LBG Capital No. 1 Plc & Anor v BNY Mellon Corporate Trustee Services Ltd

This is an appeal by the defendants, LBG Capital No. 1 Plc and LBG Capital No. 2 Plc (“the Issuers”), two special-purpose companies in the Lloyds Banking Group (“LBG”), against an order made by the Chancellor (“the judge”) dated 3 June 2015. By that order the judge decided against the Issuers on a point of contractual interpretation heard as an expedited Part 8 claim.

The issue, in summary, is whether the Issuers are entitled to redeem, pursuant to their terms, certain contingent convertible securities (Footnote: ¹) known as Enhanced Capital Notes (“ECNs”) issued in 2009, in advance of their respective maturity dates. There are some £3.3 billion worth of ECNs outstanding which carry a high coupon (averaging 10.33%) (Footnote: ²). Such a redemption can take place if a Capital Disqualification Event (“CDE”), as defined in condition 19 (“Condition 19”) of the terms and conditions of the ECNs, has occurred and is continuing.

The claimant, BNY Mellon Corporate Trustee Services Ltd (“the Trustee”), claims as trustee of a trust deed dated 1 December 2009 (“the Trust Deed”) (Footnote: ³), which constituted a programme for the issue from time to time of the ECNs. The terms and conditions to which the ECNs are subject are set out in Part A of schedule 4 to the Trust Deed. The Trustee issued the Part 8 proceedings on 31 March 2015, seeking a declaration as to whether a CDE had occurred. The Issuers contend that a CDE has occurred and that they are accordingly entitled to redeem the ECNs. The Trustee (on behalf of the ECN noteholders) contends that no such CDE has occurred.

In his judgment (Footnote: ⁴) the judge held that no CDE had occurred. That was because, on his view, on the true construction of the ECNs, they had not ceased “to be taken into account for the purposes of any stress test” applied by the Prudential Regulatory Authority (“PRA”) “in respect of” the ratio between LBG’s top-grade loss absorbing capital and its risk-weighted assets. Accordingly, in the judge’s view, the Issuers were not entitled to redeem the ECNs following a stress test conducted by the PRA in December 2014 and must continue to pay the interest due under them. The judge gave permission to the Issuers to appeal against his order.

The appeal was heard on an expedited basis on 26 and 27 August 2015. On the appeal, Mr Robert Miles QC and Mr Gregory Denton-Cox appeared on behalf of the Issuers and Mr Robin Dicker QC and Mr Stephen Robins appeared on behalf of the Trustee.

Following the financial crisis in 2008, banks and other financial institutions were required by regulators to increase their capital.

At the time when the ECNs were issued, LBG was subject to the capital adequacy requirements in the Second Basel Accord (“Basel II”), implemented through Directive 2006/48/EC, known as the Capital Requirements Directive (“CRD I”) (Footnote: ⁵). This was interpreted by LBG’s then prudential regulator, the Financial Services Authority (“the FSA”), in the manner set out in the General Prudential Sourcebook (“GENPRU”) published by the FSA, which, together with stress testing carried out by the FSA, formed the basis of the FSA’s capital adequacy regime.

Under Basel II, the capital of financial institutions was arranged in tiers. The highest tier was known as core tier 1 (“CT1”). This was calculated by adding the fully paid-up ordinary shares and retained earnings (and other similar items) before deducting certain more vulnerable categories of asset on the balance sheet. For example, to calculate CT1 capital, it was necessary to deduct any goodwill included in the balance sheet (Footnote: ⁶). A bank’s CT1 capital was part of its CT1 ratio, being the bank’s CT1 capital divided by the value of its risk-weighted assets. The second tier of capital was divided into “upper tier 2 capital” and “lower tier 2 capital". The distinction is not relevant for present purposes but at the time lower tier 2 capital included non-perpetual capital such as dated subordinated debt. So far as UK institutions were concerned, the FSA would define CT1 capital from time to time in its published statements.

Risk-weighted assets are calculated by adjusting each asset class for risk in order to determine a bank’s exposure to potential losses in times of economic stress. Regulators then use the risk weighted total to calculate how much loss-absorbing capital a bank needs to sustain it through difficult markets. The risk weighting varies according to each asset’s potential for default and what the likely losses would be in case of default. For example, a secured loan is regarded as less risky than one that is unsecured. Thus a high CT1 ratio indicates that the bank could sustain a high level of losses without encountering financial difficulties, and a low CT1 ratio the opposite.

Stress testing was and is a significant element of the process of determining the minimum capital resources or capital required to be maintained by banks. Various scenarios, and economic assumptions, designed to simulate adverse economic conditions, are applied. The profit and losses and balance sheet of an institution, including its capital and risk-weighted assets, are modelled against the assumptions in those scenarios and the bank is required to show that it would have an adequate ratio of capital (of a specified kind) to such modelled assets. The results of stress testing show the impact of the stress scenarios on an institution’s core capital ratio, CT1 ratio and/or its total capital ratio; banks are required to hold “sufficient” levels of each.

Prior to the issue of the ECNs, the FSA, as part of its developing supervisory regime following the financial crisis, had been conducting ad hoc stress tests of the capital of banks and building societies, including LBG, to identify their vulnerabilities in a future severe downturn. It was common ground before the judge that the FSA anticipated that the application of stress tests would continue to evolve, and that the precise parameters would continue to change. It was also common ground that the regulators had said that the capital framework for financial institutions would be subject to major reforms and that the expectation was that the framework would be tightened and that regulatory capital requirements would become stricter.

On 14 November 2008, the FSA issued its “Statement on Capital Approach Utilised in UK Bank Recapitalisation Package”. The statement included a requirement that banks maintained a ratio of CT1 capital to risk-weighted assets of at least 4% after applying an FSA prescribed stress scenario which anticipated significant future losses (“the Capital Framework”). This requirement was intended to ensure that “the amount of capital for each institution would sustain confidence in that institution”, and that “each individual institution would have a sufficient capital buffer over minimum capital requirements both to absorb losses that might ensue from a recession and to continue lending on normal commercial criteria”. In particular the statement included the following passage:

“Within the Tripartite structure, the FSA was responsible, in consultation with the other two authorities, for determining the appropriate level of capital for each individual institution. In reaching this determination two factors were taken into account:

1.

Ensuring that the amount of capital for each institution would sustain confidence in that institution.

2.

Ensuring that each individual institution would have a sufficient capital buffer over minimum capital requirements both to absorb losses that might ensue from a recession and to continue lending on normal commercial criteria.

To ensure broad consistency between different institutions, the process included utilisation of a stress test based on some standard assumptions but with weightings tailored to the specific institutions. 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.

