SNCB Holding v UBS AG

The Claimant (SNCB) seeks damages from the Defendant (UBS) for breach of contract. There is an issue as to the contractual documentation, since SNCB maintains that this includes a Term Sheet sent to it by UBS on the 19 November 2001 and the 7 December 2001. An Amended Deposit Agreement dated as of 19 November 2001 (the ADA), which was, on the evidence, executed in January 2003, and Security Agreements dated 17 January 2003 and 15 January 2009 (which are not materially different), are agreed to be part of the contractual documentation.

The claim arises out of the ADA by which SNCB paid UBS a sum of $39.75M in 2001 in return for payments made by UBS to SNCB of approximately $12.86M dollars in January 2003-January 2005 and a further sum of approximately $165M to be paid in 2031. The payments due to SNCB under the Agreement were intended to enable it to pay its obligations under a cross border lease in respect of Belgian railway infrastructure, where SNCB had entered into a sale and lease back with an option of repurchase at the end of the 30 year term. The critical features of the ADA, for current purposes, were that UBS was obliged to make the repayments set out in Annex 1 subject to the occurrence of a Credit Event in respect of any specified Reference Entity, as those terms were defined in the ADA. Should such a Credit Event occur, UBS’ future repayment obligations would be terminated in respect of the portion of the Deposit linked to that Reference Entity and UBS would be bound, instead of making that repayment, to deliver to SNCB, bonds of that Reference Entity with a face value equivalent to an Accreted Amount to be calculated in accordance with the terms of the ADA. The ADA also provided that UBS was to set up a Collateral Account, being a segregated account, which would constitute security for its repayment obligations. In SNCB’s submission, it was also security for the obligation of UBS to deliver the Reference Entity bonds on the happening of a Credit Event. The Collateral Account was to consist of bonds of Reference Entities and/or cash in US dollars. The essential points of construction and implied terms at issue between the parties concern the link (if any) between the Collateral provisions and the Credit Event provisions of the ADA.

In March and July 2010 Credit Events are said to have occurred in respect of one of the Reference Entities, Ambac Assurance Corporation. SNCB now accepts that all three were Credit Events within the meaning of the ADA, though it did not do so at the time. At the end of March, the Collateral Account contained Ambac bonds (in fact Municipal Bonds, guaranteed by Ambac) which had a market value of around $9M. SNCB maintains that under the ADA, UBS was required to deliver to it those Ambac Municipal bonds in the Collateral Account at the time of the Credit Event, whereas what in fact happened was that, over a three and a half month period, UBS replaced the Ambac Muncipal bonds in the Collateral with cash and then subsequently substituted other Ambac guaranteed bonds (Ambac Terwin Bonds) of much lesser value (about $2m), served a Credit Event Notice on July 12 and delivered them to SNCB on the 12 August 2010.

Of the three relevant Credit Events, the first, as determined by ISDA on 26 March, took place on 24 March 2010, and was the subject of contest in correspondence between the parties thereafter. No Credit Event Notice was served in respect of it. The second took place on 25 March but did not come to the attention of UBS until 9 June 2010. The third occurred on 1 July. UBS relied only on the latter two in its Credit Event Notice on 12 July. No issue arises as to the timeliness of that Notice in respect of those two events. The question is whether or not UBS was entitled to take this course of action, which gives rise to arguments about the composition of the contractual documentation and its construction, about implied terms and about the exercise of contractual discretion.

SNCB’s case is that UBS’ decisions to replace the contents of the Collateral Account after the ISDA Credit Event and to deliver to it the cheapest bonds it could find had the purpose and effect of benefiting UBS’ commercial interests at the expense of SNCB’s interests. Those decisions are alleged to be contrary to SNCB’s rights, its reasonable expectations and the purposes for which UBS’ power to manage the Collateral was conferred, amounting to an abuse of UBS’ contractual power and a breach of contract that has caused SNCB substantial loss.

The principal issues, as set out in SNCB’s skeleton argument are said to be as follows:-

Paragraph 9 of the Re- Amended Particulars of Claim, served a week before the trial, provides as follows:-

“On the true construction of the express terms of the Deposit Agreement, in particular, the terms set out in Schedule 2 in the light of the factual background to that agreement pleaded herein, and/or by way of an implied term:

(1)

From 31 January 2003, UBS was required to ensure that on the last business day of each month the mark to market value of the Collateral held in the Collateral Account was at least 100 per cent of the mark to market value of the Deposit.

(2)

UBS was required on the last business day of each month to transfer Collateral into the Collateral Account in an amount sufficient to satisfy its obligation described at paragraph 9 (1) above if on that day the mark to market value of the Collateral held in the Collateral Account was less than 100 per cent of the mark to value of the Deposit.

