Trinity
Term
[2016] UKSC 29
On appeal from: [2015] EWCA Civ 1257
JUDGMENT
BNY Mellon Corporate Trustee Services Limited
(Appellant) v LBG Capital No 1 Plc and another (Respondents)
before
Lord Neuberger, President
Lord Mance
Lord Clarke
Lord Sumption
Lord Toulson
JUDGMENT GIVEN ON
16 June 2016
Heard on 21 March 2016
|
Appellant
Robin Dicker QC
Stephen Robins
(Instructed by
Allen & Overy LLP)
|
|
Respondents
Mark Howard QC
Robert Miles QC
Andrew De Mestre
Gregory Denton-Cox
(Instructed by
Norton Rose Fulbright LLP)
|
LORD NEUBERGER: (with whom
Lord Mance and Lord Toulson agree)
1.
The issue in this case is whether Lloyds Banking Group (“LBG”) is
entitled to redeem £3.3 billion of loan notes which would otherwise carry a
relatively high rate of interest, namely over 10% per annum. The loan notes are
contingent convertible securities (perhaps inevitably known as “Cocos”), and
are formally described as enhanced capital notes, or the ECNs. The ECNs are
potentially convertible into fully paid up shares in LBG, and they were issued
in November 2009, at a time when LBG, like many other banks, was in dire need
of recapitalisation in order to protect its capital position and to comply with
regulatory requirements.
2.
Before turning to the terms on which the ECNs were issued, it is
necessary to understand a little about the Regulations as at that time, and, in
order to understand the issues on this appeal, it is necessary to set out some
of those terms and then explain a few of the changes effected to the
Regulations in 2013 and the way in which they were applied.
The regulatory position when the ECNs were issued
3.
As at the time that the ECNs were issued, the capital requirements of
financial institutions in the EU were governed by a 2006 Directive known as CRD
I. This Directive was inevitably based on the current international banking
accord, at that time the so-called Basel II. The relevant regulatory authority
in the United Kingdom at the time was the Financial Services Authority, the
FSA.
4.
Under CRD I, the capital of financial institutions was arranged in
tiers. The highest tier of capital was Core Tier 1, known as CT1; the next tier
was divided into Upper Tier 2 Capital and Lower Tier 2 Capital. CT1 included,
inter alia, paid up shares and retained earnings. Lower Tier 2 Capital included
dated subordinated debt. The FSA’s practice was to require a financial
institution to maintain a minimum ratio of CT1 assets and in addition to pass
certain “stress tests”, which involved subjecting the bank’s balance sheet to
hypothetical challenging market situations.
5.
In November 2008, the FSA issued a Statement which described a “Capital
Framework” which it intended to apply to all financial institutions. The
November 2008 Statement explained that the FSA “used as common benchmarks
within this framework ratios of capital to risk weighted assets of total Tier 1
Capital of at least 8% and Core Tier 1 Capital, as defined by the FSA, of at
least 4% after the stressed scenario”. The November 2008 Statement also stated
that the FSA “will be addressing the longer term capital regime for deposit
takers in a discussion paper in the first quarter of 2009, the expectation being
that this document will form part of the wider review of the global regulatory
environment, which the FSA along with the other regulatory authorities, will be
participating in”.
6.
From time to time, the FSA issued further Statements and Guidance. Thus,
in May 2009, it issued a Statement indicating that it had “[g]reatly increased
the use of stress tests as an integral element of our ongoing supervisory
approach”. The May 2009 Statement also stated that the FSA “expected UK banks
to maintain Core Tier 1 Capital, as defined by the FSA, of at least 4% of Risk
Weighted Assets after applying an FSA defined stress test”. The Statement added
that “[t]his current framework will remain in place until the Basel accord,
which is implemented through EU capital requirement directives, has been
modified to reflect the lessons learned from recent events”. The May 2009
Statement also explained that the stress tests “look forward over five years
but with greater detail over the first three” and that the tests “are used to
identify if at any time in the next five years there is a danger that under the
stress scenario the level of capital will fall below the 4% Core Tier 1
minimum”.
7.
In September 2009, in response to transitional legislation issued by the
EU to control the use by financial institutions of hybrid securities as
capital, the FSA issued another Statement making it “clear that the FSA will
work to ensure the timing of the introduction of a new long-term capital regime
…”. The September 2009 Statement also stated that “hybrid capital instruments
must be capable of supporting Core Tier 1 by means of a conversion or
write-down mechanism at an appropriate trigger. Instruments with these
characteristics could be seen as a form of contingent Core Tier 1 Capital”.
The issue of the ECNs
8.
Meanwhile, in March 2009, the FSA had stress-tested LBG, and had found
that it had a shortfall in its CT1 Capital, in the light of the 4% minimum
requirement referred to in the November 2008 Statement. As a result, the FSA
required LBG to demonstrate that it had raised at least £21 billion which could
qualify as CT1 Capital. After considering alternative options, LBG decided to
raise £13.5 billion by issuing new fully paid-up shares through a rights issue,
and £8.3 billion through the medium of the ECNs, to be issued in exchange for
existing securities. These ECNs were intended to be Cocos which would satisfy
what was said in the passage in the September 2009 Statement quoted at the end
of para 7 above.
