Financial List signposts tough road for contractual construction

Published on 26 May 2016

A recent decision in the High Court (Hayfin v Windermere VII CMBS), one of the first from the Financial List, has demonstrated a strict approach to contractual construction and interpretation in relation to negotiated documentation for financial traded instruments. It also shows the potential of the Financial List to provide helpful and clear guidance on the application of existing case law in the context of financial markets.


In one of the early decisions handed down by the recently established Financial List in Hayfin v Windermere VII CMBS, Mr Justice Snowden has firmly disposed of a detailed case regarding construction of complex documents in a Commercial Mortgage-Backed Securitisation (CMBS) structure.The judgment shows a concerted effort to apply the relevant cited authorities, including numerous recent decisions from the Supreme Court, to the particularities of cases relating to financial traded instrument. 

The judgment demonstrates a strict approach to contractual construction and interpretation in cases concerning financial traded instruments, which invariably involve highly negotiated documents. It serves as a clear reminder that the courts will not be willing to "refashion" negotiated deals with the benefit of hindsight to assist the unwise or penalise the astute.

Factual Background

The decision relates to an expedited trial of 7 issues in a Part 8 claim, all concerning questions of interpretation and construction in order to determine the rights attaching, and correct computation of payments to be made, to the holder of the "Class X Note" within the CMBS structure.

The CMBS structure in this case was Windermere VII, which was arranged in 2006 by Lehman Brothers (Europe) Limited (LBIE). The Claimants are the current holder of the Class X Note, and the Defendants to the claim included (i) Winderemere VII CMBS plc (the "Issuer"), (ii) US Bank Trustees Limited (the "Note Trustee"), and (iii) Elavon Financial Services Limited (the "Cash Manager").  The parties had cooperated to get the trial heard urgently, in order to obtain determination prior to the maturity date for the Class X Note on 22 April 2016.

The Windermere VII CMBS structure included the issue of eight series of notes with an aggregate nominal amount of €782,500,000 (the "Notes"). All of the seven classes of Notes except the Class X Note (collectively the "Regular Notes") had principal amounts running into millions of euros and provided for interest at a floating rate of 3 month EURIBOR plus margin (ranging between 0.13% and 3.40% depending on the Regular Note's series). 

In contrast, the Class X Note had a nominal value of only €50,000 and did not pay a rate of interest in a conventional sense. It was envisaged that the Class X Note would receive the excess interest (if any) in the relevant interest period which the Issuer may receive from the underlying commercial mortgages which were subject to the securitisation. This equated to any interest received by the Issuer from those mortgages over and above amounts which were required for payment of the costs and fees for the CMBS structure, and interest payable on the Regular Notes.  

The funds raised by the issue of the Regular Notes were used to purchase interests in a number of commercial European mortgage loans to numerous borrowers (the Mortgage Loans and the Borrowers). All of these were securitised by way of the CMBS except for the Mortgage Loans relating to three Borrowers, which were tranched into "senior" or "junior" loans, the former of which was transferred to the Issuer and securitised, the latter was sold on to other lender(s).

The Nordostpark Mortgage Loan

Within the Mortgaged Loans securitised by the CMBS was part of a loan made by Lehman Brothers Bankhaus AG in August 2005 for the acquisition of a commercial property in Nuremberg, Germany (the "Nordostpark Mortgage Loan"). The Nordostpark Mortgage Loan was due for repayment by the borrower (the "Nordostpark Borrower") on 15 October 2012.

The Issuer had acquired and securitised the senior tranche of the lending to the Nordostpark Borrower, which comprised around €55.5 million (the "Senior Loan"). The junior tranche of lending to the Nordostpark Borrower (€15 million) was sold by Lehman Brothers Bankhaus AG to other entities (the "Junior Lenders").  The relationship between the Issuer and the Junior Lenders was governed by an intercreditor deed (the "Nordostpark Intercreditor").

