State Street Bank and Trust Company v Sompo Japan Insurance Inc & Ors

On 4th April 2005 the second defendant Cheyne CLO Investments Ltd (“the Issuer”) issued floating rate notes (“the Notes”) to a face value of $140.5m in six tranches with varying priorities due in 2018. The Notes were constituted by a Trust Deed dated 4th April 2005 and made between the claimant (“the Trustee”), the Issuer and the first defendant and the Conditions set out in the First Schedule thereto (“the Conditions”). The Notes were secured by, inter alia, total return swaps made between the Issuer and Credit Suisse First Boston International (“the Swap Counterparty”) referencing collateralised loan obligations. The obligations of the Issuer to the Swap Counterparty were guaranteed by the first defendant (“the Guarantor”) on the terms of a Guarantee Agreement made between the Guarantor, the Trustee and the Swap Counterparty. The obligations of the Issuer to the Guarantor were set out in a Reimbursement Agreement made between the Issuer and the Guarantor.

On 31st March 2009 an event of default, as prescribed by paragraph 10(j) of the Conditions, occurred with the consequence that the swap agreements terminated. Accordingly, the Swap Counterparty claimed $160.2m from the Issuer and, after allowing sundry set-offs, $157.9m from the Guarantor. The Guarantor paid the sum claimed and sought reimbursement of the like amount from the Issuer under the Reimbursement Agreement. The issue which then arose and was set out in detail in a memorandum from the solicitors acting for the Guarantor was whether under the terms of the Reimbursement Agreement and the Conditions the Guarantor was entitled to the reimbursement it claimed.

These Part 8 proceedings were instituted by the Trustee on 11th January 2010 for the purpose of resolving that doubt. The nature of the doubt was crystallised by a Part 20 claim issued by the Guarantor on 12th March 2010. The Guarantor contends that the doubt arises from an obvious error which the court can and should correct either (1) as part of the process of construction of the relevant documents or (2) by their rectification. The third defendant KBC Investments Ltd (“the Noteholder”) was joined as a representative noteholder but declined to take any part in the proceedings. In those circumstances counsel for the Trustee, discharging his duty to the court, presented to me such arguments as he considered might reasonably be available to the noteholders in respect of the two issues I have identified. I will deal with them in due course but first it is necessary to describe the relevant documents in more detail and to identify the doubt. This task is made more complicated by the use of over 500 defined terms.

The starting point must be the Trust Deed made between the Issuer, the Trustee and the Guarantor. The Issuer is a special purpose vehicle incorporated in the Republic of Ireland. It has no assets other than such as are derived from the issue of the Notes. Its shares are held by a third party on charitable trusts. By clause 3 the Issuer covenanted with the Trustee to pay to the Trustee all amounts payable to the noteholders in accordance with the Conditions and the Trustee undertook to hold the benefit of that covenant in trust for the noteholders and others. The Trustee agreed by clause 7 to make payments of interest and principal in accordance with two orders of priority called respectively Pre-Enforcement and Post-Enforcement Priority of Payments. Those priorities are set out at length in the Conditions. Clause 23 of the Trust Deed makes it clear that the only assets of the Issuer available for payment of its obligations are the proceeds of the issue of the notes and other property representing them, called “Collateral”.

The Conditions are set out in Schedule 1 to the Trust Deed. They refer throughout to the Guarantor as the Supersenior Guarantor but do not explain or justify the description ‘supersenior’. Clause 1 contains numerous definitions of which I should refer to the following:

“Financial Guarantee Floating Amount means, upon the occurrence of an Event of Default with respect to the Notes, a Financial Guarantee Trigger Event or a Financial Guarantee Solvency Event, an amount equal to the sum of (a) the balance recorded on the Total Return Swap Interest Ledger, (b) the balance recorded on the Total Return Swap Principal Ledger, (c) any amounts due and payable under the Liquidity Swap;

Financial Guarantee Reimbursement Amount means an amount payable by the Issuer to the Supersenior Guarantor to reimburse the Supersenior Guarantor for payments of Financial Guarantee Floating Amounts;