(3)

UBS had a discretion to determine whether the Collateral which it was required to transfer into the Collateral Account as described in paragraph 9(2) above or which it was entitled to transfer into the Collateral Account would be in the form of Obligations of the Reference Entities (“Obligations”) or cash in US Dollars (“cash”).

(4)

UBS’s discretion described at paragraph 9(3) above cannot be exercised by UBS for any purpose other than the purposes for which that discretion was conferred. The purposes for which the aforesaid discretion was conferred on UBS was limited:

To transferring cash into the Collateral Account if on the last business day of each month the mark to market value of the Deposit was more than 100% of the mark to market value of the Collateral and UBS was unable to transfer sufficient Obligations into the Collateral Account by the last business day of the month. Such cash was permitted to be held in the Collateral Account only for such period of time as was necessary to enable UBS to obtain sufficient Obligations to replace the cash in the Collateral Account.

(4A) UBS was not entitled to remove any Obligations of a Reference Entity that were held within the Collateral Account at any time after: (a) an event had occurred with respect to that Reference Entity which entitled UBS to serve a Credit Event Notice under clause 4 of the Deposit Agreement; or (b) UBS had formed or expressed an intention of serving a Credit Event Notice in respect of that Reference Entity. If UBS elected to serve a Credit Event Notice in respect of that Reference Entity and to deliver a Delivery Portfolio to SNCB, UBS was required to deliver any Obligations of that Reference Entity held in the Collateral Account at the time of the Credit Event or when UBS formed or expressed an intention to serve a Credit Event Notice as part of the Delivery Portfolio.

In my judgement, the real issue between the parties is the question of construction of the contractual documents, whether or not the processes of construction and implication of terms have become assimilated. In my judgment, there is real difficulty in seeking to imply terms of the kind suggested into agreements of the nature of those concluded here, whatever language is adopted as the test for implication of terms, as set out in the different authorities on the point. Further, when two or more implied terms are put forward, which differ in substance (as opposed to semantics only), the force of the argument is diminished that any one of them is necessarily to be implied to give effect to the true meaning of the contract and/or fulfil the parties’ joint expectations as the only term which “fits”. Moreover, there is difficulty in the suggestion that a commercial party to a sophisticated Credit Linked Deposit Agreement of this kind could act contrary to the reasonable expectations of the parties to it and/or abuse its contractual discretion, in such a way as to give rise to a claim for damages, if the express terms of the contract appear to allow it to do what was done.

SNCB has had several attempts at formulating terms which are said to be implied into the ADA, as set out in its statement of case, its evidence, its written opening, its written closing and oral submissions. That does not in itself cast doubt upon the final formulation, but the reason for reconstruction of those provisions may be significant. In its opening, SNCB accepted that UBS had no obligation to have any specific Reference Entity bonds in the Collateral Account prior to a Credit Event. No implied term was pleaded as to the matching of Reference Entity bonds in the Collateral Account with the Current Percentage selected by UBS for the credit protection provisions. The benefit which SNCB seeks to obtain by the implication of such terms is therefore the delivery of bonds of a particular Reference Entity, the presence of which in the Collateral Account, it is accepted, is, so far as SNCB is concerned, a matter of happenstance, since UBS was free to decide which bonds of the Reference Entities were in the Collateral Account prior to the event upon which, it is said, the Collateral Account becomes effectively frozen. The effect of the implied terms is thus to create a windfall for SNCB- in other words to provide for something which was essentially unforeseeable or unpredictable and outside SNCB’s control. In closing arguments, a new unpleaded implied term of matching was put forward.

In order to understand the issues of construction and implication of implied terms, it is necessary to set out in extenso, some of the provisions of the ADA, including the paragraph on the frontispiece:-

“The Credit Risk of the Deposit is that of the Reference Entities. Principal is at risk on the deposit if there is a Credit Event in respect of bonds of a Reference Entity. Following a Credit Event the Deposit will partially be terminated early (to the extent of the Current Percentage of the Affected Reference Entity) and the Depositor will be delivered Obligations in lieu of repayment of the Deposit. The Obligations may have a market value below par, subject to a minimum of zero.

1.

Deposit

1.1

The Depositor will pay or cause to be paid to UBS by crediting such account of UBS, as shall be notified by UBS to the Depositor, the Deposit Amount in same day funds on the Deposit Payment Date.

1.2

Subject to Clause 4, UBS shall pay on the Repayment Dates the Scheduled Repayments, in accordance with the Repayment Schedule In Annex 1, to the Depositor in same day funds by crediting such account of the Depositor as notified by the Depositor to UBS.

