BNY Mellon Corporate Trustee Services Ltd v LBG Capital No 1 Plc & Anor [2016] UKSC 29

Lloyds Banking Group sought to redeem £3.3 billion of high-interest contingent convertible loan notes (ECNs), arguing regulatory changes had triggered a Capital Disqualification Event. The Supreme Court held by majority that LBG was entitled to redeem, as the ECNs could no longer perform their intended capital function.

Facts

In November 2009, Lloyds Banking Group (LBG) issued £8.3 billion of enhanced capital notes (ECNs), a form of contingent convertible securities (Cocos), as part of a recapitalisation programme required by the FSA. The ECNs carried an average interest rate of approximately 10.33% and were redeemable on specified maturity dates between 2019 and 2032. Under clause 7 of the Terms and Conditions, the ECNs were convertible into LBG ordinary shares if LBG’s Consolidated Core Tier 1 (CT1) Ratio fell below 5% (then 1% above the FSA’s minimum 4% requirement).

Clause 8(e) permitted early redemption if a ‘Capital Disqualification Event’ (CDE) occurred. Clause 19 defined a CDE as occurring (1) where the ECNs ceased to be eligible as Lower Tier 2 Capital, or (2) where, as a result of changes to Regulatory Capital Requirements or their interpretation/application, the ECNs ceased to be taken into account for any stress test applied by the FSA in respect of the Consolidated Core Tier 1 Ratio.

Following the 2013 implementation of CRD IV and Basel III, the regulatory landscape changed significantly: CT1 was replaced by the more restrictive Common Equity Tier 1 (CET1); the PRA replaced the FSA; new conversion thresholds for AT1 Capital were set at 5.125% CET1; and the FPC/PRA required adjusted CET1 ratios of 7% (equivalent to a 10% unadjusted CET1 ratio for LBG). The ECNs’ conversion trigger, translated into the new measure, equated to a CET1 ratio of approximately 1% — far below the new regulatory minimums. In December 2014, LBG announced that the ECNs had not been taken into account in PRA stress tests and that a CDE had occurred, entitling LBG to redeem the remaining £3.3 billion of ECNs.

Issues

The Supreme Court had to decide two issues:

(1) Whether the reference to ‘Consolidated Core Tier 1 Ratio’ in paragraph (2) of the CDE definition should, following regulatory changes, be read as referring to its regulatory equivalent (CET1).

(2) Whether the ECNs had ‘ceased to be taken into account’ for the purposes of any stress test in respect of the Tier 1 Ratio — specifically whether this required (a) actual participation by the ECNs in enabling LBG to pass a stress test, or (b) merely eligibility in principle to be treated as top tier capital.

Arguments

LBG’s case

LBG argued that as a result of the 2013 regulatory changes (CRD IV and the PRA Supervisory Statement), the ECNs could no longer be taken into account for stress testing in respect of the relevant Tier 1 ratio, because their conversion trigger sat well below the minimum required pass ratio. The ECNs were not in fact relied upon in the 2014 stress tests.

The Trustee’s case

The Trustee contended (1) that the 2014 stress test was in respect of CET1, not CT1, and thus fell outside paragraph (2); and (2) that the ECNs had not ‘ceased to be taken into account’ because they remained capable of converting into paid-up shares (albeit only if CET1 fell to around 1%), and could in principle still be considered.

Judgment

The Supreme Court dismissed the Trustee’s appeal by a majority (Lord Neuberger, Lord Mance and Lord Toulson; Lord Sumption and Lord Clarke dissenting).

Approach to interpretation

Lord Neuberger emphasised that, where instruments govern negotiable securities held by varied creditors, considerable circumspection is required before extrinsic documents are taken into account. He cited Lord Collins in In re Sigma Finance Corp, noting that the wording of the instrument is paramount and must be interpreted in light of the commercial intention inferable from the face of the instrument. While the general thrust of FSA regulatory material in 2008-2009 could legitimately inform interpretation, the Exchange Offer Memorandum and chairman’s letter were of limited assistance.