Total Return Swap Principal Ledger means the ledger maintained by [the Trustee] to record amounts payable by the Issuer under the Ledger Swap of each of (a) the Accrued Total Return Swap Floating Amount, (b) the Total Return Swap Issuer Unwind Amount, (c) the Final Payment (as defined in the Total Return Swap Confirmation) and/or (d) any amount due on the redemption, in full or in part, of a Reference Obligation, as reduced from time to time;

Total Return Swap Termination Amount means, with respect to the Total Return Swap Agreement, the net amount due from one party to the other under the Total Return Swap Agreement calculated pursuant to Section 6(e) of the ISDA Master Agreement as a result of a Total Return Swap Agreement Event of Default or a Total Return Swap Termination Event thereunder.”

Those definitions are repeated exactly in the Master Definitions and Interpretation Schedule which governs all the documents relevant to these transactions. As will become apparent in due course the problem in this case arises from the limitation in the first definition to the sum of the three categories (a), (b) and (c).

Paragraph 3.4 of the Conditions deals with Priority of Payments before enforcement of security over the Collateral in respect of interest and principal. Paragraph 11.2 deals with priority of payments post-enforcement of the security over the Collateral. In each case, with only immaterial exceptions, the Financial Guarantee Reimbursement Amount is payable before payment to any class of noteholder.

The Guarantee Agreement was made on 31st March 2005 between the Guarantor, the Trustee and the Swap Counterparty, therein called the Creditor. Amongst the definitions is the following:

“Guarantee Payment Amount means...the amount payable by the Guarantor to the Creditor pursuant to Clause 2.”

By clause 2.1

“...the Guarantor unconditionally and irrevocably guarantees the amount of (i) any and all sums due and payable by the Issuer to the Creditor under the Total Return Swap Agreement and (ii) any and all sums due and payable by the Issuer to the Creditor under the Liquidity Swap Agreement...”.

The rights of the Guarantor against the Issuer are limited by clause 4 to those conferred by the Reimbursement Agreement.

The Reimbursement Agreement was made between the Issuer and the Guarantor alone. Clause 1.1 contains the following definition:

“Financial Guarantee Reimbursement Amount means...the amount (if any) paid by the Issuer to the .. Guarantor pursuant to clause 3...”

It will be noted that this definition is different to the definition of the same term in the Conditions set out in paragraph 5 above. By clause 2.2(k) the Issuer covenanted with the Guarantor that it would “on the terms and subject to the conditions of this Agreement, reimburse the ..Guarantor, subject to the Priorities of Payments..”. Clause 3 provides:

“3.

On each Payment Date on or following a date on which the ... Guarantor has paid a Guarantee Payment Amount (as defined in the .... Guarantee), the Issuer shall reimburse the .. Guarantor in an amount equal to the excess of (i) the aggregate of the Guarantee Payment Amounts paid by the ... Guarantor over (ii) the aggregate of all Financial Guarantee Reimbursement Amounts paid by the Issuer to the ... Guarantor prior to such Payment Date.”

Clause 4 restricts the recourse the Guarantor may have to the Collateral applied in accordance with the Post-Enforcement Priority of Payments. It follows that if the reimbursement of the Guarantor does not fall within that priority it cannot be made. The Financial Guarantee Reimbursement Amount does fall within that priority but as defined in the Conditions not as defined in the Reimbursement Agreement.

The definition in the Conditions and the Master Definitions and Interpretation Schedule of Financial Guarantee Reimbursement Amount brings in the definition of Financial Guarantee Floating Amount, namely the sum of the balance of the two specified ledgers and the equivalent under the Liquidity swap. Nowhere is any reference made to sums paid or payable by the Issuer to the Swap Counterparty on the termination of the total return swap and guaranteed by the Guarantor by clause 2.1 of the Guarantee Agreement. In those circumstances those seeking to find out the reason naturally turn to the Offering Circular required by the relevant regulators (“the Circular”). This is a substantial document extending to 208 pages including (pp.50-135) the Conditions. There are a number of relevant passages to which I should refer.

On page 3 it is pointed out that with immaterial exceptions

“..all...termination payments payable by the Issuer under the...Guarantee, the Total Return Swap Agreement and the Liquidity Swap Agreement shall rank in priority to the payments of interest and principal on the Notes in accordance with the Priority of Payments.”