Pre-default interest payable by the Nordostpark Borrower under the Nordostpark Mortgage Loan was fixed (at a fixed rate of 2.9975% per annum plus a margin of 1.45% per annum plus a further additional "mandatory cost"). The default interest provisions under the Nordostpark Mortgage Loan provided that interest on the overdue amount would accrue from the due date up the date of payment at (i) 1% per annum above the rate which would have been payable if the overdue amount had constituted a loan in the period of non-payment, and (ii) 1% per annum above the aggregate of the applicable margin, mandatory costs and EURIBOR for that period.

The terms of the Notes exposed the Issuer to EURIBOR fluctuations, whereas the pre-default interest under the Nordostpark Mortgage Loan was fixed. The Issuer entered into a swap agreement to provide a hedge in respect of the fixed rate element of the pre-default interest under the Nordostpark Mortgage Loan (2.9975%) (the "Swap Agreement"); it did not enter into a hedge in respect of the fixed margin on the pre-default interest rate. The benefit of the Swap Agreement was shared with the Junior Lenders. It was due to expire a week after maturity of the Nordostpark Mortgage Loan.

Nordostpark Default and Subsequent events

The Nordostpark Borrower ran into financial difficulties towards the end of the Nordostpark Mortgage Loan.  A "special servicer" was appointed to take over management and administration of the Nordostpark Mortgage Loan on 21 November 2011. Two critical events then occurred:

  1. The principal due on the Nordostpark Mortgage Loan was not repaid at maturity on 15 October 2012, constituting an event of default pursuant to the underlying facility agreement; and
  2. The following week the Swap Agreement expired and was not replaced. By that time, 3 month EURIBOR had dropped to 0.2% (a significant drop since the applicable rate at the time when the Swap Agreement had been transferred to the Issuer, at which time it had been around 2.89%).

January to October 2015

The CMBS structure remained in this position for several years. By the quarterly interest payment date in January 2015 (the "January 2015 Payment Date"), of the original Mortgage Loans only three remained subject to the CMBS. These were (i) the Nordostpark  Mortgage Loan, (ii) the "Adductor Mortgage Loan", and (iii) the "Mülheim Mortgage Loan".

By this time, the Class X Note had been sold by LBIE, and the principal on the Class X Note had been repaid. On the January 2015 Payment Date the holder of the Class X Note received €474,052.01 in respect of the "Class X Interest Amount" (as defined in the CMBS documents).

In April 2015 both tranches of the Nordostpark Mortgage Loan were sold to a third party.  By the quarterly interest payment date in October 2015 only the Adductor and Mülheim Mortgage Loans remained within the CMBS structure. In July 2015, the Claimants purchased the Class X Note.

At around that time, €1,843,664.10 of unpaid interest on the Adductor Mortgage Loan was capitalised. Calculations by the Issuer showed that this resulted in an overall reduction of €2,235,314.29 to interest due and payable to the Issuer that quarter. The inference was that without the capitalisation, the amount of interest due and payable to the Issuer on the October 2015 interest payment date would have been €4,078,978.39.

The Issuer based the October 2015 calculations for interest on the Class X Notes on the lower amount of interest which remained due and payable on the Adductor Mortgage Loan, which resulted in a zero interest payment for the Class X Note that quarter.  Had the larger amount been applied, on the Issuer's numbers the Class X Note would have received around €331,000.  On the Claimants' slightly different numbers, this would have been around €525,000.

Construction Issue 1: The meaning of Senior Rate and Junior Rate

The first issue to be determined concerned the construction of the Nordostpark Intercreditor. The Nordostpark Intercreditor set out how receipts under the Nordostpark Mortgage Loan should be shared between the Issuer and Junior Lenders.  In short, in terms of interest the Nordostpark Intercreditor provided that the Issuer and the Junior Lenders would be entitled (both pre and post default) to interest at the "Senior Rate" and "Junior Rate" respectively. The definitions of the Senior and Junior Rate both:

  1. Included a share of the fixed margin of interest (1.45%) payable by the Nordostpark Borrower; and
  2. Provided for a simple EURIBOR component to the aggregate rate (in each case as limb (b) of the each definition of the rate).