9.
This decision was duly implemented. The terms of the £8.3 billion ECNs
were described in a so-called Exchange Offer Memorandum. The exchange invited
in that Memorandum was taken up, and the ECNs were issued and subscribed in a
number of different series in December 2009.
10.
The ECNs were loan notes whose terms were contained in a Trust Deed,
which included in Schedule 4 detailed Terms and Conditions (“T&Cs”). In
very broad terms, the ECNs (i) carried interest at varying rates depending on
the series, but averaging about 10.33% per annum, (ii) subject to points (iii)
and (iv), were redeemable only at certain specified dates under clause 8(a) of
the T&Cs, which, depending on the series, varied between 2019 and 2032, but
(iii) could be redeemed early by LBG, albeit only on a so-called “Capital Disqualification
Event” under clauses 8(e) and 19 of the T&Cs, and (iv) were in the meantime
potentially convertible into paid up shares in certain specified circumstances
described in clause 7(a) of the T&Cs.
11.
Clause 7 of the T&Cs was concerned with “Conversion” of the ECNs.
Clause 7(a) was headed “Conversion upon Conversion Trigger”, and clause 7(a)(i)
provided that “[i]f the Conversion Trigger occurs at any time, each ECN shall …
be converted … into … Ordinary Shares credited as fully paid”. The “Conversion
Trigger” was defined as occurring at any time when “LBG’s Consolidated [CT1] Ratio
is less than 5 per cent”. The 5% figure was 1% above the minimum 4% ratio
required at the time by the FSA, as explained in the Statements cited in paras
5 and 6 above. The remainder of clause 7 was concerned with consequential
machinery.
12.
Clause 8 of the T&Cs was headed “Redemption and Purchase”. Clause
8(a) provided for the ECNs to be redeemed on the relevant “Maturity Date”
(which was a date which varied between 2019 and 2032 depending on the particular
series of the ECN) “[u]nless previously converted, redeemed or purchased and
cancelled as provided in these Conditions”. Clause 8(e) provided that “[i]f … a
Capital Disqualification Event has occurred and is continuing, then [LBG] may …
redeem … all, but not some only, of the ECNs at [a specified price]”.
13.
Clause 19 of the T&Cs was headed “Definitions”. It provided that “a
‘Capital Disqualification Event’ is deemed to have occurred”:
“(1) if at any time LBG … is
required under Regulatory Capital Requirements to have regulatory capital, the
ECNs would no longer be eligible to qualify in whole or in part (save where
such non-qualification is only as a result of any applicable limitation on the
amount of such capital) for inclusion in the Lower Tier 2 Capital of LBG … on a
consolidated basis; or
(2) if as a result of any
changes to the Regulatory Capital Requirements or any change in the
interpretation or application thereof by the FSA, the ECNs shall cease to be
taken into account in whole or in part (save where this is only as a result of
any applicable limitation on the amount that may be so taken into account) for
the purposes of any ‘stress test’ applied by the FSA in respect of the
Consolidated Core Tier 1 Ratio.”
14.
Certain other definitions in clause 19 of the T&Cs are also of some
relevance. “Core Tier 1 Capital” was defined as “core tier one capital as
defined by the FSA as in effect and applied (as supplemented by any published
statement or guidance given by the FSA) as at 1 May 2009”. “Tier 1 Capital” and
“Lower Tier 2 Capital” were each defined as having the “meaning given to it by
the FSA from time to time”. “Regulatory Capital Requirements” was defined as
meaning “any applicable requirement specified by the FSA in relation to minimum
margin of solvency or minimum capital resources or capital”. The “FSA” was
defined elsewhere in the Trust Deed as including any “governmental authority in
the United Kingdom … having primary supervisory authority with respect to LBG”.
15.
The effect of this arrangement was that (a) the ECNs counted as Lower
Tier 2 Capital so long as they were neither redeemed under clause 8 nor
converted under clause 7, and (b) if the ECNs were converted under clause 7
they would count towards the CT1 Capital. That is because, as explained in para
4 above, CT1 Capital included paid up shares and Lower Tier 2 Capital included
dated subordinated debt. If conversion was avoided, the current shareholders
did not have their shareholdings diluted, but the ECN holders received a good
rate of interest. And the conversion under clause 7 would only occur when LBG’s
CT1 Capital fell below 5% of risk weighted assets - ie when it was getting near
the minimum 4% set by the FSA.
Subsequent relevant regulatory developments
16.
With effect from 1 April 2013, the FSA was replaced as the body
responsible for the regulation and supervision of UK financial institutions by
the Prudential Regulation Authority, the PRA (which is wholly owned by the Bank
of England).