It is important to recognise that this methodology was not intended to set new minimum capital ratios. It was adopted in the context of implementing the Tripartite's support package with the intention of securing (1) and (2) above.

As the FSA has already announced, it 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.”

The stress testing process was therefore seeking to ensure that banks could remain as a going concern even in the prescribed stress scenario. The Capital Framework, and in particular the 4% ratio of CT1 capital to risk weighted assets in stressed scenarios, was confirmed in the FSA’s “Statement on Regulatory Approach to Bank Capital” issued on 19 January 2009.

A good description of the function of stress tests as carried out by the FSA at the time, and the potential for future evolution, was contained in the FSA’s statement on its use of stress tests dated 28 May 2009. This was the most recent statement by the FSA in relation to stress tests published prior to the issue of the ECNs:

“This statement clarifies how stress tests have been used within the UK, provides information on the macro-economic parameters currently being used, and describes how the UK approach fits within the EU-wide stress testing exercise on the aggregate banking system being coordinated by the Committee of European Banking Supervisors (CEBS).

The UK authorities have not applied stress in the same way as in the US - a single exercise covering simultaneously the top 19 banks which account for two thirds of the assets of the US banking system. Instead, over the last eight months since the intensification of the financial crisis, the Financial Services Authority (FSA) has:

• Greatly increased the use of stress tests as an integral element of our ongoing supervisory approach.

• Begun the process of embedding this revised approach in our intensive supervisory regime.

• Used stress tests to inform policy decisions such as access to the Credit Guarantee Scheme (CGS) and the Asset Protection Scheme (APS) working closely with the other Tripartite authorities.

The stress tests are used within the context of our current regulatory framework for UK bank capital. On January 19^th 2009 we published a statement that we 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. This 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 stress tests analyse all the relevant variables which may affect an institution’s capital adequacy. These include its revenue generation potential given scenarios for GDP growth and interest rates, the probability of default and possible losses given default within its loan book, and possible declines in the market value of assets held in the trading books, as well as any known firm specific events. The tests have been applied where appropriate at the group level.

The tests look forward over five years but with greater detail over the first three. They 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. In evaluating the institution’s ability to meet the minimum requirement under the stress scenario, the FSA may consider actions that management could propose to take if and when the stress develops. Such actions may include the evolution of the balance sheet size, capital raising and asset sales.

The stress tests used are not forecasts of what is likely to happen but are deliberately designed to be severe. Their purpose is to consider whether an institution would be able to sustain adequate capital and liquidity under conditions which at the time the stress is conducted are considered unlikely to arise. They therefore aid our determination of whether firms are able to comply with our regulatory framework.

Stress testing is necessarily forward looking and therefore involves an element of judgement. This is particularly true given that the most important challenge facing the banking system has changed over the last six months.

In the early stages of the crisis, a crucial concern was the presence on bank balance sheets of specific complex structured securities (sometimes called “toxic assets”) whose values were severely depressed, and the accounting for which was sometimes unclear. But significant action has already been taken to reflect legacy asset losses in published accounts, and our stress tests allow for further possible write downs in the event of further price reductions and for variations in accounting practice.

The key challenge now is that the weakness of the financial system has produced an economic situation which may in future produce significant loan losses and further impair the strength of banks and building societies in an adverse feedback loop. The crucial issue for stress testing is not therefore, as it is sometimes suggested, to ‘identify the bad assets on the bank’s balance sheets’, but to identify future potential loan losses even among loans which currently would not be considered impaired on an accounting basis.

Since the FSA’s use of stress tests has not been a one-off exercise, but instead embedded in our regular supervisory processes, the FSA will not, as a matter of practice, be publishing details of the stress test results. Furthermore given that the application of the tests has and will continue to evolve, the precise parameters used have changed and will change over time.

But we believe it is useful to provide information on the key macroeconomic parameters used in stress tests conducted over the last four months currently being used today. These parameters were used, for instance, in the stress tests applied to those banks considering utilisation of the APS, and in the analysis of the Dunfermline Building Society which identified future potential threats to capital adequacy. The banks participating in the APS have in addition submitted to HMT full details of the specific assets proposed for inclusion in the scheme and further detailed analyse of the assets determined the design and pricing of the scheme.

The current stress scenario models a recession more severe and more prolonged than those which the UK suffered in the 1980s and the 1990s and therefore more severe than any other since the Second World War. It assumes a peak-to-trough fall in GDP of over 6%, with growth not returning until 2011 and only returning to trend growth rate in 2012. It models the impact of unemployment rising to just over 12% and, crucially, the impact of a peak-to-trough fall in house prices and a 60% peak-to-trough fall in commercial property prices.

The UK approach to stress tests is similar to that followed in most countries, other than the US, which have applied stress tests to inform decisions on specific institutions and as part of intensified supervisory process, rather than as a one-off, system wide and publicly disclosed process. CEBS has, however, now committed to co-coordinating a Europe-wide stress testing exercise to inform assessments of the aggregate health of the banking system. This exercise will use common approaches and scenarios and aims to increase the level of aggregate information available to policy makers in assessing the European financial system’s resilience to shocks.” [Emphasis added (Footnote: ⁷).]

Further changes subjecting financial institutions to more stringent regulatory capital requirements occurred or were announced during 2009. Thus, for example:

In March 2009 the FSA stress-tested LBG against a benchmark of a ratio of CT1 capital to risk weighted assets of 4%. LBG was found by the FSA to have a shortfall against that benchmark of £24 billion to £29 billion of CT1 capital. LBG was required by the FSA to take action to correct the position by increasing its core capital ratio. LBG initially intended to participate in the Government's Asset Protection Scheme ("GAPS"), and announced its intention to do so, but subsequently decided that it would be preferable to improve its own capital position without participating in GAPS. In part this was because of the substantial participation fee, in excess of £15 billion, which LBG would have been required to pay to participate in GAPS. To avoid paying this LBG was required to demonstrate to the FSA that it had a further £21 billion CT1 capital.

Consequently, in late 2009 LBG embarked on a programme of raising further CT1 capital through the private capital markets by: (1) raising further equity of £13.5 billion by way of a rights issue; and (2) carrying out exchange offers, under which holders of certain existing securities issued by LBG, which did not qualify as CT1 capital ("the Existing Securities"), were invited to exchange those securities for ECNs. The Existing Securities included various notes and securities paying fixed rates (being various rates of up to 15% per annum) in perpetuity.

