Royal Bank of Scotland Plc v Highland Financial Partners LP & Ors

This application raises two short one-off points of construction on agreements entered into in respect of a proposed collateralised debt obligation (CDO) which did not close by the issue of securities because of the collapse of the financial markets in the latter part of 2008. The claimants who are the respondents in the appeal (RBS) claim from a group of companies, the appellants in the appeal (Highland), a shortfall of approximately €40m between the realised value of the portfolio of loans acquired for the CDO and the outstanding amount of the financing made by RBS for the acquisition of those loans. RBS’s entitlement turns on the construction of the agreements. The exact quantum of the recovery, if RBS is right on the points of construction, is due to be heard at a trial in the Commercial Court in September 2010.

The transaction originated in 2006. Between December 2006 and April 2007, RBS entered into three agreements with companies in the Highland Group, a US financial group, under which it agreed it (1) would act as adviser to Highland for the issue of securities by a Special Purpose Vehicle (SPV) to be managed by the Highland Group in respect of a CDO transaction of €400-500m and (2) would arrange financing to enable the SPV to buy the loans which would form the basis of the CDO when the issue of securities was offered. For the purposes of this application, it is not necessary to distinguish between the various companies within the Highland Group or to describe the role of another bank that was party to the agreements as that role is immaterial to the dispute.

It was common ground that the three agreements, which were subsequently varied in October 2007 and March and April 2008 as I shall explain, should be read and construed together:

The Mandate Letter. This was made between RBS and a Highland company and dated 18 December 2006. It set out an outline of the overall scheme, including the arrangement of financing for the purchase of the portfolio of loans under what was described as a warehouse facility. The financing was provided by RBS through the €400m Variable Funding Note Purchase Agreement described in the next sub-paragraph. The loans would be held in the warehouse until closing which would occur on the issue of the securities. The commercial significance of the Mandate Letter to the points of construction in this appeal was that it appointed RBS to act as “adviser” for the transaction and placement agent for the offering on issue; as placement agent RBS would earn significant fees. The agreement provided that a Highland company would act as the “servicer”, in effect the manager of the loans that were to be acquired. The Mandate Letter is central to the dispute as clause 6 not only provided for termination of the agreement contained in the Mandate Letter on closing of the offer of securities with a long stop automatic termination date of 30 September 2007, but gave both RBS and the Highland company the right to terminate the agreement by notice at any time.

The €400m Variable Funding Note Purchase Agreement. This was entered into between the Highland SPV (which was to be the Issuer of the securities on closing) and RBS on 5 April 2007 to provide finance during the warehousing period. Under this agreement RBS agreed to provide a facility of up to €400m to the SPV Issuer under a note so the SPV Issuer could buy loans to be warehoused pending the issue. The agreement contained detailed provisions as to the terms of the note which could be sold or transferred by RBS. Clause 5 provided for the SPV’s obligation to repay in the ordinary course of anticipated events primarily from the proceeds of the issue; there was a final date for repayment on the day prior to the long stop date of 30 September 2007. Apart from the provisions for repayment in the ordinary course of anticipated events in Clause 5, the significance of this agreement is that RBS (or a note holder to whom the note had been assigned) could only demand repayment earlier if there was a specified “event of default” under Clause 9 of that agreement (which included by Clause 9(n) of that agreement an “Interim Servicer Event of Default” under the agreement referred to in the next sub-paragraph – the Interim Servicing Deed). It is also important to note that the obligation to repay was limited to the assets of the SPV Issuer, RBS having its security by various charges over the assets acquired by the Issuer.