17.
So far as EU regulatory requirements are concerned, CRD I was succeeded
in 2010 and 2011 respectively by CRD II and CRD III, but neither of them made
any changes relevant for present purposes. However, CRD IV, which was published
in June 2013, and followed the so-called Basel III, made substantial changes. First,
it replaced CT1 Capital with Common Equity Tier 1 capital (“CET1 Capital”),
which is a significantly more restrictive category than was CT1 Capital.
Secondly, it set the minimum core capital ratio at 4% CET1 from 1 January 2014,
increasing to 4.5% CET1 from 1 January 2015. Thirdly, it introduced a new
concept, Additional Tier 1 Capital, (“AT1 Capital”), which included
contingently convertible loan stock, such as the ECNs. It provided that such
stock would only qualify as AT1 Capital if the trigger for conversion was set
at a CET1 ratio of at least 5.125%.
18.
In March 2013, the Financial Policy Committee of the Bank of England,
the FPC, issued a news release recommending that the PRA should assess the
current capital adequacy of financial institutions in accordance with the CRD
IV and Basel III criteria, albeit subject to adjustments. In particular, it
said that by the end of 2013, banks should hold capital falling within CET1 (as
adjusted) equivalent to at least 7% of their risk-weighted assets (a 7% “adjusted
CET1 ratio” standard), which was, according to the evidence, equivalent to
requiring LBG to have an unadjusted CET1 Capital ratio of 10%.
19.
In June 2013, the PRA announced that LBG needed to raise a total of £8.6
billion further capital in order to meet the new 7% adjusted CET1 ratio
standard. In August 2013, the PRA published a consultation paper, which dealt
with the eligibility of Cocos and other convertible instruments to count as
core capital. It stated that if financial institutions “issue AT1 instruments,
the PRA expects them to set AT1 triggers … at a level higher than 5.125% CET1”.
20.
By contrast, and crucially for present purposes, the evidence in this
case establishes that the effect of the terms of the ECNs is that conversion of
the ECNs into fully paid up LBG shares would only be triggered if LBG’s CET1
ratio fell to 1%, which is, of course, far below the minimum required by the
PRA under its 2013 Regulatory regime.
21.
In December 2013, the PRA published a “Supervisory Statement”
effectively confirming as requirements what had been trailed by the FPC and the
PRA earlier that year.
22.
In anticipation of the requirements in the December 2013 Supervisory
Statement, LBG had substantially strengthened its capital position by the end
of 2013. This involved a number of steps, including offering to exchange up to
a maximum of £5 billion of the ECNs for new Cocos which would qualify as AT1 Capital,
on the basis that they would convert to paid-up shares if LBG’s adjusted CET1 Capital
ratio fell to 7% or lower. As explained in the supporting memorandum issued by
LBG, the 7% conversion trigger was selected because of “statements by the PRA …
that a conversion trigger of 5.125% … may not convert in time to prevent the
failure of a firm and that it expects major UK firms to meet a 7% CET1 ratio determined
in accordance with … CRD IV”. £5 billion of the ECNs were duly exchanged for
these new Cocos in March and April 2014.
23.
In April 2014, the Bank of England announced that, in relation to stress
testing, the previous CT1 4% capital ratio would be replaced by a “hurdle rate”
of a ratio of 4.5% of CET1 to risk-weighted assets, although a stress test
outcome was not dependent on a simple “pass/fail” exercise.
24.
In December 2014, the PRA reported that LBG’s CET1 ratio at the end of
2013 was 10.1% and that its “minimum ‘stressed’ ratio in the stress test was
5%”. The ECNs were not taken into account in either assessment. That was
inevitable, as Gloster LJ pointed out in her judgment in the Court of Appeal,
“because LBG remained above the minimum capital threshold in that stress test -
in that its CET1 ratio did not fall below 4.5% - by reason of the strength of
its capital position without any need to take into account the ECNs, the
conversion trigger point for which was well below the new CET1 capital pass
ratio”.
These proceedings
25.
On 16 December 2014, LBG announced that the ECNs had not been taken into
account in the December 2014 stress test and accordingly a Capital
Disqualification Event (hereafter a “CDE”) had occurred under para (2) of the
definition in clause 19 of the T&Cs, and accordingly LBG was entitled to
redeem the outstanding £3.3 billion ECNs in accordance with clause 8(e) of the
T&Cs. The consent of the PRA to the redemption was required and was duly
obtained. However, BNY Mellon Corporate Trustee Services Ltd (“the Trustee”),
as trustee for the holders of the ECNs under the Trust Deed mentioned in para
10 above, challenged LBG’s claim to be entitled to redeem the outstanding ECNs.
26.