The summary of terms on pages 23 to 25 refer at some length to the Guarantee. They point out that the Guarantee will cover all amounts payable to the swap counterparty upon the occurrence of an event of default. On such an event:

“...the Trustee will direct the ...Guarantor to pay to the Total Return Swap Counterparty, … an amount equal to any unpaid portion of (a) the balance recorded on the Total Return Swap Interest Ledger; (b) the balance recorded on the Total Return Swap Principal Ledger; (c) any Total Return Swap Termination Amount owed by the Issuer to the Total Return Swap Counterparty and (d) any amounts due and payable under the Liquidity Swap (such sum, the "Financial Guarantee Floating Amount").”

It will be noted that that definition of Financial Guarantee Floating Amount includes in paragraph (c) “any Total Return Swap Termination Amount owed by the Issuer to the Total Return Swap Counterparty”. This amount is not to be found in the definition of the same term in the Conditions and the Master Definitions and Interpretation Schedule quoted in paragraph 5 above. The summary continues:

“... The Issuer will be required to reimburse the ... Guarantor, on any Payment Date thereafter, in accordance with the Priorities of Payment and to the extent funds are available, for the excess of (i) the aggregate of the Financial Guarantee Floating Amounts paid by the ... Guarantor over (ii) the aggregate of all Financial Guarantee Reimbursement Amounts (as defined below) paid by the Issuer to the ... Guarantor prior to such Payment Date...”

In a section headed ‘Subordination’ it is stated on page 33:

“Payments of principal and interest on each Class of Notes are subordinated to the payment of certain other amounts payable by the Issuer, as set out in the Priorities of Payments. In particular, all payments under the Total Return Swap Agreements (except for Defaulted Total Return Swap Termination Payments), the Supersenior Financial Guarantee and the Liquidity Swap Agreement, shall rank in priority to the payments of interest and principal on all Notes except in certain circumstances, in respect of the Class A Notes, subject to the Priorities of Payments.”

After setting out the Conditions the Circular contains various sections giving details of the participants and other matters. Pages 185 to 186 describe the Guarantee. They contain passages corresponding to those on pages 23 to 25 quoted in paragraph 10 above but not in the same terms. In a passage describing the credit protection provided it is stated that:

“upon the occurrence of an Event of Default, the Trustee will direct the ... Guarantor to pay to the Total Return Swap Counterparty and/or the Liquidity Swap Counterparty, as applicable, an amount equal to any unpaid portion of the sum of (a) the balance recorded on the Total Return Swap Interest Ledger, (b) the balance recorded on the Total Return Swap Principal Ledger, (c) any amounts due and payable under the Liquidity Swap (such sum, the Financial Guarantee Floating Amount.”

The definition in this passage is in the same terms as that contained in the Conditions and the Master Definitions and Interpretation Schedule but different from that quoted on page 23 of the Circular in that it does not contain the reference to “any Total Return Swap Termination Amount owed by the Issuer to the Total Return Swap Counterparty”.

On page 186 of the circular the description of the position resulting from a payment of the Floating Amount by the Guarantor is, in substance, the same. It reads:

“In the event that the ... Guarantor pays the Financial Guarantee Floating Amount....The Issuer will be required to reimburse the ... Guarantor on each Payment Date thereafter and to the extent funds become available in accordance with the Priorities of Payment in an amount equal to the excess of (i) the Financial Guarantee Floating Amounts paid by the ... Guarantor over (ii) the aggregate of all amounts paid by the Issuer to the ... Guarantor with respect to the Financial Guarantee Reimbursement Amount prior to such payment.”

The Circular records on page 188 that as at the Closing Date the Issuer had entered into Total Return Swaps with an aggregate notional value of $212m.

In these circumstances counsel for the Guarantor submits that there is an obvious mistake in the definition of Financial Guarantee Floating Amount set out in the Conditions which can and should be cured by the established process of construction. It is contended that the definition should be read as including paragraph (c) of the definition of that term to be found on page 23 of the Circular so as to include “any Total Return Swap Termination Amount owed by the Issuer to the Total Return Swap Counterparty”. That is the first issue referred in paragraph 3 above to which I now turn.