The rationale for, and terms of, the ECNs were set out in a formal invitation by the Issuers (“the Exchange Offer Memorandum”) (Footnote: ⁹) dated 3 November 2009 to the holders of the Existing Securities to invite them to exchange their Existing Securities for ECNs. The Exchange Offer Memorandum included a letter from Sir Winfried Bischoff, Chairman of LBG (“the Chairman’s letter”). The judge viewed the Chairman’s letter as an important part of the factual matrix. In summary the letter explained that:

The Exchange Offer Memorandum set out (Footnote: ¹⁰) an overview of the proposed terms of the ECNs as well as the full terms and conditions of the ECNs (Footnote: ¹¹) which were in substantially the same terms as they subsequently appeared in Part A of Schedule 4 to the Trust Deed. These included the terms relating to the Issuers’ right to redeem the ECNs as well as the definition of a CDE. I set out the relevant terms and conditions below.

In relation to risk factors, the Exchange Offer Memorandum identified inter alia the following factors in relation to the possibility of redemption of the ECNs:

“2.1

Differences between the Existing Securities and the New Securities

The form and terms and conditions of the Existing Securities are substantially different from those of the New Securities. Holders should carefully consider the differences (which include, inter alia, in some cases the payment dates, the maturity dates, the ranking, obligations with respect to interest payments, the redemption prices in the event of tax or capital disqualification redemption triggers, the identity of the obligor and the form in which the New Securities are issued and, in the case of all ECNs, the inclusion of an automatic conversion feature into Ordinary Shares in certain prescribed circumstances).

……

5.10

Redemption risk

The ECNs may, subject as provided in the ECN Conditions and subject to the prior consent of the FSA, be redeemed prior to their stated Maturity Date in the circumstances described below.

Upon the occurrence of a Tax Event or a Capital Disqualification Event (each as defined and more fully described in Part A of Appendix 6 ("Terms and Conditions of the ECNs - Redemption and Purchase"), the ECNs may, subject to the Conditions, be redeemed by the relevant ECN Issuer at any time (in the case of a Fixed Rate ECN) or on any Interest Payment Date (in the case of a Floating Rate ECN) prior to the Maturity Date specified in the relevant Pricing Schedule, in each case at their principal amount (or, in relation to a Capital Disqualification Event only, at such other amount as may be specified in the relevant Pricing Schedule), together with accrued but unpaid interest.

5.11

ECN Security holders have no right to call for redemption. The relevant ECN Issuer is under no obligation to redeem the ECNs at any time prior to the stated Maturity Date and the ECN Security holders shall have no right to call for their redemption at any time.”

The purpose of the Proposals was also explained by Sir Winfried Bischoff and other directors at a presentation and Q&A session on 3 November 2009. Thus Sir Winfried said that the Proposals represented “a transformational event for our organisation” which “creates a strong platform that ensures the Group is able to meet the FSA’s stress test”; and Tim Tookey (LBG’s Group Finance Director) said that “the proposals will create a significant capital buffer from new contingent core tier 1 capital and will establish a high quality capital base that meets the FSA’s severe stress test requirements...”

Following the offers made in the Exchange Offer Memorandum, £8.3 billion of ECNs were issued in December 2009 in accordance with the terms and conditions set out in Schedule 4 to the Trust Deed, and a Deed Poll executed by LBG (Footnote: ¹²). £5 billion of those ECNs have recently been exchanged for other instruments, and approximately £3.3 billion across 33 series remain in issue in their original form. The outstanding ECNs have various maturity dates from 2019 to 2032 when the Issuers are required to repay the capital amounts of the ECNs. Until then, or earlier redemption where permitted, interest is payable on the ECNs at an average rate across the outstanding ECNs of around 10.33%. The ECNs are held by a large number of retail investors as well as by institutional investors. As already explained, at the time of their issue the ECNs qualified as lower tier 2 capital and would automatically convert into ordinary shares, and therefore CT1 capital, if LBG’s published consolidated CT1 capital ratio fell to less than 5 per cent., thereby increasing LBG’s CT1 capital at such time.

The relevant terms and conditions of the ECNs, which are set out in Part A of Schedule 4 to the Trust Deed (which by clause 1.5 of the Trust Deed was stated to be part of the Trust Deed and to have effect accordingly), are the following:

“7.

Conversion

(a)

Conversion upon Conversion Trigger

(i)

If the Conversion Trigger occurs at any time, each ECN shall, subject to and as provided in this Condition 7(a) and in the Deed Poll, be converted on the Conversion Date into new and/or existing (as determined by LBG) Ordinary Shares credited as fully paid in the manner and in the circumstances described below and in the Deed Poll.

The ECNs are not convertible at the option of ECN Holders at any time.

The "Conversion Trigger" shall occur if at any time, as disclosed in the latest published annual or semi-annual consolidated financial statements of LBG or as otherwise publicly disclosed by LBG at any time, LBG's Consolidated Core Tier 1 Ratio is less than 5 per cent. As used in these Conditions, "Consolidated Core Tier 1 Ratio" means the ratio of the Core Tier 1 Capital of LBG to the risk weighted assets of LBG, in each case, calculated on a consolidated basis.

As soon as reasonably practicable following the occurrence of the Conversion Trigger, the Issuer shall give notice thereof to holders of the ECNs (the "Conversion Trigger Notice") in accordance with Condition 17. The Conversion Trigger Notice shall specify the Consolidated Core Tier 1 Ratio, the prevailing Conversion Price and the Conversion Date, which shall be not earlier than 20 London business days nor later than 30 London business days following the giving of the Conversion Trigger Notice.

(ii)

If the Conversion Trigger occurs, the ECNs will be converted in whole and not in part as provided below and in the Deed Poll.

(iii)

Prior to giving the Conversion Trigger Notice, the Issuer shall deliver to the Trustee a certificate signed by two Authorised Signatories of LBG stating that the Conversion Trigger has occurred and the Trustee shall accept such certificate without any further enquiry as sufficient evidence of such matters, and such certificate will be conclusive and binding on the Trustee and the ECN Holders.

….

(b)

Payment of Conversion Settlement Sum

(i)

Upon Conversion, the Issuer shall redeem the ECNs at a price (the "Conversion Settlement Sum") equal to their principal amount. ECN Holders shall be deemed irrevocably to have directed and authorised the Issuer to pay the Conversion Settlement Sum to LBG as consideration for LBG's agreement to Issue Ordinary Shares pursuant to the Deed Poll and the obligations of the Issuer and [the]*/[each]** Guarantor to pay principal on the relevant ECNs to holders of the ECNs shall be discharged by the Issuer's obligation to pay the Conversion Settlement Sum to LBG.