First issue

The Court agreed with Sir Terence Etherton and the Court of Appeal that ‘Consolidated Core Tier 1’ in paragraph (2) should be treated as referring to its regulatory equivalent (CET1). It was notorious that regulatory requirements would be strengthened; the T&Cs contemplated changing definitions; and limiting the term to the now-defunct CT1 would defeat the commercial purpose of the ECNs.

Second issue

The majority preferred LBG’s construction. Lord Neuberger gave several reasons:

(i) The phrase ‘any stress test in respect of the Tier 1 Ratio’ indicates that the ECNs must be capable of doing the job for which their convertibility was designed — converting before the regulatory minimum Tier 1 Ratio is reached. Under the 2013 Regulations, the ECNs could not perform that function.

(ii) The contrast between paragraph (1) (‘no longer eligible to qualify’) and paragraph (2) (‘cease to be taken into account’) was significant. Paragraph (2) is concerned with what happens in practice under the regulations, not merely formal eligibility.

(iii) On the Trustee’s reading, it was almost impossible to envisage paragraph (2) ever being invoked, since paid-up share capital would always count as Tier 1.

The majority rejected the Trustee’s points: foreseeability of regulatory tightening did not undermine LBG’s interpretation; clause 8(e) was merely an option to redeem; the changed regulations had effectively ‘disqualified’ the ECNs from performing their saving function; and the contra proferentem rule was a last refuge not required here.

Dissent

Lord Sumption (with whom Lord Clarke agreed) would have held the ECNs not redeemable. He preferred Sir Terence Etherton’s interpretation: ‘taken into account’ meant eligibility in principle for use in a stress test, not actual contribution to passing one. He reasoned that: (i) the ECNs might always have been irrelevant to passing an actual stress test depending on circumstances; (ii) a test depending on outcomes of actual stress tests would be wholly uncertain; (iii) the clause’s title ‘disqualification’ indicated the eligibility approach; and (iv) these were long-dated securities not intended to be redeemed early except where their function was fundamentally undermined, which had not occurred.

Implications

The case is of considerable financial significance, allowing LBG to redeem £3.3 billion of high-coupon notes, but as Lord Sumption observed, it raises ‘no questions of wider legal significance’. Nonetheless, several interpretative principles emerge.

First, the judgment reinforces the approach in Sigma Finance that, when construing instruments governing negotiable securities held by diverse creditors, the wording of the instrument is paramount and reference to extrinsic background material should be approached with considerable caution. Background regulatory context may be considered in a generalised way, particularly where the instrument explicitly engages with that regulatory framework.

Second, the decision illustrates that contract drafters using time-sensitive regulatory definitions (such as ‘Core Tier 1 Capital’) should anticipate that courts may interpret such terms as referring to their regulatory successors where the commercial purpose so requires. This may be relevant for issuers and holders of other financial instruments whose terms depend on evolving regulatory categories.

Third, the case highlights the importance of careful drafting of redemption triggers in contingent convertible instruments. The contrast between ‘eligible to qualify’ and ‘taken into account’ was significant: drafters seeking to ensure that redemption depends on principled regulatory eligibility should use the former language, whereas language about being ‘taken into account’ may allow redemption based on practical outcomes of regulatory testing.

The decision matters most directly to issuers and holders of Cocos and similar regulatory capital instruments, as it demonstrates how subsequent regulatory change may permit issuers to redeem high-coupon instruments earlier than holders may have anticipated. Holders of similar instruments should review redemption provisions carefully to assess vulnerability to comparable arguments. The dissent demonstrates that the question was genuinely finely balanced and that contrary outcomes are conceivable on similarly worded clauses with different surrounding wording.

Verdict: The Supreme Court dismissed the Trustee’s appeal by a majority of 3-2. It held that a Capital Disqualification Event had occurred under paragraph (2) of the Definition in clause 19 of the Terms and Conditions, and accordingly LBG was entitled to redeem the outstanding £3.3 billion of ECNs under clause 8(e).

Source: BNY Mellon Corporate Trustee Services Ltd v LBG Capital No 1 Plc & Anor [2016] UKSC 29