Hence these proceedings, in which LBG contends that a CDE has occurred,
so that it can redeem the outstanding ECNs, and the Trustee denies that a CDE
has occurred. LBG argues that a CDE has occurred because para (2) of the
definition of a CDE in clause 19 of the T&Cs (“the Definition”) is
satisfied. LBG’s case is that “as a result of [a change] to the Regulatory
Capital Requirements or any change in the interpretation or application thereof
by the FSA”, namely the implementation of CRD IV through the 2013 Supervisory
Statement, “the ECNs [have ceased] to be taken into account … for the purposes
of any ‘stress test’ applied by the [PRA] in respect of the Consolidated Core
Tier 1 Ratio”, as is evidenced by the stress tests carried out in 2014 in
respect of LBG’s financial position as at December 2013.
27.
The Trustee raises two arguments why this contention is wrong. First the
Trustee contends that the December 2014 stress test was not “in respect of the
Consolidated Core Tier 1 Ratio”, as specified in para (2) of the Definition;
rather, it was a stress test in respect of a CET1 ratio. Secondly and
alternatively, the Trustee contends that the fact that the ECNs were not taken
into account in the December 2014 stress test when assessing the Tier 1 Ratio
is not enough to trigger a CDE; in order for para (2) of the Definition to
apply, the ECNs must be disallowed in principle from being taken into account for
the purposes of the Tier 1 Ratio before para (2) of the Definition can be
invoked by LBG.
28.
At first instance, Sir Terence Etherton C, in a clear and careful
judgment, rejected the Trustee’s first argument, but accepted the Trustee’s
second argument - [2015] EWHC 1560 (Ch). Accordingly, he found in favour of the
Trustee and held that the ECNs were not redeemable under clause 8(e) of the
T&Cs. For reasons given in a very full judgment in the Court of Appeal,
Gloster LJ agreed with Sir Terence on the first argument but disagreed with him
on the second argument; Briggs LJ agreed with Gloster LJ for reasons given in a
short judgment, and Sales LJ agreed with Gloster LJ. Accordingly, LBG won
in the Court of Appeal, who concluded that the ECNs were redeemable under
clause 8(e) of the T&Cs - [2015] EWCA Civ 1257. The Trustee now appeals to
the Supreme Court.
The proper approach to interpretation
29.
Much of the argument before us was given over to the question whether,
when construing the Trust Deed, and in particular the T&Cs, the Court of
Appeal had been entitled to take into account statements in the substantial
Exchange Offer Memorandum and in the lengthy letter from the chairman of LBG
which accompanied it, and indeed the details of the statements and other
documents issued by the FSA in 2008 and 2009.
30.
Over the past 20 years or so, the House of Lords and Supreme Court have given
considerable (some may think too much) general guidance as to the proper
approach to interpreting contracts and indeed other commercial documents, such
as the Trust Deed in this case. What, if any, weight is to be given to what was
said in other documents, which were available at the time when the contract
concerned was made or when the Trust Deed in question took effect, must be
highly dependent on the facts of the particular case. However, when construing
a contract or Trust Deed which governs the terms upon which a negotiable
instrument is held, as in the present case, very considerable circumspection is
appropriate before the contents of such other documents are taken into account.
31.
In this connection, it is worth repeating the remarks of Lord Collins
(with whom Lord Hope and Lord Mance agreed) in In re Sigma Finance Corp (in
administrative receivership) [2010] 1 All ER 571, paras 36 and 37. Having
pointed out that the trust deed in that case concerned “debt securities” issued
to “a variety of creditors, who hold different instruments, issued at different
times, and in different circumstances”, Lord Collins, at para 37, said
“[c]onsequently this is not the type of case where the background or matrix of
fact is or ought to be relevant, except in the most generalised way.” More
generally, he said:
“Where a security document secures
a number of creditors who have advanced funds over a long period it would be
quite wrong to take account of circumstances which are not known to all of
them. In this type of case it is the wording of the instrument which is
paramount. The instrument must be interpreted as a whole in the light of the
commercial intention which may be inferred from the face of the instrument and
from the nature of the debtor’s business.”
32.
As Mr Dicker QC points out on behalf of the Trustee, the same point was
made by Lord Macmillan when giving the decision of the Privy Council in Egyptian
Salt and Soda Co Ltd v Port Said Salt Association Ltd [1931] AC 677, 682.
Disapproving the trial judge’s reliance on “surrounding circumstances at the
time when the memorandum was framed”, Lord Macmillan said that “the purpose of
the memorandum is to enable shareholders, creditors and those who deal with the
company to know what is its permitted range of enterprise, and for this
information they are entitled to rely on the constituent documents of the
company” and that the “intention of the framers of the memorandum must be
gathered from the language in which they have chosen to express it”. (See also
the observations of Lord Hoffmann to much the same effect in Attorney
General of Belize v Belize Telecom Ltd [2009] 1 WLR 1988, para 36, Homburg
Houtimport BV v Agrosin Private Ltd [2004] 1 AC 715, para 74, and Chartbrook
Ltd v Persimmon Homes Ltd [2009] AC 1101, para 40).
33.