The Interim Servicing Deed. This was also made on 5 April 2007 between various Highland companies and RBS and set out the role of the Interim Servicer. The Interim Servicer was another Highland company appointed by the SPV Issuer to perform a number of duties, but primarily to select the loans to be acquired during the warehouse period. RBS agreed to make advances for the acquisition of loans subject to various conditions, including compliance with eligibility criteria and a veto by RBS over any proposed loan. The importance of this agreement to the points of construction is the provision in Clause 1 (the definition clause) which set out the definition of “Termination Date” and the provisions in Clause 5 as to the obligations of Highland companies consequent upon the occurrence of the Termination Date. If the Termination Date occurred prior to the closing, the clauses of the agreements operated so that (1) RBS could call for the repayment of the advances made under the Variable Funding Note Purchase Agreement, (2) the loans in the warehouse facility were realised and (3) under clause 5.6 the Highland companies were obliged to pay RBS any shortfall between the sums obtained from the realisation of the loans and the outstanding amount of the financing advanced by RBS. The definition of the “Termination Date” provided that the long stop termination date was the same as in the other agreements, namely 30 September 2007 but there were provisions for the Termination Date to occur on other events including:

After the making of these agreements, RBS advanced €240m to the SPV Issuer to purchase loans. However, during 2007 the financial markets deteriorated. It became clear that the issue could not be closed by the long stop date of 30 September 2007, but there remained an expectation that the issue would still proceed. Therefore two amending agreements were made by agreements dated 31 October 2007.

The First Loss Deposit Facility Deed. This was made between RBS and various Highland companies. The Highland companies agreed to pay RBS €7.5m as cash collateral to secure their obligations under the Interim Servicing Deed and another Highland company agreed to guarantee the liabilities of other Highland companies under clause 5.6 of the Interim Servicing Deed.

A First Amendment Deed. This was made between RBS, the SPV Issuer and various Highland companies. It extended the long stop date of the Interim Servicing Deed and the Variable Funding Note Purchase Agreement to 28 February 2008. Among other amendments, it also amended the definition of an Interim Servicer Event of Default to which I referred at sub-paragraph iii) so that in place of an overall decline of 2.25% in market value of the loans that particular event would occur only if the difference between the purchase price of the loans and their market value plus the collateral was greater than €2m, subject to the right of Highland to post additional collateral.

On 25 March 2008, RBS and Highland executed an amended and re-stated Mandate Letter. The amendments are immaterial. It is of importance to note that the Mandate Letter remained terminable by either party on notice at any time.

On 1 April 2008 the arrangements that had been made in April 2007 and amended in October 2007 were amended by a Second Amendment Deed between RBS, the SPV Issuer and Highland companies. Under this, the First Loss Deposit Facility Deed was amended to require Highland to pay further cash collateral to secure their obligations totalling €35m, payable in instalments ending on 30 June 2008. An amendment was made to the definition of the Interim Servicer Event of Default, so that the provision in respect of market decline was replaced by a provision requiring a breach by Highland. The Variable Funding Note Purchase Agreement was amended in a number of respects; no further loans were to be purchased; the rate of interest payable by the Issuer SPV was increased; the long stop date was extended to the next due date for payment of the collateral and after the last payment to 31 January 2009.

In September 2008 the financial markets went into crisis, marked particularly by the collapse of Lehman Brothers and other banks. This had a severe effect on CDO transactions. By October 2008 this proposed CDO transaction showed such a significant decline that it was clear to RBS that there would be no closure by the issue of securities under it.

On 30 October 2008 RBS served a written notice of termination on the Highland company which was party to the Mandate Letter terminating that agreement. It was RBS’s contention that that was an event which was a Termination Date under the Interim Servicing Deed under the provisions to which I have referred; that in consequence, loans could be realised and, as it was prior to the closing, Highland was obliged to pay the shortfall. It is not necessary to set out any of the details in relation to the realisation or the dispute in relation to it or the extent of any liability of the Highland companies, as these matters are to be determined in the Commercial Court, if RBS are correct in their contention that the termination of the Mandate Letter was a Termination Date under the Interim Servicing Deed.

As Highland disputed RBS’s contention, RBS commenced proceedings on 11 May 2009. RBS then made an application for summary judgment under Part 24 which was heard by Burton J. In the course of that hearing five points were raised as set out in paragraph 9 of Burton J’s judgment of 10 February 2010. Each was decided in favour of RBS. He refused permission to appeal.