It is well established that in appropriate circumstances a clear mistake may be corrected as part of the process of construction. I have been referred to a number of authorities. They are, in chronological order Schuler AG v Wickman Machine Tool Sales Ltd [1974] 235; East v Pantiles (Plant Hire) (1981) 263 EG 61; The Antaios [1985] AC 191; City Alliance Ltd v Oxford Forecasting Services Ltd [2001] 1 AER (Comm) 233; Holding & Barnes plc v Hill House Hammond Ltd (No.2) [2001] EWCA civ 1334; Dalkia Utilities Services plc v Celtech International Ltd [2006] 1 Ll.L.R. 599; KPMG v Network Rail Infrastructure Ltd [2007] EWCA Civ 363 and Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101. It is only necessary for me to refer to two of them.

In East v Pantiles (Plant Hire) (1981) 263 EG 61 the Court of Appeal was concerned with the date by which notice was required to be served so as to trigger a rent review clause. The principle to be applied was formulated by Brightman LJ, with whom Lawton and Oliver LJJ agreed, in these terms:

“It is clear on the authorities that a mistake in a written instrument can, in certain limited circumstances, be corrected as a matter of construction without obtaining a decree in an action for rectification. Two conditions must be satisfied: first, there must be a clear mistake on the face of the instrument; secondly, it must be clear what correction ought to be made in order to cure the mistake. If those conditions are satisfied, then the correction is made as a matter of construction. If they are not satisfied then either the claimant must pursue an action for rectification or he must leave it to a court of construction to reach what answer it can on the basis that the uncorrected wording represents the manner in which the parties decided to express their intention. In Snell's Principles of Equity 27th ed p 611 the principle of rectification by construction is said to apply only to obvious clerical blunders or grammatical mistakes. I agree with that approach. Perhaps it might be summarised by saying that the principle applies where a reader with sufficient experience of the sort of document in issue would inevitably say to himself, “Of course X is a mistake for Y”.”

Counsel for the Trustee suggested that a noteholder might rely on this proposition to oppose the relief sought by the Guarantor on the ground that it is not clear from the face of the Reimbursement Agreement that there has been any mistake. Whilst accepting that the Circular was admissible on any issue of construction he pointed out that it is not a contractual document. Given that there are no fewer than five definitions of the term Financial Guarantee Floating Amount and only one of them is in the terms for which counsel for the Guarantor contends, he submitted that it was not clear either what the mistake was or what correction ought to be made.

In response to this forceful submission counsel for the Guarantor relied on the speech of Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101 which is the second case to which I need refer. It concerned a mistake in the formula to be used to calculate the price payable for some development land. In paragraph 15 Lord Hoffmann noted that it required a strong case to persuade the court that something had gone wrong with the language the parties had used in their contract. In paragraph 17 he noted the relevance of the label or defined term used. In paragraph 21 he reiterated that the process of interpretation did not require any precise formulation of an alternative form of words to correct the clear mistake.

In paragraphs 22 to 24 Lord Hoffmann considered the judgment of Brightman LJ in East v Pantiles (Plant Hire) Ltd. He said:

22.

In East v Pantiles (Plant Hire) Ltd (1981) 263 EG 61 Brightman LJ stated the conditions for what he called "correction of mistakes by construction":

"Two conditions must be satisfied: first, there must be a clear mistake on the face of the instrument; secondly, it must be clear what correction ought to be made in order to cure the mistake. If those conditions are satisfied, then the correction is made as a matter of construction."

23.

Subject to two qualifications, both of which are explained by Carnwath LJ in his admirable judgment in KPMG LLP v Network Rail Infrastructure Ltd [2007] Bus LR 1336, I would accept this statement, which is in my opinion no more than an expression of the common sense view that we do not readily accept that people have made mistakes in formal documents. The first qualification is that "correction of mistakes by construction" is not a separate branch of the law, a summary version of an action for rectification. As Carnwath LJ said, at p 1351, para 50:

"Both in the judgment, and in the arguments before us, there was a tendency to deal separately with correction of mistakes and construing the paragraph 'as it stands', as though they were distinct exercises. In my view, they are simply aspects of the single task of interpreting the agreement in its context, in order to get as close as possible to the meaning which the parties intended."