(ii)

In order to obtain delivery of Ordinary Shares on a Conversion, ECN Holders will be required to comply with the provisions of the Deed Poll which require, amongst other things, the delivery of a Conversion Notice and the relevant ECNs or the Certificate representing the same (in the case of Registered ECNs) on or before the Notice Cut-off Date. If ECN Holders fail to make such delivery on or before the Notice Cut-off Date or otherwise the relevant Conversion Notice shall have been determined to be null and void pursuant to the Deed Poll, the Deed Poll contains provisions relating to the sale of the relevant Ordinary Shares and the payment of the net proceeds of such sale (the "Ordinary Share Sale Proceeds") to such ECN Holders.

……

8, Redemption and Purchase

(a)

Final Redemption

Unless previously converted, redeemed or purchased and cancelled as provided in these Conditions, each ECN shall be redeemed on the Maturity Date at the Final Redemption Amount specified in, or determined in the manner specified in, the relevant Final Terms.

(b)

Conditions to Redemption and Purchase

Any redemption or purchase of the ECNs in accordance with Condition 8(c), (d), (e) or (g) is subject to

(i)

LBG giving at least one month's prior written notice to, and receiving no objection from or, in the case of any redemption of the ECNs prior to the fifth anniversary of the Issue Date, receiving the consent of, the FSA (or such other period of notice as the FSA may from time to time require or accept and in any event, provided that any such notice is required to be given) and (ii) LBG (both at the time of, and immediately following, the redemption or purchase) being in compliance with the Regulatory Capital Requirements applicable to it from time to time (and a certificate from any two Authorised Signatories of LBG confirming such compliance shall be conclusive evidence of such compliance).

Prior to the publication of any notice of redemption pursuant to Condition 8 (d) or (e), the Issuer shall deliver to the Trustee a certificate signed by two Authorised Signatories of the Issuer stating that the relevant requirement or circumstance giving rise to the right to redeem is satisfied and the reasons therefor and the Trustee shall accept such certificate without any further inquiry as sufficient evidence of the satisfaction of the relevant conditions precedent, and such certificate shall be conclusive and binding on the Trustee and the ECN Holders.

……

(e)

Redemption for regulatory Purposes

If immediately prior to the giving of the notice referred to below, a Capital Disqualification Event has occurred and is continuing, then the Issuer may, subject to Condition 8(b) and having given not less than 10 or more than 21 days’ to the ECN Holders in accordance with Condition 17, the Trustee, the Issuing, Paying and Conversion Agent and the Registrar (which notice shall, subject as provided in Condition 8(f), be irrevocable), redeem in accordance with these Conditions at any time (in the case of a Fixed Rate ECN or in the Fixed Interest Rate Period in the case of a Fixed/Floating Rate ECN) or on any Interest Payment Date (in the case of a Floating Rate ECN or in the Floating Interest Rate Period in the case of a Fixed/Floating Rate ECN) all, but not some only, of the ECNs at their Capital Disqualification Event Redemption Price, together with any accrued but unpaid interest to but excluding the relevant redemption date. Upon the expiry of such notice, the Issuer shall redeem the ECNs as aforesaid.

(f)

Conversion Trigger

The Issuer may not give a notice of redemption of the ECNs pursuant to this Condition 8 if a Conversion Trigger Notice shall have been given. If a Conversion Trigger Notice shall be given after a notice of redemption shall have been given by the Issuer but before the relevant redemption date, such notice of redemption shall automatically be revoked and be null and void and the relevant redemption shall not be made.

(i)

Trustee Not Obliged to Monitor

The Trustee shall not be under any duty to monitor whether any event or circumstance has happened or exists within this Condition 8 and will not be responsible to ECN Holders for any loss arising from any failure by it to do so. Unless and until the Trustee has actual knowledge of the occurrence of any event or circumstance within this Condition 8, it shall be entitled to assume that no such event or circumstance exists.

……

19.

Definitions

a "Capital Disqualification Event' is deemed to have occurred (1) if at any time LBG or, where LTSB is a or the Guarantor, LTSB 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 or, as the case may be, LTSB 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;

……

"Core Tier 1 Capital" means 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;

……

"Lower Tier 2 Capital" has the meaning given to it by the FSA from time to time.

……

“Regulatory Capital Requirements” means any applicable requirement specified by the FSA in relation to minimum margin of solvency or minimum capital resources or capital;

“Tier 1 Capital” has the meaning given to it by the FSA from time to time” and

“Upper Tier 2 Capital” has the meaning given to it by the FSA from time to time”.

The definition in the Deed Poll of the FSA (which was also applicable for the purposes of the terms and conditions) was:

“the Financial Services Authority or such other governmental authority in the United Kingdom ….. having primary supervisory authority with respect to LBG and the LBG Group.”

It was common ground before the judge that, at the time when the ECNs were issued, it was already anticipated that there would be further changes to the regulatory regime which would make the capital requirements more robust and would involve amending or superseding the definition of CT1 capital (Footnote: ¹³). The subsequent history of regulatory changes post-dating the issue of the ECNs and the actions taken by LBG to improve its capital position as a result, are relevant to a determination as to whether a CDE had occurred. It was common ground that post-December events and statements (such as, for example, those made by LBG in the ATI exchange offer memorandum quoted below) were not permissible aids to the interpretation of the terms of the ECNs.

In 2010 and 2011, two further EU capital requirement directives, known as “CRD II” and “CRD III” respectively, came into force. However they did not alter the concept of core regulatory capital such as to affect the status of the ECNs in the stress tests conducted prior to 2014.

The key regulatory changes for the purposes of this appeal related to the implementation of the Third Basel Accord (“Basel III”) by the EU Fourth Capital Requirements Directive (“CRD IV”) (Footnote: ¹⁴) and the Capital Requirements Regulation (“the CRR”) (Footnote: ¹⁵) (together referred to in the judgment and this judgment as “the CRD IV package”). The CRD IV package:

In particular the CRR expressly provided that convertible capital instruments such as the ECNs would only qualify as AT1 Capital, if the trigger for conversion was set at a CET1 ratio of 5.125% or higher, which was above the corresponding minimum CET1 permitted ratio of 4%/4.5%.

CET1 capital is more restrictive than CT1 capital. The new regime changed the manner in which financial institutions’ capital was calculated. Thus under CET1, as opposed to under CT1, more categories of assets in the balance sheet must be deducted, in addition to goodwill. Thus, for example, the following fall to be deducted for the purposes of CET1 capital:

The result of the requirement to deduct such items meant that, in some cases, a bank’s CT1 capital (and CT1 ratio) would be different from its CET1 capital (and CET1 ratio). For example, a bank which had substantial deferred tax assets and/or a large holding in another financial institution would find that its CET1 capital was substantially lower than its CT1 capital, whereas a bank which owned no assets in the newly deductible classes would find that its CET1 capital and its CT1 capital were broadly the same.