This simple reference to EURIBOR did not pose any problem while the Swap Agreement remained in place, on the basis that the fixed interest components being paid by the Nordostpark Borrower were being swapped for the prevailing EURIBOR rate before being applied in the intercreditor waterfall. However, after expiry of the Swap Agreement, these definitions of Senior and Junior Rates created a mismatch between (i) the higher fixed rate component payable by the Nordostpark Borrower under the Nordostpark Mortgage Loan, and (ii) the division of interest monies between the Issuer Junior Lenders which were calculated by reference to the lower floating rate. The Claimants submitted that this mismatch resulted in a build-up of surplus interest which was being paid by the Nordostpark Borrower but was incapable of distribution to the Issuer and Junior Lenders under the Nordostpark Intercreditor.

The Claimants invited the Court to therefore interpret the Nordostpark Intercreditor so as to "corrected by construction" (in the manner described by Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd [1]) the language to eliminate the mismatch in the event that the Swap Agreement had fallen away. The Claimants proposed to amend the simple reference to EURIBOR in the definitions of both Senior and Junior Rate to be read as:

"EURIBOR or (where no Hedging Arrangement remains in place) the Fixed Rate or (following an Event of Default where no hedging Arrangement remains in place), the higher of EURIBOR and the Fixed Rate."

The court was not persuaded that the clause ought to be interpreted in any way other than the express terms which had been drafted, and held that no correction by construction should be made.

The judgment sets out a helpful analysis of case law on contractual interpretation as provided by Supreme Court in the recent decisions of Marks and Spencer PLC v BNP Paribas Securities Services Trust Co (Jersey)  [2], and Arnold v Britton. [3]

The judgment also makes particular reference to which of the factors to consider are of most relevance in cases of contractual interpretation of documents which form part of the structure underpinning tradable financial instruments, noting that in such cases "there is a premium to be placed upon the language actually used in the instrument." The judgment observes that for cases involving traded financial instruments "the permissible use of the background facts known or reasonably available to both contracting parties" is "far less relevant than in the case of a bilateral contract."

The court concluded the analysis confirming that the test for permitting contracts to be interpreted otherwise than in the terms in which they are written is strict, and it will not suffice to show that the addition of words would be reasonable in the circumstances.  The addition of words must be necessary "because the agreement is incomplete or commercially incoherent without them". The court was also persuaded by the Issuer's submissions that the Nordostpark Intercreditor did provide contractual provisions by which the treatment of any surplus interest created by the mismatch could be decided upon and distributed, and it held that it is preferable to rely on a clause which the parties chose to include to deal with unforeseen events, rather than to refashion the negotiated documents with the benefit of hindsight.

Construction issue 1(1): Default Interest on Nordostpark Mortgage Loan

The court was also invited to determine upon disagreement as to whether the interest due on the Class X Note ought to have been higher to reflect the inclusion of default interest which was payable by the Nordostpark Borrower on the Nordostpark Mortgage Loan.

The Claimants submitted that the amounts payable on the Class X Note are calculated by reference to "Expected Available Interest Collections" (as defined in the conditions for the Notes), which is defined to include the sums payable under the Mortgage Loans assuming "full and timely payment… of interest due and payable" on the Mortgage Loans".

The court preferred the Issuer's interpretation of the calculation provisions, which provided that the definition of "Available Interest Collections" meant that the calculation of sums owing to on the Class X Note cannot be premised entirely on the notional amounts which would be available assuming full and timely payment by the Borrowers. Instead it was necessary to base the calculations on the amounts which were in fact received by the Issuer in the relevant transaction account. The Court held that it seems to be inherent in the basic structure that it is the "nature of the monies received, as seen from the perspective of the Issuer, that will determine whether they fall to be treated as available" for payment to the holder of the Class X Note. Under the Nordostpark Intrecreditor, the Issuer was not entitled to receive default interest paid by the Nordostpark Borrower until after any unpaid interest and principal had been paid to the Issuer and Junior Lenders. The court held that because the waterfall provided that the Issuer would not be entitled to receive the default interest monies, it followed that they not qualify as Expected Available Interest Collections.