1.3

All dates specified for payment to be made pursuant to this Agreement, whether in respect of interest or otherwise, shall be subject to adjustment in accordance with the Modified Following Business Day Convention.

2.

Reference Entity Current Percentages

2.1

Provided that no Credit Event shall have occurred, the aggregate of all Current Percentages shall equal 100 per cent. The percentage of the Accreted Amount applicable to any Reference Entity at any time as selected by UBS is referred to as the "Current Percentage”. After a Credit Event the aggregate of the Current Percentages will be reduced by the current Percentage applicable to the Affected Reference Entity at the time of that Credit Event. The Current Percentages at any time relate to the Initial Accreted Amount disregarding any Credit Events that have occurred.

2.2

UBS may change the Current Percentage for any Reference Entity at any time, provided that the Reference Entity current Percentage Limits are observed. Any Reference Entity with a Current Percentage of greater than zero may only be replaced with one of at least equivalent rating (ratings from Standard & Poors and Moody's) as at the time of replacement UBS will notify the Depositor of the Reference Entity Current Percentages at least every six months following the Deposit Payment Date and on any change to such current Percentages.

3.

Collateral

The Deposit is a secured obligation of UBS and is secured by way of a first priority continuing security interest over the Collateral, in accordance with the Security Agreement dated on or about the date hereof.

3.1

The Collateral may only include Collateral Securities or USD cash.

3.2

The mark to market value when determined by UBS acting in good faith

(“MTMV”) of the Collateral is required to be at least 100 per cent of the MTMV of the Deposit. All coupons or other payments from the Collateral will be retained by UBS.

3.3

UBS will be required, until 17 December 2002, semi-annually to ensure that the correct amount of Collateral is held in the Collateral Account. From the 31 January 2003, UBS will be required monthly, on the last business day of each month, to ensure that the correct amount of Collateral is held in the Collateral Account. This may involve UBS transferring Collateral to the Collateral Account or removing Collateral from the Collateral Account. UBS will deliver the Collateral to the Collateral Account within an accumulation period of 20 Business Days from Deposit Payment Date.

3.4

UBS will provide a statement of the Collateral following each semi-annual mark to market. The first such statement will be prepared immediately following 17 December 2001. The second mark to market will take place on 20 May 2002 and a statement will be prepared immediately thereafter. From the 31 January 2003, the mark to markets will take place monthly on the last business day of each month. The statement will specify:

(a)

the mark to market value of the Deposit; and

(b)

the Collateral in the Collateral Account and its mark to market value.

4.

Credit Event

4.1

UBS shall have the right following the occurrence of one or more of the Credit Events (regardless of whether such Credit Event is still in existence) on or after the Deposit Payment Date and on or prior to the Business Day immediately preceding the Scheduled Final Repayment Date, on giving notice in writing (the “Credit Event Notice”) to the Depositor, to Deliver the Delivery Portfolio in lieu of partial repayment of the Scheduled Repayments. UBS shall determine in its absolute discretion whether a Credit Event has occurred. No later than 30 calendar days following the delivery of the Credit Event Notice, UBS shall send a notice (the “Notice of Portfolio”) to the Depositor, listing the Obligations in the Delivery Portfolio and on the Physical Settlement Date, Deliver the Delivery Portfolio to the Depositor (to the account specified by Depositor) and the Depositor shall accept Delivery of such Delivery Portfolio, In each case subject to and in accordance with the Physical Settlement Provisions.

4.2

Subject to Defaulted Issuer Replacement following Delivery of the Delivery Portfolio in accordance with Clause 4.1, early termination of this Agreement and the rights and obligations of the parties hereto in respect of such terminated part ("Partial Early Termination”), will occur on the Physical Settlement Date in respect of the Current Percentage of the future Scheduled Repayments and Accreted Amount applicable to the Affected Reference Entity at the time of the Credit Event (ignoring for the avoidance of doubt any reduction as a result of prior Credit Events).

The Accreted Amounts and the future Scheduled Repayments will be reduced by amounts equal to the Initial Repayment Schedule multiplied by the Current Percentage of the Reference Entity.

For the avoidance of doubt, the Scheduled Repayments and Accreted Amount are exposed to the Reference Entities to the extent of their respective Current Percentages, not to the actual amount of bonds of the Reference Entity in the Collateral Account at the time of a Credit Event.

Schedule

Definitions

Save as otherwise defined in this Agreement, the following expressions shall have the following meanings:

"Accreted Amount” means the Deposit Amount accreted at the Accretion Yield, allowing for Scheduled Repayments Amount (as set out in Annex 1) and amended as described in Clause 4 for any Credit Events. The Accreted Amounts on certain dates (ignoring any reduction for Credit Events) are set out in Annex 1.

