What was the appeal about?
Credit Suisse Asset Management (“CSAM”) was the originator of Titan 2006-1, a commercial mortgage backed securitization (“CMBS”). The Titan 2006-1 SPV (“Titan”) issued eight tranches of bonds (A to H) for a total of EUR 723 million. It used the proceeds to acquire commercial real estate loans from CSAM.
Like many CMBS structures of that vintage, the Titan CMBS featured “Class X notes”. These were a small (EUR 50,000) tranche of bonds that ranked ahead of the other tranches in certain respects and bore a special variable rate of interest. Their purpose was to ensure that if Titan was due to receive more in interest from the loans than it owed to the tranche A to H bondholders, that “excess spread” would be paid to the Class X noteholder (which was CSAM). In other words, the Class X notes allowed CSAM to extract any surplus interest from the loans it had securitized, rather than leave it trapped in Titan.
Because the excess spread was generated across hundreds of millions of euros of loans and bonds but paid as interest on only EUR 50,000 of Class X notes, the Class X interest rate could be thousands of percent and tens of millions of euros.
The loans Titan had acquired suffered significant defaults. Titan became unable to pay the interest due on the bonds it had issued. However, interest was still due on the Class X note, because the transaction documents defined the Class X interest rate by reference to sums due to Titan on the loans, rather than sums actually received.
Disputes arose between CSAM and some class A to H noteholders about various aspects of how the Class X interest rate should be calculated, and when the Class X notes should be redeemed. These issues were decided by Mr Justice Etherton in the High Court earlier in 2016. When the case reached the Court of Appeal, only one issue remained: whether, when calculating the Class X interest rate, the fact that default interest was due on some of Titan’s loans should be taken into account.
What was the issue surrounding the default interest?
The defaults on the loans meant that under the loan agreements the borrowers had to pay a higher “default” rate of interest to Titan. The Class X interest rate was the difference between the rate due to Titan under the loans and the rate payable by Titan on the bonds. So if the rate due to Titan under the loans meant not just the ordinary interest rate but any applicable default interest rate, the Class X interest rate would increase dramatically.
The transaction documents referred to “the related per annum interest rate due on such loan”. The argument was about whether this term was intended to mean the interest rate ordinarily due on a loan, or whatever rate was due on the loan, including a default interest rate, if applicable.
Why did the judges disagree?
There was, as Lord Justice Briggs put it, “no measurable difference” between the judges as to the principles of contractual interpretation that applied. Both cited the Supreme Court decision in Arnold v Britton and made clear that primary importance is now given to the words of the agreements, rather than to wider considerations of commercial purpose.
But in interpreting the text, Lady Justice Arden, giving the majority judgment, considered that the words “per annum” were key. She treated these words as words of limitation: the relevant interest rate was not in her view any interest rate payable on the loans, but only the per annum interest rate. The default interest rate was not a per annum rate: it accrued only while a default existed. She referred to instances in the transaction documents and the offering circular in which she said the term per annum interest rate was used in a manner that suggested it was not intended to include any default interest rate.
Lord Justice Briggs, giving the dissenting judgment, considered that the words “per annum” were not words of limitation but words of denomination. They were used as part of a formula in which the weighted average per annum interest rate under the bonds was deducted from the weighted average per annum interest rate under the loans to work out the excess interest rate. The formula would not work if the interest rates were not denominated in the same unit, i.e. a per annum rate of interest.
There were commercial arguments against either approach. If default interest was excluded from the excess spread, that meant that if default interest was paid on the loans any surplus after the A to H tranche noteholders were paid would get trapped in the Titan structure and end up being given to charity; a result the court accepted was unlikely to have been intended. But if default interest due was included in the excess spread, the Class X noteholder would get a large windfall even when the default interest was not paid and there were large losses to the A to H tranche noteholders. In other words, CSAM would take a profit that wasn’t really there while the other noteholders suffered losses on the bonds in the Titan structure CSAM had created.
Lady Justice Arden considered that this latter factor made her interpretation more likely to have been intended. Lord Justice Briggs considered that the words were clear enough that they could not be displaced just because they had this “nasty side effect” for the noteholders.
What are the practical implications of the case for practitioners?
There are a number of takeaways from this decision. On a narrow level, it is the latest of several decisions against Class X noteholders seeking to read securitization documents in ways that give them large windfalls based on accrued but unpaid default interest obligations under the underlying loan agreements. It appears that the courts are being led by the overriding commercial arguments to reject those claims. The prospects for other Class X claims look bleak.
More broadly the Court of Appeal reinforced the Arnold v Britton approach to contractual interpretation and made clear that it applies equally to complex structured finance agreements. There had been suggestions in the first instance decisions in this case and Windermere VII that special considerations apply in these types of cases. But here all the judges underlined the need to find the “contextual meaning to the parties’ words” and not to allow commercial common sense to “undervalue the importance of the language” of the agreements.
That said, the judgments provide a case study in the limits of these principles of interpretation in predicting the outcome of a dispute. Here the judges agreed on the principles, but nonetheless reached opposite decisions based on their reading of the key provisions of the agreements.
Finally, Lord Justice Briggs ended with the candid admission that despite dissenting from the majority, he was “by no means unhappy at being in a minority as to the outcome”. He described the majority view as avoiding the need to confer on the Class X noteholders “an advantage which, although in my view conferred on them by the Ts & Cs, was probably unforeseen by them when they made their investment”. Even judge that found for the Class X noteholders wanted their claims to fail.