In 2013, the PRA, as successor to the FSA, required LBG to raise a substantial amount of further capital, in order to meet (and exceed) the new minimum capital requirements. This was preceded by various regulatory statements from the regulators.

On 27 March 2013 the interim Financial Policy Committee of the Bank of England (“the FPC”) (Footnote: ¹⁶) issued a news release recommending amongst other things that:

On 20 June 2013, the FPC issued a further news release, setting out the results of a ‘capital shortfall exercise' carried out by the PRA with regard to major UK banks including LBG. That showed that the PRA had announced that various banks, including LBG, fell short of the 7% adjusted CET1 ratio standard, and that it was requiring LBG to raise a further £7 billion of capital (in addition to £1.6 billion that would be raised by capital actions already planned by LBG) by the end of 2013. In its material parts the document read:

“The PRA has judged that, after these adjustments have been made, each firm should target a risk-weighted capital ratio based on the Basel III definition of at least 7%.

The PRA's assessment is that, at the end of 2012, five of the eight banks (Barclays, Co-operative Bank, LBG, Nationwide and RBS) fell short of this standard. They had an aggregate capital shortfall relative to this standard of £27.1bn. When the FPC made its announcement in March this shortfall was provisionally estimated to be around £25bn. At that time, five firms had in place plans to take actions that generated the equivalent of approximately £12.5bn of capital during 2013. The final figure for these actions is £13.7bn. A number of these intended actions will require regulatory approval before being implemented. As such, they cannot be assumed to have contributed to meeting the requirement until approval is given. In the event that they are either not carried out or fail to be approved, other actions will be required of those firms in order to reach the specified standard.

After these planned actions, the PRA assesses that four of the five firms will have a shortfall against the 7% standard. (Nationwide's shortfall was already accounted for in its planned 2013 actions.) These firms have been required to submit plans for additional actions. All of the firms have been informed of their requirements and have produced for the PRA plans to meet them. It is for the firms themselves to announce the actions they plan to take. In aggregate, the additional actions, which include disposals and restructurings, will generate the equivalent of an additional £13.4bn of capital. The PRA believes that these plans can be put into effect. The vast majority of actions are due to be completed by end-2013, but the PRA has allowed some limited flexibility for a small part of these actions to be delivered during the first half of 2014. …. The PRA will hold firms to these plans, and will require additional actions to be taken if capital to cover the full shortfalls is at risk of not being delivered by any firm.”

The document then set out a table in relation to the 8 banks. This showed that LBG had a CET1 ratio of 8.2 and that the FPC “recommended” certain adjustments to the amount of its capital and the amount of its risk weighted assets. The table also showed that LBG was itself planning to take additional actions to improve its capital position in the sum of £1.6 billion, and was additionally required to take further action to improve its capital position by the sum of £7 billion, in order to meet the required target of a risk-weighted capital ratio of at least 7% based on the Basel III definition. The analysis was not based on any stress testing model, but rather on actual figures in the context of LBG's balance sheet at the relevant time.

In August 2013, the PRA published Consultation Paper 5/13, entitled 'Strengthening capital standards: implementing CRD IV”. Draft Supervisory Statement 7/13, which formed an appendix to that paper, dealt with the eligibility of 'Co-Cos' and other convertible capital instruments to count as core capital for the purposes of regulatory stress testing. The PRA described those instruments which it intended to consider as eligible as AT1 securities with 'ATI triggers'. Given that, as already stated, the CRR provided that convertible ATI capital instruments should have a minimum conversion trigger set at a ratio of CET1 capital to risk weighted assets of 5.125%, the PRA's draft statement stated that:

"The aim of the trigger and conversion is to contribute to the firm's recovery following a significant stress. Therefore, if UK firms, especially those whose failure may have systemic consequences for the United Kingdom, issue ATI instruments, the PRA expects them to set ATI triggers at a level that is unambiguously consistent with being able to recover from a stress without entering into resolution. This may be at a level higher than 5.125% CET1. The PRA also expects the conversion or write-down to be for the full amount of the instrument and to be permanent."

In October 2013, the Bank of England issued a discussion paper, "A framework for stress testing the UK banking system”. The FPC had recommended in March 2013 that the PRA develop proposals for regular stress testing of the UK banking system, to assess capital adequacy. The Bank of England paper set out the main features of the proposed stress testing framework. It described the stress testing process as follows:

“Bank staff, under guidance from the FPC and the PRA Board, will synthesise the outputs of these models to form a single, overall view about the performance of the system and individual banks in each scenario, interpreting these results, and reaching a judgement around capital adequacy, will require a view on the level of capital that regulators want banks to maintain in the face of such losses. This is ultimately a policy decision by the FPC and the PRA Board, according to their respective responsibilities. At the very least, banks would need to maintain sufficient capital to be able to absorb losses in the stress scenario and not fall below internationally agreed minimum standards.”

The “internationally agreed minimum standards” referred to the requirement under CRD IV for a minimum CET1 capital ratio (including in a stress scenario) of 4%, as from 1 January 2014, increasing to 4.5% as from 1 January 2015. The discussion paper also made clear that:

“Crucially, the results of the stress tests are not expected to be mechanically linked to policy responses. This is not intended to be a simple “pass-fail” regime. Rather, it aims to deliver a more graduated policy framework, where the magnitude of remedial actions taken would be a function of policymakers’ judgment around the adequacy of banks’ capital plans. For example, if the stress tests revealed that individual banks — or the system as a whole — fell below internationally agreed minima in the stress scenarios, this could point to material inadequacies in their capitalisation. In turn, this would likely result in the PRA requiring material remedial actions to strengthen capital levels. Required remedial actions would likely be smaller if stress tests revealed that banks remained above internationally agreed minima, but still below the appropriate level of post-stress capital determined by the FPC and the PRA Board. Banks could also be required to take remedial actions in light of identified inadequacies in their stress testing and capital management capabilities, even if the PRA Board judged that they were adequately capitalised to withstand the range of scenarios explored as part of the stress test.”

The document went on to explain the framework for assessing capital adequacy and in particular the requirement for a bank to maintain a minimum level of capital required by internationally agreed standards. It stated:

“Framework for assessing capital adequacy

The process outlined above will result in a central view of the size of stressed Losses in a given scenario and, hence, remaining capital resources. Interpreting these results, and reaching a judgment around bank capital adequacy, requires a view on the level of capital that regulators want banks to maintain in the stress scenario. This is often referred to as the 'hurdle rate'.

Ultimately, this is a policy decision by the FPC and the PRA Board. But there are a number of considerations the FPC and the PRA Board might take into account in considering the level of capital banks should maintain in a stress.