Issue 2: Servicing Fees - deductible from Expected Available Interest Collections

The Court was invited to determine as a matter of construction whether sums payable as "Servicing Fees" under the Nordostpark Intercreditor would be included in the calculation of the Expected Available Interest Calculation, which would operate to reduce the amounts payable on the Class X Note commensurately. This included the sums which were payable to the "special servicer" appointed in November 2011.

The Nordostpark Intercreditor provided that, if an event of default had occurred and for so long as it continued, the waterfall prioritised any payments for "fees, costs and expenses of the Agent and any receiver which are then due and payable under the Finance Documents, including any fees, costs or expenses of the … Special Servicer".

For the reasoning applied in relation to the default interest described above, the court determined that the effect of the waterfall meant that the amount paid into the Issuer's transaction account would have been reduced by the amount of any priority payment for Servicing Fees.  Therefore the amount for the Expected Available Interest Collections for the purposes of calculating sums due on the Class X Note should be correspondingly reduced. 

Issues 4 and 5: The effect of capitalisation of interest on the Adductor Mortgage Loan

The next question of construction was whether, for purpose of determining the amount of interest due on the Class X Note in October 2015, the Issuer had been correct to include the effect of the capitalisation of interest on the Adductor Mortgage Loan (which operated to significantly reduce the amounts payable on the Class X Note).

The court held that the Issuer had been correct to reduce the amount of the Expected Available Interest Collections to take account of the capitalisation of interest.  This was because the ability to capitalise interest after it remained unpaid for a year was expressly provided in the Adductor Mortgage Loan. The holders of the Notes therefore must have envisaged that such a power was available to be utilised. The court stated that "if it had been intended that such capitalisation of unpaid interest should not have the result of reducing the amount of the Expected Available Interest Collections or that the computation of such amount should disregard any capitalisation of interest, that could and should have been spelt out the documents. It was not."

Issue 6: Interest on Unpaid Interest

The final question of construction was whether any amounts of historic unpaid interest on the Class X Note should accrue interest at the "Class X Interest Rate" or some other rate (and if so, what rate) until payment. 

In light of the determination of the earlier issues, no amounts were held to be owed and unpaid on the Class X Note. However, the court acceded to the parties' requests to determine this issue given its wider implications in the market.

The Claimants relied on contractual provisions which designate contractual rates of interest in the event of shortfalls in amounts paid to noteholders. However, the Court accepted the Issuer's interpretation of these provisions, holding that the relevant conditions in the Notes are not contractual remedies for miscalculations and resultant underpayments, and do not apply where the parties subsequently discover a mis-declaration and underpayment. Instead the clauses were held to operate as specific mechanisms to address possible cash flow shortages by the Issuer.

The Court observed that this did not leave the noteholder without any remedy in the event of a miscalculation and underpayment; it would be available to the Note Trustee to bring proceedings for breach of contract, under which it would be entitled to claim statutory interest in the ordinary way.


Whilst a disappointing outcome for the Claimants, the robust approach to applications for construction remains consistent with recent case law.  The judgment makes brief reference to the expectations and rewards for Class X Notes in CMBS structures, observing that in this instance the Class X Note Interest rate ranged between around 2,700% and 5,100% or quarter in 2006, and also refers to the general understanding in the market that class X notes could yield significant profits for arranging banks. The judgement is a clear illustration of the appointed judiciary's familiarity with the products in question and the markets in which they operate, and a concerted effort to provide guidance and case law which is tailored to the particularities of the international financial markets.

[1]  Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101 at paragraphs 22-25

[2]Marks and Spencer PLC v BNP Paribas Securities Services Trust Co (Jersey) Ltd [2015] 3 WLR 1843

[3] Arnold (Respondent) v Britton and others (Appellants) [2015] UKSC 36