Highland sought permission to appeal; the application was adjourned for hearing to the Full Court with the appeal to follow if permission was granted. On the appeal Highland pursued one of the points that had been determined by Burton J (set out in paragraph 9(ii) and 20-28 of his judgment) and raised a new point. It is not therefore necessary to refer to most of the judgment of Burton J, as it is accepted that he was plainly right on four of the five points. Before turning to the one point decided by him which is the subject of the appeal, it is convenient to consider the new point, as that new point sets the context in which the point decided by Burton J can be seen.

Mr Raymond Cox QC’s submissions began with reference to the principles of construction recently reconsidered by the House of Lords in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38 [2009] 1 AC 1101 and by the Supreme Court in Re Sigma Finance Corporation [2009] UKSC 2. In Chartbrook Lord Hoffmann set out the principles applicable where the drafting had been careless or a mistake made. In Sigma the court emphasised the need to construe an agreement which was part of a series of agreements by taking into account the overall scheme of the agreements and reading sentences and phrases in the context of that overall scheme. As a mistake was made in the drafting of the Termination Date and as the agreements were part of an overall scheme, I have approached the construction of the agreements in accordance with the principles set out in these two decisions.

It was the contention of Highland, elegantly advanced by Mr Raymond Cox QC, that if the overall scheme of the transaction was considered, the parties cannot have intended RBS to have the right, by terminating the Mandate Letter, to terminate the arrangements for financing under the Interim Servicing Deed and the Funding Note Purchase Agreement. Although it was not disputed that the Mandate Letter could be terminated at any time on notice, RBS had given a commitment in the other two agreements to provide funding for the purchase of loans and that repayment of the financing could only be demanded either in accordance with the provisions of the agreement for termination in the ordinary course of events or the provisions which set out defined events of default (to which I have referred in paragraph ii) above).

Thus when the Interim Servicing Deed provided in the definition of Termination Date that the termination of the Mandate Letter could be an event that terminated the Interim Servicing Deed, the ungrammatical clause must have meant that it was only termination of the Mandate Letter by the Highland company and not by RBS which entitled RBS to give notice terminating the Interim Servicing Deed. The clause should therefore read (with the amendments shown in bold):

If the clause was not given this construction, then in effect Highland had what was an “on demand facility” and the protections and details of the Variable Funding Note Purchase Agreement and the Interim Servicing Deed which set out the circumstances in which the repayment of financing could be required were no protection; they were simply otiose, as RBS could terminate the overall arrangement at any time by terminating the Mandate Letter. Nothing in either the Interim Servicing Deed or the Funding Note Purchase Agreement made the financing repayable or terminable at will. Furthermore, if the Mandate Letter was terminated, it would have no effect upon the Interim Servicing Deed or the Funding Note Purchase Agreement, as RBS would have its protection under those agreements and a new adviser would have to be found to perform the functions of RBS under the Mandate Letter, principally the function of advising and acting as placement agent for the offering under the issue.

In my view this argument cannot succeed. It is clear that RBS’s role under the Mandate Letter was a central part of the overall scheme; there was a very significant benefit to RBS in being the adviser and placement agent. In the latter capacity, it would no doubt if the issue had proceeded to an offer have earned significant fees; looking at the transaction overall a major element in the scheme was that benefit to RBS. If RBS was not going to be able to place the securities (if market conditions collapsed) or if for some other reason it was not to be the placement agent, then from RBS’s point of view a very significant part of the rationale of the overall scheme had gone. Thus in the context of the overall scheme, a provision entitling RBS to terminate the Interim Servicing Deed if it terminated the Mandate Letter fitted in with the commercial purpose of the overall arrangements.

There was, it is plain, a mistake in the language of the Termination Date definition, but that error was one that could be cured by substituting the word “notice” for the word “which”. This is simply the correcting of what was no doubt a typographical error. If the additional words Highland suggested were written in to the definition, then the effect would be to restrict the right of termination to circumstances where it was only the Interim Servicer’s termination of the Mandate Letter that gave rise to the right to give notice to terminate the Interim Servicing Deed. The additional words suggested by Highland would change the meaning completely.

Should the insertion of those additional words be made as part of the construction of the overall scheme of the agreements? In my view the clear answer is No.