A key consideration will be the minimum level of capital required by internationally agreed standards. Banks need to maintain sufficient capital resources to be able to absorb losses in the stress scenario and remain above these minimum requirements. Minimum capital standards have been set internationally by the Basel Committee on Banking Supervision and transposed into European Legislation under the Capital Requirements Regulation and Directive (CRD IV). For example, under the PRA's proposed implementation of CRD IV, the minimum Pillar 1 common equity Tier 1 capital requirement will be set at 4.5% from 1 January 2015 onwards.

But requiring banks to remain above internationally agreed minima in a stress may be insufficient to mitigate risks to financial stability. There are other factors that the FPC and the PRA Board will consider when setting the hurdle rate.”

In November 2013, the PRA announced in its Supervisory Statement SS3/13 that, from 1 January 2014, it would no longer monitor the capital of banks by reference to the 1 May 2009 definition of CT1 capital.

In December 2013 the PRA published its “Supervisory Statement SS7/13 CRD IV and capital”. As foreshadowed in the earlier Consultation Paper 5/13, the PRA required AT1 instruments to contain a conversion trigger of at least 5.125 % CET1, but allowed firms to select a higher trigger.

It was against this regulatory background that, by 31 December 2013, LBG had substantially strengthened its capital position. According to its Chief Executive’s statement which accompanied LBG’s 2013 annual accounts:

“This uplift was driven by capital generation in the core business, as well as management actions including the reshaping of our core business portfolio, the substantial reduction of non-core assets in a capital accretive manner and the payment of dividends of £2.2 billion to the Group by the Insurance business. We reduced non-core assets by £34.9 billion, while at the same time releasing approximately £2.6 billion of capital.”

There is a factual dispute between the Trustee and the Issuers on the evidence as to whether the improvement in LBG’s capital position was brought about as a result of a change in Regulatory Capital Requirements as defined in the terms and conditions.

As a further measure of capital improvement, LBG formulated a further exchange offer (capped at £5bn) whereby holders of the ECNs (i.e. lower core tier 2 capital) were invited to exchange them for new securities which were to qualify as ATI capital within the meaning of the CRD IV Package ("the AT1 Securities"). The Exchange Offer Memorandum for this offer (“the 2014 AT1 Memorandum”) made it clear that (a) for the new securities to qualify as AT1 Securities under the CRD IV Package they needed to trigger when LBG’s CET1 capital ratio fell to 5.125%; and (b) the PRA had confirmed in late 2013 that such a conversion trigger might not prevent the failure of a firm and that it expected UK firms to meet a 7% CET1 capital ratio. As a consequence, the conversion trigger for the proposed AT1 Securities was therefore set at a 7% CET1 capital ratio.

The 2014 AT1 Memorandum also stated under the heading "Purpose of the Exchange Offers:”

“The terms and conditions of the ECNs include a Regulatory Call Right (as defined herein) should, amongst other things, the ECNs cease to be taken into account for the purposes of any "stress test" applied by the PRA (successor to the FSA) in respect of core capital. Whilst still uncertain, management of LBG believes recent developments resulting in higher capital requirements for banks, including a changed definition of core capital, make it likely that the ECNs will not provide going concern benefit under future stress tests.

These recent developments include:

-

a requirement in the CRR that with effect from 1 January 2014 convertible Additional Tier 1 ("AT1') capital instruments should have a conversion trigger set at no less than 5.125 per cent. CET1 Ratio. (“CET1 Ratio” means the ratio of a firm’s common equity Tier 1 capital to risk-weighted assets, and calculated in accordance with the end-point requirements of CRD IV.)

-

Statements by the PRA in late 2013 that a conversion trigger of 5.125 per cent. CET1 Ratio may not convert in time to prevent the failure of a firm and that it expects major UK firms to meet a 7 per cent. CET1 Ratio determined in accordance with the end-point requirements of CRD IV;

-

a statement by the EBA in January 2014 that tier 2 instruments must have a conversion trigger above 5.5 per cent. CET1 Ratio to be recognised in its forthcoming stress tests; and

-

an announcement by the PRA that, following a consultation commenced in October 2013, it expects to revise stress testing methodology and pass marks in 2014.

As a result of differences in definition, the Group's CET1 Ratio is substantially lower than the core tier 1 ratio on which the conversion trigger of the ECNs is based. As at 31 December 2013, the difference was 4.0 per cent. Applying the same difference to the 5.0 per cent. core tier ratio used as the ECN conversion trigger gives a 1.0 per cent. CET1 Ratio determined in accordance with end-point requirements of CRD IV, well below the CRR minimum requirements.”

The exchange took place over the various series of ECNs in March and April 2014. Approximately £5bn worth of ECNs were exchanged for ATI Securities, with approximately £3.3bn of ECNs remaining outstanding following the exchange exercise.

In April 2014, the Bank of England stated in its document “Stress testing the UK banking system: Key elements of the 2014 stress test” that the previous CT1 capital ratio requirement of 4% in the event of the FSA’s stressed scenario would be replaced with what was often referred to as “a hurdle rate” of a ratio of CET1 to risk-weighted assets of 4.5%. The document made clear that the PRA’s evaluation of the capital adequacy of an individual institution was not dependent upon a simple ‘pass/fail’ exercise in relation to the stress test. It stated:

“If a firm’s capital ratio was projected to fall below the 4.5% CET1 ratio in the stress, there is a strong presumption that the PRA would require the firm to take action to strengthen its capital position over a period of time to be agreed between the firm and the PRA…If a firm’s capital position was projected to remain above the 4.5% CET1 ratio in the stress, the PRA may still require it to take action to strengthen its capital position”.

The document also stated that firms should model the impact of any triggers of contingent capital instruments. Thus in 2014, the only published “hurdle rate” which enabled an institution to “pass” the stress test was the ratio of 4.5% CET1 capital to risk-weighted assets.

Consistent with the statements made in relation to the stress testing regime, as summarised above, in the stress test carried out by the PRA in December 2014 (“the December 2014 Stress Test”), the PRA tested whether UK financial institutions’ CET1 ratio (to risk weighted assets) would remain above a minimum 4.5% CET1 ratio threshold in the stressed projections, using figures based on the respective financial positions of the banks as shown in their balance sheets as at 31 December 2013. The Bank of England published the results of the 2014 stress test in a document entitled “Stress testing the UK banking system: 2014 results”. As the judge summarised (Footnote: ¹⁷), the results of the stress test so far as LBG was concerned were as follows:

“18…… So far as concerned LBG, its actual CET1 ratio as at the end of 2013 was 10.1%, and its minimum "stressed" ratio in the stress test was 5% before the impact of strategic management actions, or 5.3% after the impact of such actions. The ECNs were not taken into account by the PRA in the December 2014 stress test.”