In the present case, the Trust Deed, and in particular those parts of
clauses 7, 8 and 19 of the T&Cs which fall to be construed, cannot be
understood unless one has some appreciation of the regulatory policy of the FSA
at and before the time that the ECNs were issued. That is self-evident from the
provisions of clause 19 which are set out in paras 13 and 14 above.
Accordingly, I consider that at least the general thrust and effect of the FSA
regulatory material published in 2008 and 2009 can be taken into account when
interpreting the T&Cs. That would also accord with good sense: while the
individual purchasers of the ECNs may not by any means all have been
sophisticated investors, it is appropriate to assume that most of them would
have had advice from reasonably sophisticated and informed advisers before they
purchased such moderately complex financial products. The Exchange Offer
Memorandum and the letter from the LBG chairman present more difficulties, and
the answer may depend on whether such documents would have been known about or
in the minds of subsequent purchasers of the ECNs, a point on which there was
no evidence, so far as I am aware.
34.
As it is, I do not consider that the terms of the Exchange Offer
Memorandum or the letter from the LBG chairman take matters any further in this
case. In my view, once one has in mind the general thrust and effect of the FSA
regulatory approach in 2009, as summarised in paras 4 to 7 above, coupled with
the commercial purpose of the ECNs as summarised in para 15 above, it is simply
unhelpful on the facts of this case to cast one’s eyes further than the
T&Cs when resolving the issues on this appeal. I now turn to those two
issues.
The first issue: did the possibility of a CDE fall away
following CRD IV?
35.
I have no hesitation in agreeing with Sir Terence Etherton and the Court
of Appeal in their conclusion that the reference to “the Consolidated Core Tier
1” in para (2) of the Definition should, in the events which have happened, be
treated as a reference to “its then regulatory equivalent” - ie in the current
context the Common Equity Tier 1 Capital. Etherton C and the Court of Appeal
considered that this conclusion involves a departure from the strictly literal
meaning of the definition of “Core Tier 1 Capital” in clause 19, but they
concluded that such a departure was justified because it was “clear that
something has gone wrong with the language and [it was] clear what a reasonable
person would have understood the parties to have meant”, applying the test laid
down by Lord Hoffmann in Chartbrook, para 25.
36.
The reasons given by Gloster LJ in para 85 of her judgment for departing
from what she considered was the literal meaning of the closing words of para
(2) of the Definition were based on the arguments of Mr Miles QC. They were, in
summary, that (i) it was notorious at the time of the issue of the ECNs that
the regulatory requirements as to financial institutions’ capital would be
“strengthened and changed”, (ii) it was envisaged in the T&Cs, in
particular in clause 19, that expressions such as “Regulatory Capital
Requirements” and “Core Tier 1 Capital” could change their meaning; (iii)
indeed, it was inherent in the terms of the Definition that this was so; (iv)
it was obvious that changes of substance might lead to changes of nomenclature;
and (v) one of the essential features of the ECNs was that, if necessary, they
could be converted into LBG core capital, whatever expression was used to
define it.
37.
Gloster LJ concluded that, given these points, coupled with the existence
of the ECN maturity dates, it made no commercial sense to limit the reference
to “Core Tier 1 Capital” in para (2) of the Definition to CT1 Capital, as
opposed to holding that it could, in the events which had happened (as
summarised in paras 16 to 20 above), apply to CET1 Capital. She also considered
that the error would “have been obvious to a reasonable addressee of the
Exchange Offer Memorandum”. She referred in this connection to another
observation of Lord Collins in Sigma, where, in para 35, he said that in
complex documents such as the Exchange Offer Memorandum, “there are bound to be
ambiguities, infelicities and inconsistencies” and had gone on to warn against
an “over-literal interpretation of one provision without regard to the whole”,
which may “distort or frustrate the commercial purpose”.
38.
Subject to one point, I have no hesitation in agreeing with the analysis
as summarised in paras 35 to 37 above. My only doubt is as to whether this
conclusion really does involve a departure from the literal meaning of the
closing words of para (2) of the Definition, not least in the light of the
definitions of “Core Tier 1 Capital” and “Tier 1 Capital” in clause 19. It may
involve a departure from the literal meaning, but, if it does, it is on the
basis of a rather pedantic approach to interpretation. I do not, however,
propose to discuss the point further: it is completely arid.
39.
I would add, however, that if the Trustee’s argument was correct, it
seems to me that LBG would have had a powerful basis for saying that this
appeal should be dismissed rather than allowed. That is because, as a matter of
language at least, LBG could say that para (2) of the Definition applied on the
grounds that the ECNs had, on any view “cease[d] 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”, because that ratio was no longer being used by
the FSA.
The second issue: have the ECNs “ceased to be taken into
account”?
40.