First the language of the definition of the “Termination Date”, with the correction of the typographical error by the substitution of the word “notice” for “which”, is clear; it was not disputed that on the ordinary reading of the clause in those terms, the termination by RBS of the Mandate Letter and the provision of notice of that was a Termination Date.

Second the argument could not be made that, without the insertion, the agreements made did not reflect the commercial sense of the overall scheme. With the correction of the typographical error, the clause mirrored the commercial purpose of the arrangements. It is clear that RBS had a number of different commercial interests in the overall agreement; one of these was to earn fees through lending and another was to earn fees through the placement of the issue. If there was no prospect of it earning fees on the placement of the issue, then it lost a significant commercial benefit. It made good commercial sense to enable it to terminate the other parts of the agreement.

I therefore conclude that the wording of the agreement corrected by substituting “notice” for “which”, which is simply the correction of a minor typographical error, gives effect to the wording of the termination clause and also to the overall scheme of the agreement. I therefore reject Highland’s argument. It is a striking fact that Highland did not raise this argument at any time until the skeleton arguments served for this appeal. If the overall scheme of the agreement had been as was contended by Highland, this surely would have been a point that would immediately have been taken. The fact that it was not shows that the overall scheme of the arrangements was as I have described them and that it was always intended that if RBS terminated the Mandate Letter it would result in the termination of the other parts of the arrangement.

The argument put forward on behalf of Highland on the second point was in two parts; the first was new and the second that advanced as point (ii) before Burton J. The new argument advanced to us was that even if Highland’s construction of the Termination Date was wrong, RBS was not entitled to terminate the Interim Servicing Deed, because it had in the Second Amendment Deed given up the right to terminate the Interim Servicing Deed if it gave notice terminating the Mandate Letter. That was because, when the parties agreed in April 2008 to provide €32.375m by way of further collateral and the long stop was extended to 31 January 2009, there would have been no commercial sense in providing additional collateral, if after that agreement RBS could have brought about a Termination Date under the Interim Servicing Deed at any time by terminating the Mandate Letter. In effect Highland would have paid the further sum for nothing. The second argument (which was that put to Burton J) was that the agreement in the Second Amendment Deed for the replacement of the provision under which an Interim Servicer Event of Default was a decline in the market value of the loans by a provision which provided there had to be a breach by Highland, would also be rendered nugatory, if in the event of a decline in the market value of the loans, RBS was entitled to bring about a Termination Date by terminating the Mandate Letter. It was therefore necessary to construe the agreement to prevent an inconsistency which would arise if RBS could terminate the other arrangements by terminating the Mandate Letter.

Clause 3.2 of the Second Amendment Deed provided for inconsistency:

Burton J described the part of the argument advanced before him as “not an easy one” for Mr Raymond Cox QC. He considered that there was no inconsistency in the provisions; the fact that termination in the event of a decline in the market was removed did not mean there was an inconsistency with the right to terminate if the Mandate Letter was terminated.

The judge was right; his reasoning applies to both arguments. There are no provisions of the Second Amendment Deed which are inconsistent with any of the documents listed in Clause 3.2. The provisions of the Second Amendment Deed operate and can be made to operate consistently with the Termination Date definition as actually written, subject to the typographical error to which I have referred. What Highland seeks to do in both parts of its argument is, under the guise of a commercial rationale put forward, to rewrite the agreement. However, even if it was possible to do so, there is no commercial merit in the argument put forward. It is clear that what Highland did in putting forward further collateral was to obtain in April 2008, prior to the financial crisis, more time in which to proceed with the issue of securities. For that, given market conditions, they had to provide further collateral. But none of that affected the right of RBS under the Mandate Letter to terminate that Letter with the consequent effect on the Interim Servicing Deed and the Funding Note Purchase Agreement in circumstances where RBS would not be able to benefit from acting as arranger under the Mandate Letter. That became clear to RBS when it was obvious that there would be no issue of securities.

For those reasons, therefore, I consider the construction of the agreements put forward by RBS to be correct. The judge was right in granting summary judgment under Part 24. In view of the fact we heard full argument from Mr Raymond Cox QC, I would grant permission on both points argued by him, but dismiss the appeal, as the points on examination have no merit.

I agree.

I also agree.