Indeed it was clear from the table at page 7 of this document that, as Mr Dicker accepted (Footnote: ¹⁸), the ECNs had not been included so far as LBG was concerned in the modelling for its stress scenario. That was because the combination of a “hurdle rate” of 4.5% CET1 capital to risk-weighted assets and LBG’s financial position was that its capital position was not reduced sufficiently to trigger the Conversion Trigger.

In its document, the Bank of England made clear that there was a distinction between the results of the stress test itself and any consequential action which regulators might take by way of regulatory action in response. Thus the document stated:

“The FPC and PRA Board actions taken in response to the stress test

The stress-test results were used by the PRA Board and the FPC as part of their evaluation of the capital adequacy of individual institutions and the resilience of the system as a whole. The overall 'hurdle rate' framework had been agreed by the FPC and the PRA Board earlier in the year. This is not a mechanistic 'pass-fail' test and there is, therefore, no automatic link between stress-test results and capital actions required. Although the exercise only assessed the impact of a single stress scenario, it allowed policymakers to form judgements on the resilience of the UK banking system to a severe macroeconomic downturn, which could be a feature of different possible stressed states.

From an individual-institution perspective, the PRA Board judged that this stress test did not reveal capital inadequacies for five out of the eight participating banks, given their balance sheets at end-2013 (Barclays, HSBC, Nationwide, Santander UK and Standard Chartered). The PRA Board did not require these banks to submit revised capital plans.”

In relation to LBG, the PRA took the view that, although LBG had passed the stress test, nonetheless further improvements to its capital position were required. The document stated:

“Lloyds Banking Group;

Lloyds Banking Group's projected CET1 capital ratio remains above the 4.5% CET1 threshold in the stress scenario. The PRA Board has, however, judged that, as at December 2013, the bank's capital position needed to be strengthened further. The PRA Board noted that, since end-2013, Lloyds Banking Group has delivered positive financial results and is continuing to take steps to strengthen and de-risk the balance sheet, ahead of baseline projections. In April 2014, the bank also exchanged certain Tier 2 capital instruments into £5.3 billion of high-trigger ATI securities. In light of the measures that Lloyds Banking Group already has in train to augment capital, the PRA Board did not require the bank to submit a revised capital plan.”

Indeed, it was common ground before the judge, and before this court, that the ECNs were not taken into account by the PRA in the December 2014 stress test 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.

Following the December 2014 Stress Test, the PRA nonetheless judged that LBG’s capital position required to be strengthened but noted changes and improvements made since the 2013 year-end including the exchange in April 2014 of £5.3 billion of ECNs for “the high-trigger AT1 Securities”. The PRA did not refer to the continued existence of the remaining ECNs as being a factor in the decision not to require the submission of a revised plan.

On 16 December 2014 LBG announced that the ECNs had not been taken into account in the December 2014 stress test and that accordingly a CDE had occurred. It stated that it intended to approach the PRA to seek the appropriate permission to redeem 23 series of outstanding ECNs.

The PRA's consent to the proposed redemption of the ECNs was necessary because: (1) condition 8(b) of the ECNs requires one month's notice to the PRA, and non-objection from the PRA; and (2) Articles 77 and 78 of the CRR require the prior permission of the PRA for the redemption of any Tier 2 instruments prior to their contractual maturity. Permission was received from the PRA on 31 March 2015. It was common ground that this was based on LBG's capital position rather than any determination by the PRA as to whether a CDE had in fact taken place. LBG agreed to defer redemption in the light of the Trustee's intention to issue the present proceedings, the Trustee having been directed in writing by the requisite proportion of one series of noteholders to issue a claim seeking a declaration that the Issuers were not entitled to redeem the ECNs.

There was subsequently further correspondence between inter alios holders of ECNs (“the ECN Holders”), the PRA and Allen & Overy, solicitors for the Trustee.

In response to enquiries from the ECN Holders, the PRA stated in a letter dated 17 March 2015 as follows:

“LBG Enhanced Capital Notes (ECNs) and stress testing

Further to your interest in the LBG ECNs, I am sharing with you information that is being provided in response to enquiries from other investors about the LBG ECNs and stress testing, to ensure that all interested parties have received the same information

2014 stress test

The Bank of England's 2014 stress test involved an assessment of how LBG would perform against current regulatory capital requirements and expectations through a hypothetical stress scenario.

In April 2014 we provided guidance on the stress test for participating firms. This set out, amongst other things that firms should model the impact of the stress including any triggers of contingent capital instruments. We also confirmed that a key threshold for the test was set at 4.5% of risk-weighted assets (RWAs), to be met with Common Equity Tier 1 (CET1) capital using a CRD IV end-point definition of CET1 resources in line with the UK implementation of CRD IV.

As stated in the guidance, there was a strong presumption that if a firm's CETl ratio fell below 4.5% of RWAs in the stress the PRA would require the firm to take action to strengthen its capital position.

LBG remained above the 4.5% CET1 threshold in the stress testing exercise and also remained above the ECN conversion trigger level. The changes to LBG's financial position in the stress scenario were not projected to trigger the conversion of the ECNs. Therefore, the ECNs counted towards LBG's projected total capital ratio (which includes Tier 2 capital) in the stress, but did not count towards LBG’s projected CET1 capital ratio in the stress.

LBG did not include any increase in the accounting value of the embedded derivative constituted by the conversion clause in the ECNs in its CET1 capital ratio as modelled through the stress and we did not adjust this approach.

Other observations

For the above reasons, the question of whether the ECN's would have converted before the 4.5% CET1 threshold did not arise in the 2014 stress test. However, we note that as a result of the differences between the definitions of CT1 and CET1 capital, it is likely the ECNs would only reach the contractual conversion trigger at a point materially below 4.5% CET1."

On 17 April 2015 Allen & Overy, solicitors acting on behalf of the Trustee, wrote in response to this letter as follows:

“We act for BNY Mellon Corporate Trustee Services Limited (the Trustee), which is the trustee for the holders of the ECNs issued by entities in the Lloyds Banking Group (LBG) in 2009.

We refer to the ECNs and to your open letter dated 17 March 2015 in relation to the ECNs and the stress test carried out in relation to LBG in 2014.

You stated in your letter:

"LBG remained above the 4.5% CETl threshold in the stress testing exercise and also remained above the ECN conversion trigger level. The changes to LBG's financial position in the stress scenario were not projected to trigger the conversion of the ECNs. Therefore, the ECNs counted towards LBG's projected total capital ratio (which includes Tier 2 capital) in the stress, but did not count towards LBG's projected CETl capital ratio in the stress.