The critical question raised by the second issue is whether, as LBG
contends, in the light of the regulatory changes and events as described in
paras 17-24 above, “the ECNs [have] cease[d] to be taken into account in whole
or in part … for the purposes of any ‘stress test’ applied by the [PRA] in
respect of [what I will call the Tier 1] ratio”. To put the point slightly
differently, the question is whether the implementation of CRD IV by the PRA
through the new Capital Requirements summarised in paras 17 to 21 above, and
applied as described in paras 23 and 24 above, entitle LBG to say that a CDE
has occurred because para (2) of the Definition has been satisfied.
41.
The nature of the dispute on this second issue was very well expressed
by Briggs LJ in para 114 in the Court of Appeal, in these terms:
“In order to resist early
redemption of the ECNs is it sufficient that they continue to be taken into
account for some purpose or purposes in the stress-test now applied by the
[PRA], which in my view they do, or must they play a part in enabling LBG to
pass that test, which they clearly no longer do, because of the change in the
Regulatory Capital Requirements which had the effect of elevating the pass
ratio to a level above the Conversion Trigger.”
42.
I also agree with what Briggs LJ said in the next paragraph of his
judgment, namely that this is a difficult question to resolve, and I find it
unsurprising that Sir Terence and the Court of Appeal took different views, and
indeed that there is a difference of view in this court.
43.
LBG argues that the essential point is that “the Regulatory Capital
Requirements” changed in 2013 with the consequence that the ECNs could no
longer be taken into account in assisting LBG in passing the stress test,
because the conversion trigger under the terms of the ECNs was at a level lower
than the minimum required by the PRA, as explained in para 20 above, and, in
any event, the PRA did not in any way rely on the ECNs when conducting its
stress tests on LBG in 2014.
44.
By contrast, the Trustee’s argument is that, notwithstanding the
regulatory changes in 2013, the ECNs can continue to be taken into account as
part of the Tier 1 Capital by automatically converting into paid-up shares in
LBG, albeit that this would only occur when the CET1 Capital ratio fell to 1%.
45.
I prefer LBG’s argument, as advanced by Mr Howard QC, for the following
reasons. First, it appears to me that the Trustee’s argument does not give full
weight to the phrase “any ‘stress test’ … in respect of the [Tier 1] Ratio”. I
accept that, under the new Regulations introduced in 2013, the ECNs could be
taken into account in a “stress test”, and I accept that there could be
circumstances in which the ECNs could convert into ordinary shares so as to
become part of Tier 1 capital. However, if and when a stress test is applied to
see if LBG satisfies the Tier 1 Ratio, it appears to me that the vital point is
that, under the Regulations introduced in 2013, the ECNs cannot be taken into
account so as to do the very job for which their convertibility was plainly
designed, namely to enable them to be converted before the regulatory minimum
Tier 1 Ratio is reached. That, to my mind, is what the expression “taken into
account … for the purposes of any ‘stress test’ … in respect of the [Tier 1]
Ratio” is concerned with.
46.
Secondly, the question which has to be asked under para (2) of the
Definition is whether the ECNs have “cease[d] to be taken into account” for the
specified purpose. This is in marked contrast with the wording of para (1) of
the Definition, where the question is whether the ECNs are “no longer … eligible
to qualify” for the purpose specified in that paragraph. It seems to me that
eligibility to qualify depends on what the Regulations say, whereas being taken
into account depends more on what happens in practice - no doubt pursuant to
the Regulations. That view is reinforced by the fact that para (1) is based
simply on the requirements of “Regulatory Capital Requirements”, whereas para
(2) is also based on “any changes to the Regulatory Capital Requirements or any
change in the interpretation or application thereof”. It seems to me that the
way on which the Trustee puts its case, as summarised in para 44 above, is
ultimately concerned with the eligibility of the ECNs for the purpose described
in para (2) of the Definition, whereas LBG can fairly rely on the fact that the
ECNs were not, as a matter of fact (and it does not signify whether it was due
to the terms of the 2013 Regulations, or the PRA’s application of those
Regulations) invoked for the purpose described in para (2) - see para 24 above.
47.
Thirdly, if the Trustee’s interpretation is correct, it is very
difficult to envisage circumstances in which it could have been thought that
para (2) of the Definition could ever be invoked. The notion that fully paid up
share capital could ever be excluded from the definition of Tier 1 Capital
(whether CT1, CET1, adjusted CET1 or any other possible definition) seems
fanciful. Accordingly, it is hard to see how the parties could have envisaged
that a Coco, ie a loan note which automatically converted into paid-up share
capital, could be excluded, in the sense that the Trustee’s case requires, from
being “taken into account … for the purposes of any ‘stress test’ … in respect
of the [Tier 1] Ratio”.
48.