24.

The second qualification concerns the words "on the face of the instrument". I agree with Carnwath LJ, paras 44-50, that in deciding whether there is a clear mistake, the court is not confined to reading the document without regard to its background or context. As the exercise is part of the single task of interpretation, the background and context must always be taken into consideration.

25.

What is clear from these cases is that there is not, so to speak, a limit to the amount of red ink or verbal rearrangement or correction which the court is allowed. All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant. In my opinion, both of these requirements are satisfied.”

In my view Lord Hoffmann makes it clear in those passages that although the mistake must be clear it may emerge from a consideration of all the relevant documents, not only on the face of one of them; nor is there a limit to the correction which may be made provided that it is clear to the reasonable person having regard to all the relevant documents what the parties meant. Accordingly, it appears to me that the argument assumed to have been put forward by a noteholder seeks to place limits on how the mistake may appear and how it may be corrected which the authorities do not warrant.

It is true, as submitted by counsel for the Trustee, that the apparently unlimited obligation of the Issuer to reimburse the Guarantor contained in clause 3 of the Reimbursement Agreement is restricted by the provisions of clause 4 to recourse to the net proceeds of the Collateral applied in accordance with the Post-Enforcement Priority of Payments. But it is plainly envisaged that the obligation of the Issuer to reimburse the Guarantor for payments made on the termination of the swaps appears somewhere in that order of priority. Were it otherwise clause 4 would recognise that in the event of a shortfall the Guarantor would not be entitled to any reimbursement.

That such reimbursement is contemplated is confirmed by the use of the term Financial Guarantee Reimbursement Amount in paragraph (i) of the Post-Enforcement Priority of Payments set out in Condition 11.2. Had the definition of that term been taken from the Reimbursement Agreement rather than the Conditions the present problem would not have arisen. As it is, the definition actually applied is limited to the sum of the three items set out in it. Sub-paragraph (b) refers to the balance recorded on the Total Return Swap Principal Ledger. The definition of that term in both the Conditions and the Master Definitions and Interpretation Schedule appears to exclude the Total Return Swap Termination Amount as defined. The contrary has not been asserted. The consequence is that such termination amounts are not included in the relevant ledger balance.

But that makes no commercial sense. The ledger balances, be they for interest or principal, record, in the absence of an early termination, the gross amounts due but not paid by the Issuer to the Swap Counterparty during the currency of the swap agreement. The Total Return Swap Termination Amount is the net amount arrived at after netting off sums due by the Issuer against the sums due to the Issuer after termination. Thus the amounts appearing in the ledger accounts before termination include gross amounts which go to produce the net sum defined as the Total Return Termination Amount due after termination. But whereas the former is subject to reimbursement by the Issuer to the Swap Guarantor the latter is not. No reason has been suggested why the right of the Swap Guarantor to be reimbursed from the Collateral should depend on whether or not there has been an early termination.

These conclusions appear from the convoluted definitions used in the Conditions. The Total Return Swap Principal Ledger referred to in paragraph (b) of the definition of Financial Guarantee Floating Amount is defined in the Conditions as the ledger recording amounts payable by the Issuer described as:

“(a)

the Accrued Total Return Swap Floating Amount, (b) the Total Return Swap Issuer Unwind Amount, (c) the Final Payment (as defined in the Total Return Swap Confirmation and/or (d) any amount due on the redemption, in full or in part, of a Reference Obligation, as reduced from time to time;”

These terms are themselves defined, albeit not solely by reference to the Conditions. The Accrued Total Return Swap Floating Amount (a) is defined in the Conditions as all amounts accrued due by the Issuer but unpaid for the time being. The definition of the Total Return Swap Issuer Unwind Amount (b) in the Conditions incorporates the expression “Unwind Payment” in the Total Return Swap Confirmation. In the Total Return Swap Confirmation the expression “Unwind Payment” refers to an amount agreed by or determined as between the Issuer and the Total Return Swap Counterparty which is payable on or prior to the Scheduled Termination Date. A Reference Obligation (d) refers to an obligation under the Total Return Swaps. Thus it appears that, by one route or another, all sums due, but which remain unpaid by the Issuer to the Swap Counterparty prior to an early termination should be reflected in the Total Return Swap Principal Ledger.