LBG did not include any increase in the accounting value of the embedded derivative constituted by the conversion clause in the ECN's in its CETl capital ratio as modelled through the stress and we did not adjust this approach"

We understand from this that the reason the ECNs were not counted towards LBG's projected CETl capital ratio in the stress scenario was that, in simple terms, LBG's capital position was sufficiently robust so as not to result in the conversion of the ECNs into shares. We do not understand this to mean that if they were to convert in the stress scenario, the resulting additional CETl capital constituted by the shares would not be taken into account.

You went on to state that:

"For the above reasons, the question of whether the ECN's would have converted before the 4.5% CETl threshold did not arise in the 2014 stress test. However, we note that as a result of the differences between the definitions of CTl and CETl capital, it is likely the ECN's would only reach the contractual conversion trigger at a point materially below 4.5% CETl."

It is unclear to us from this passage whether you are: (a) commenting as to the likelihood of the ECNs counting towards projected CETl capital in a future stress test; or (b) suggesting that they are now disqualified from counting towards projected CETl capital, so that even if they were to convert in the stress scenario, the resulting additional CETl capital constituted by the shares would not be taken into account.

If the latter, we would be grateful if you could explain whether this is a result of a change in law, regulation or policy since the ECNs were issued in 2009 and, if so, the nature of that change.”

The PRA responded in a letter dated 23 April as follows::

“Enhanced Capital Notes and stress testing

Your letter of 17 April asked for clarification of my open letter of 17 March. I am publishing your letter and this response to ensure that interested parties have the same information available to them.

The first passage you cite from my letter was part of a response to a question about the treatment of the ECN's in the 2014 stress test. It was not intended as a comment on how the ECN's might have been treated in different circumstances. As noted in that letter, LBG was projected to remain above the 4.5% CET1 ratio threshold in the 2014 stress test.

The second passage you cite dealt with the hypothetical situation of a stress test in which the firm was projected to cross the 4.5% CET1 ratio threshold.

The setting of that threshold for presumed action was a supervisory judgement in the design of the 2014 stress test. That judgement was reached against the wider regulatory background. This included the binding requirement, introduced by the Capital Requirements Regulation, that banks should at all times meet a CET1 ratio of 4% from 1 January 2014 and 4.5% from 1 January 2015.

The PRA's actual response if a firm were projected to cross that threshold in a stress test would depend on a supervisory judgement that would be taken by reference to the relevant circumstances of that firm at that time. The point at which an instrument issued by the firm would convert to CET1 capital, including in particular whether this would be before or after it crossed that threshold, would be a relevant factor in determining the PRA's response.”

In summary, before the judge, the Issuers submitted that a CDE had occurred, for two reasons:

In summary, the Trustee submitted:

The judge rejected the Trustee’s preliminary argument that the December 2014 stress test was not a relevant one for the purposes of the CDE definition. He held that the Trustee’s reading was the “literally correct reading” (Footnote: ¹⁹) but that the provision should not be interpreted literally. That was either because “it produces such an extraordinary result that it cannot have been intended” (Footnote: ²⁰) or because there “has been an obvious mistake in the drafting of the definition of a CDE in condition 19” (Footnote: ²¹).

However he went on to reject both LBG’s arguments in support of the proposition that a CDE had occurred. He held that the expression “shall cease to be taken into account” in the definition of CDE “connotes a disallowance in principle of the ECNs on stress testing with continuing effect in the foreseeable future” (Footnote: ²²), such that the ECNs were precluded from counting as CT1 capital for the purposes of the stress test when the stressed projection showed a CT1 ratio below 5% (Footnote: ²³). He concluded that there had been no such change because, if the stress test had showed that the capital position had reached the trigger point for the conversion of the ECNs, the ordinary shares created would still rank as CT1 capital (Footnote: ²⁴).

He thus concluded that the regulator had not disallowed the ECNs in principle. He said:

“[N]othing has changed to bring about a CDE… because, as has always been the case, the ECNs will be treated as converted and ordinary shares will be treated as created in any stress test if, in the hypothetical stress scenario, the risk weighted capital has diminished to the point at which the conversion of the ECNs would be triggered” (Footnote: ²⁵);

and that:

“the ECNs will still be relevant, if LBG were to fail the stress test, in ascertaining the extent of any shortfall in capital and the kind and extent of remedial action required.” (Footnote: ²⁶)

The judge placed considerable reliance on the use of the word “Disqualification” in the expression “Capital Disqualification Event” as supporting his interpretation. He said:

“46……. The definition of a CDE 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. The FSA's statement on stress tests published on 28 May 2009, following earlier statements made on 14 November 2008 and 19 January 2009, makes clear that there were no fixed rules for the formulation of the severe hypothetical scenario for a stress test. The assumptions made by the regulator could and would involve an element of judgement about perceived economic risks and would change and evolve over time.

47.

That explains why the expression "shall cease to be taken into account…” is not looking at the actual performance of LBG on a particular stress test at any one particular moment of time but rather connotes a disallowance in principle of the ECNs on stress testing with continuing effect in the foreseeable future. The very word "Disqualification" in the expression "Capital Disqualification Event" also supports that connotation.”

In the circumstances the judge did not consider it necessary to consider the factual argument advanced in the Trustee’s reply submissions that, on the evidence, the conversion of the ECNs would not have been triggered, even if the additional £8.6 billion had not been raised in response to the PRA’s requirements in 2013.

I agree that this appeal should be allowed, substantially for the reasons given by Gloster LJ. Since we are differing from the Judge, and out of respect for the powerful submissions of Mr Dicker on what my Lady calls the main construction issue, which I admit provisionally persuaded me at the time, I add a few short observations of my own.

Once all the voluminous and technical background detail has been trawled through, as Gloster LJ has done with commanding thoroughness, the question of construction of this one-off provision is really quite short. 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 FSA, 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.

This is a difficult question on which my mind has vacillated several times since first reading the papers for this appeal. In the end I have become convinced, like my Lady, that it is the ability of the ECNs to assist in passing the stress test that is the governing criterion. If the language of the clause stopped before the words “in respect of the [relevant ratio]”, I would have found Mr Dicker’s submissions compelling. But, taking the dispositive part of the clause as a whole, the inclusion of those concluding words is just enough in my judgment to import the notion of passing the test as a necessary element in the continuing utility of the ECNs, for them to survive LBG’s right of early redemption.

I am comforted, even in this technically intricate context, by the perception that it was to assist in passing, rather than merely featuring in, the stress test that the ECNs were issued in the first place, that they have now ceased to play any useful part in doing so, and are on the face of it unlikely to do so again for the foreseeable future.

I agree that this appeal should be allowed for the reasons given by Gloster LJ.