While some of them are not without force, the arguments which have been
raised against LBG’s case do not persuade me the other way. There is, I accept,
some force in the point that, if LBG’s reading of para (2) of the Definition is
correct, it must have been foreseeable when the ECNs were issued that a CDE
would be likely to occur in the not-too-distant future. That is because it was
well known that the capital requirements of financial institutions were to be
strengthened (see paras 5 to 7 above), and so, runs the argument, it must have
been appreciated that the minimum permitted Tier 1 Ratio was likely to go above
the equivalent of a CT1 ratio of 5%. There are, however, two answers to this
point. First, it was by no means certain that the increased capital
requirements would involve increasing the minimum Tier 1 Ratio above the
equivalent of a CT1 ratio of 5%. Apart from anything else, the new requirements
could have retained or only slightly increased this minimum, while introducing
a new intermediate tier between what was CT1 and Upper Tier 2: that that is not
a fanciful possibility is demonstrated by the actual introduction of the new
concept of AT1 Capital (see para 17 above). Quite apart from this, the notion
that it must have been perceived as likely that the ECNs would be redeemable
well before their respective maturity dates is not a particularly surprising
proposition, especially as clause 8(e) operated not as an automatic redemption,
but merely gave rise to an option in LBG to redeem.
49.
The expression “Capital Disqualification Event” does not strike me as an
inapt description of what has happened on LBG’s case. Thus, the effect of the
change in the Regulations in 2013 and the application of those changed
Regulations in 2014 can fairly be said to have “disqualified” the ECNs from having
the potentially saving effect on the Tier 1 Ratio which they were intended to
have, and could properly have had under the Regulations as they stood in 2009.
50.
The argument that the 2013 Regulations have not made any difference
because the ECNs might not have ensured that LBG had a sufficiently high Tier 1
Ratio even under the 2009 Regulations appears to me to involve a
mischaracterisation of LBG’s case. That case is not that the convertibility of
the ECNs could be guaranteed to save the day under the 2009 Regulations. It is
that their convertibility could be invoked to increase the Tier 1 Ratio before
that ratio had fallen below the minimum under the 2009 Regulations of a CT1 Capital
ratio of 4%. Thus, in 2009, the convertibility of the ECNs had the ability to
enable LBG to keep above the minimum Tier 1 Ratio, whereas that was no longer
possible under the 2013 Regulations. The force of the point is underlined by
the PRA’s requirement in 2013 that the Tier 1 Ratio conversion trigger for any
qualifying Cocos should be at least 5.125% (see paras 17 and 19 above).
51.
I am also unimpressed with the point that, on LBG’s argument, the ECNs
may be redeemed under clause 8(e) because they have “cease[d] to be taken into
account” on one stress test (as in 2014), notwithstanding that they might have
been taken into account on a subsequent stress test. Such a possibility is
inherent in para (2) of the Definition, whatever meaning one gives it. Thus, if
para (2) is simply concerned with the ECNs’ eligibility to convert into Tier 1
Capital, as the Trustee contends, and the Regulations were changed to provide
that they could no longer do so (highly improbable to say the least, as already
pointed out), it could always be said that the Regulations might change back.
52.
It is said that LBG’s case leads to arbitrary results, as it may depend
on the practices and assumptions of the PRA when applying a particular stress
test or set of stress tests. There are two answers to that. The first is that,
on the facts of this case, that is not a fair charge: given that the minimum
Tier 1 Ratio has changed so that the ECNs cannot convert to Tier 1 capital
until that capital has fallen below, indeed substantially below, the
permissible minimum as a result of the changes effected by the 2013 Regulations,
para (2) of the Definition applies. Quite apart from that, given the reference
to the “application” of the Regulations “by the FSA … for the purposes of any
‘stress test’ applied by the FSA”, it is inherent in para (2) that the PRA’s
practices could determine whether the paragraph is satisfied.
53.
Finally, there is also some force in the argument that the wording of
para (2) of the Definition is not wholly clear and that, in the event of doubt,
it should be construed against LBG, as the person responsible for drafting the
Trust Deed, the proferens. The closing words “in respect of the … Tier 1
Ratio” are inherently imprecise: identifying the precise ambit of the
expression “in respect of” frequently leads to arguments. However, the contra
proferentem rule is very much a last refuge, almost an admission of defeat,
when it comes to construing a document, and, in this case, for the reasons
which I have attempted to give in paras 45-52 above, I do not think that it is
necessary, or indeed appropriate, to resort to it in this case.
Conclusion
54.
Accordingly, I would dismiss the Trustee’s appeal, on the basis that I
consider that a Capital Disqualification Event has arisen under para (2) of the
Definition of that expression in clause 19 of the T&Cs.
LORD SUMPTION: (dissenting) (with whom Lord Clarke
agrees)
55.
This case is of considerable financial importance to the parties but
raises no questions of wider legal significance. There is therefore no point in
dissenting at any length. But since I would have held that that these
securities are not redeemable, I should, however briefly, explain why.
56.