In addition no coherent explanation has been given why a Total Return Swap should, in this respect, be treated differently from a liquidity swap referred to in paragraph (c) of the definition of Financial Guarantee Floating Amount contained in the Conditions. Further the definition of Financial Guarantee Floating Amount set out on page 24 of the Circular is further confirmation of an intention that the Guarantor should be reimbursed with the like order of priority.

I conclude that it is clear from a consideration of all the relevant documents that a mistake has been made in the definition of Financial Guarantee Reimbursement Amount as defined in the Conditions and applied in condition 11.2(i). The term ought to include the Total Return Swap Termination Amount. If the appropriate construction is to read the definition of Financial Guarantee Floating Amount where it appears in the Conditions as being in the form set out on page 24 of the Circular then the Total Return Swap Termination Amount owed by the Issuer to the Swap Counterparty will be included. Consequently the Issuer would be obliged to reimburse that amount to the Guarantor. As the obligation to reimburse only arises if the Guarantor has paid the amount due to the Total Return Swap Counterparty it matters not that the definition describes it as owed by the Issuer. Accordingly I conclude that it is clear from this consideration of the relevant documents what is the appropriate construction to adopt to correct the obvious mistake.

For these reasons I accept the submissions made by Counsel for the Guarantor and will make the appropriate declaration as to the true construction of the relevant documents. In these circumstances the question of rectification does not arise. There would be no issues of fact to resolve if it did and it is not, therefore, necessary for me to deal with it.

Not the least surprising feature of this case is the absence of any noteholder prepared to participate. As the Notes were issued in dematerialised form to Clearstream and Euroclear and are payable to bearer the Trustee is unable to ascertain the identity of all noteholders. Nevertheless the interlocutory processes, which included advertisement, revealed KBC Investments Ltd, BAWAG, Unicredit, Uniqa and Nataxis as noteholders. None of them was prepared to take any part in the proceedings. In those circumstances I was grateful to counsel for the Trustee for his very helpful submissions but I think it is necessary to add a few words in relation to the position of a trustee in an application such as this.

In view of the absence of any noteholder prepared to participate I indicated before the hearing that I expected the Trustee to advance any arguments reasonably available to the noteholders as a class. The response was a letter from the Trustee’s solicitors stating

“we are mindful of our duties to the Court, but we write on behalf of our client to request that the Chancellor does not require us or our client’s counsel to address the court on any arguments available to any side in this litigation.”

The reason for this request was stated to be the wish of the Trustee “to maintain complete neutrality”. The letter indicated that if I was not minded to accept their request the Trustee should be formally ordered to make such arguments and an adjournment to enable such arguments to be advanced would be required. In the event I made no such order, granted no adjournment and received considerable assistance from counsel for the Trustee.

Nevertheless I remain concerned that the duties of a trustee in seeking the assistance of the court should be properly understood. In the case of a private trust, including a pension scheme, the trustee has been likened to a watchdog for unrepresented interests, see Re Druce [1962] 1 AER 563, 568. The trustee is expected to assist the court in the varied circumstances indicated in paragraph 21.81 Lewin on Trusts 18th Edition and the cases there cited. Of course there are differences between those trustees and the Trustee in this case but those differences do not, in my view, lead to any difference in the duty of the Trustee to the Court. If a trustee, of any description, applies to the court he is expected to assist the court by bringing to the court’s attention any relevant legal proposition or argument affecting the position of unrepresented beneficiaries or parties. This is, in my view, but a specific application of the general duty to which Lord Birkenhead LC referred in Glebe Sugar Refining Company Ltd v Trustees of the Port and Harbours of Greenock [1921] WN 85 to the case of particular fiduciaries. That said I am in no doubt that, in the event, the duty was amply observed and performed by Counsel for the Trustee.