of the group in a sale process. Proudman J. rejected both arguments:
…the question is not what the clause ought to achieve in the events which have happened, but what it does provide on its true construction. It begs the question to say that the defendants’ interpretation was potentially of benefit to all lenders. The issue is not what is or was beneficial, but what did the parties agree at the time.
In Sigma, the Court looked to the overall purpose behind a Security Trust Deed, and the aim of the document as a whole. This is at odds with the approach taken by Proudman J in the paragraph above, where the true (or literal) construction was explicitly preferred to what the clause “ought to achieve”.
The aim of the release provision in an Intercreditor Agreement is to provide a Security Agent with the power to sell the company and its subsidiaries as a going concern on a debt free basis. The literal interpretation adopted by Proudman J. would require multiple enforcement actions in relation to share pledges, as opposed to a clean sale of the group which would maximize the value of recoveries for those creditors who continue to hold an economic interest in the company.
Note that multiple enforcements across multiple jurisdictions with conflicting jurisdictional rules effectively render a clean enforcement all but impossible. In light of the fact that the second lien creditors were out of the money in the present case, the interpretation adopted ignores the commercial reality behind the hierarchy of lenders provided for in the Intercreditor Agreement, and potentially destroys value for the creditors who continue to have an economic interest in the company’s debt. HHY Luxembourg was heard over the course of a morning, with very little time for comprehensive arguments. On appeal, in our opinion, it is likely that more attention will be afforded to the commercial background of the Intercreditor Agreement, and a more commercial view will be adopted. In the meantime, holders of junior debt facing an enforcement where this style of intercreditor agreement has been used have a judicial basis to resist an enforcement, and other junior lenders who have been affected by an enforcement may be consulting their lawyers.