The notes are contingent share capital. Their immediate purpose as far
as Lloyds Banking Group was concerned was to enable it to satisfy the FSA at
the time of their issue that it would have a ratio of Consolidated Core Tier 1
Capital to risk-weighted assets of at least 4% in a hypothetical stressed
scenario. Consolidated Core Tier 1 Capital included ordinary shares but not
loan notes. The issue of these notes did not therefore actually strengthen the
Bank’s Tier 1 Capital. But because they would automatically convert to ordinary
shares if in the hypothetical stress scenario the ratio fell to within one
percentage point above the then minimum, they assisted the Bank to satisfy its
regulators. The effect of the subsequent regulatory changes was that the
definition of top tier capital was tightened up and the required ratio of
adjusted top tier capital (“Common Equity Tier 1”) to risk weighted assets was
increased to 7%. This meant that the notes were no longer as useful to the
Bank, because if its affairs deteriorated it would fail a stress test long
before the trigger for conversion was reached. From the investors’ point of
view, however, that did not matter, provided that the Bank remained solvent.
The attraction of the notes for them lay in their long maturity date and high
coupon, both features that were critical to their market value.
57.
The notes are redeemable if as a result of regulatory changes they
“cease to be taken into account” for the purposes of any stress test in respect
of the Consolidated Core Tier 1 Ratio (for which, now read the Common Equity
Tier 1 Capital ratio). The question is whether being “taken into account” means
(i) that in the hypothetical stress scenario they would convert and play a part
in enabling the Bank to pass the stress test; or (ii) that they must be
eligible, in the sense that notwithstanding their status as Lower Tier 2 Capital
the regulator would treat them as top tier capital in the hypothetical event of
the Bank’s affairs deteriorating to the point where the conversion trigger was
attained, so that the stress scenario can be modelled on that basis. The
difference is that (i) depends on how the Bank fared in an actual stress test,
whereas (ii) turns on the regulator’s rules and practices for conducting such
tests.
58.
Sir Terence Etherton concluded that (ii) was correct, because the
definition “is not looking at the happenstance of the particular strength of
LBG’s capital and the particular composition of its capital at any one
particular moment of time in the context of a particular stress test imposed by
the regulator at that time”, but at the position as a matter of principle (para
46). I think that he was right.
59.
In the first place, it was always implicit in the terms that the notes
might be irrelevant to the Bank’s ability to pass a stress test. Whether or not
there were changes to the regulatory capital requirements, the Bank’s capital
position might be strong enough to meet the minimum top tier capital ratio even
if the notes did not convert. Or it might be so weak that the notes would not
save the situation even if they did convert. If the notes would not necessarily
play a part in enabling the Bank to pass a stress test in the situation
obtaining when they were issued, I cannot see why it should be supposed that
the parties intended to allow early redemption if the same situation obtained
as a result of a change in regulatory capital requirements. The situation
introduced by such a change is no different in principle from the situation
that existed before. The change might make it more or less likely that the
notes would be critical to the outcome of a stress test, but there is no change
in the way that the scheme works.
60.
Secondly, a test dependent on how the notes affected the outcome of an
actual stress test would be wholly uncertain. Stress testing is not a fixed or
ascertainable concept. Its outcome will depend not just on the rules and
practises of the regulator, but on what the hypothetical conditions assumed in
a particular stress test are, on where the regulator pitches the stress test
hurdle (not necessarily the same as the minimum regulatory top tier capital
ratio), and what is the value and composition of the Bank’s assets at the time
of the test. Moreover the hypothetical stress scenario will test the strength
of the Bank’s capital over a substantial period of time, during which it may
fail the test throughout or for a day or two. The significance of that will be
a question of regulatory judgment. It is not just a simple question of pass or
fail. Of course, the regulatory changes which actually occurred mean that the
notes will in practice make little difference to the outcome on any reasonably
foreseeable view about these matters. But although it was anticipated that
there would be a tightening of the capital adequacy requirements, the details
were not known at the time that the securities were issued, and the terms
cannot be construed in the light of the subsequent changes.
61.
Thirdly, nothing in the definition of a “Capital Disqualification Event”
supports the suggestion that it was intended to depend on the part played by
the notes in enabling the Bank to pass an actual stress. The clause’s title is
concerned with “disqualification”, ie with a state of affairs in which the
notes are no longer eligible in principle to perform their function as contingent
capital. As regards Lower Tier 2 Capital, dealt with in sub-clause (1), this is
clear from the reference to capital being “eligible to qualify”. The only
reason why the word “eligible” is not used in sub-clause (2) of the definition,
dealing with top tier capital, is that whereas the status of Lower Tier 2 Capital
depends simply on whether it satisfies the relevant regulations, the status of
top tier capital depends on the practices and judgments of regulators as well,
a context in which it was appropriate to speak of the securities being taken
into account, rather than being eligible.
62.
These were long-dated securities, which cannot have been intended to be
redeemed early except in some extreme event undermining their intended function
and requiring their replacement with some other form of capital. The function
of the notes was to be available to boost the Bank’s top tier capital in the
hypothetical event that the ratio of top tier capital to risk-weighted assets
fell below the conversion trigger. They have always served that function and
still do. Whether that function remains as important to the Bank as it was in
2009 is irrelevant.