"Accretion Yield" means 6.0368%, calculated on 30/360 semi-annual day count basis, and applied to the Deposit Amount (taking into account the Scheduled Repayments), beginning on the Deposit Payment Date.

"Affected Reference Entity" means any Reference Entity in respect of which a Credit Event has been declared.

"Credit Event” means any event of default, howsoever described, in respect of any Obligation of any Reference Entity.

"Collateral" means the Obligations of the Reference Entities and/or USD cash.

"Collateral Account" means a segregated account in the name of UBS Warburg International Limited (or such other entity nominated by UBS in accordance with the Security Agreement) with the Custodian.

"Collateral Securities" means the Obligations in the Collateral Account from time to time.

“Current Percentage" shall have the meaning given in clause 2.2.

"Deliver" means to deliver, novate, transfer, assign or sell, as appropriate, in the manner customary for the settlement of the applicable Collateral Securities (which shall include executing all necessary documentation and taking any other necessary actions), in order to convey all right, title and interest in the Collateral Securities comprising the Delivery Portfolio to the Depositor free and clear of any and all liens, charges, claims or encumbrances (including without limitation any counterclaim, defence (other than a defence based on (a) any lack or alleged lack of authority or capacity of the Reference Entity or Collateral Securities issuer to issue the Collateral Securities, (b) any actual or alleged unenforceability, illegality, impossibility or invalidity with respect to any Collateral Securities, however described, (c) any applicable law, order, regulation, decree or notice, however described, or the promulgation of, or any change in, the interpretation by any court, tribunal, regulatory authority or similar administrative or judicial body with competent or apparent jurisdiction of any applicable law, order, regulation, decree or notice, however described, or (d) the imposition of, or any change in, any exchange controls, capital restrictions or any other similar restrictions imposed by any monetary or other authority, however described) or right of setoff by or of the Reference Entity or Collateral issuer). "Delivery" and “Delivered" will be construed accordingly.

"Delivery Portfolio" means with respect to each Credit Event, Obligations of the Affected Reference Entity, the sum of whose aggregate outstanding principal balance, without accrued but unpaid interest and other unpaid but due amounts, is equal to the Initial Accreted Amount as attached in Annex 1 (having no regard to any previous Credit Events, and applying the Accretion Yield to determine the exact Accreted Amount) muliplied by the current Percentage then applicable to the Affected Reference Entity.

“Notice of Portfolio” has the meaning ascribed to it in clause 4.1.

"Obligations” means with respect to any Reference Entity, any bonds of such Reference Entity either directly or in its capacity as unconditional guarantor, that rank at least equal in priority of payment with the senior unsecured debt obligations of the Reference Entity, and (a) are denominated and payable only in the lawful currency of G7 countries, Switzerland and Australia, and the EURO (Including all legacy currencies) (b) are repayable in an amount equal to their respective stated principal amounts, or in the case of zero coupon debt obligations, their outstanding balance calculated at their stated accretion yield (c) the repayment of which is not subject to any contingency.

In the case of AMBAC and MBIA, Obligations will include only Guaranteed Bonds.

"Physical Settlement Provisions", if applicable, mean

(a)

UBS shall be deemed to represent to the Depositor on the Physical Settlement Date that it has conveyed (or, if applicable, caused to be conveyed) to the Depositor (or, if applicable, its designee) all right, title and interest in the Collateral Securities Delivered on such date free and clear of all claims, charges, liens and encumbrances.

(c)

(i) UBS agrees (which agreement shall survive the termination of this Agreement) to execute, deliver, file and record any specific assignment, novation or other document and take any other action that may be necessary or desirable and reasonably requested by the Depositor in connection with UBS's Delivery of the applicable Collateral Securities and the Depositor agrees to co-operate reasonably with UBS in connection with the foregoing; and /or (ii) If due to an event beyond the control of UBS, it is impossible, illegal or impractical for UBS to Deliver or due to an event beyond the control of then Depositor it is impossible or illegal for the Depositor to accept Delivery of the Delivery Portfolio or Collateral Securities in whole or in part on the Physical Settlement Date. Failure to Deliver all or part of the Delivery Portfolio or Collateral Securities due to such impossibility, illegality or impracticality shall not constitute an Event of Default

“Reference Entity" means any of:

(i)

(a) AMBAC Financial Group Inc., AMBAC Insurance Corporation;

(b)

American International Group, lnc “AIG” (which expression shall include AIG entities rated AAA by Standard & Poors or Aaa by Moody's Investor Services on the Deposit Date, and

(c)

Financial Security Assurance Inc., FSA Global Funding Inc.

(d)

MBIA Inc;

(ii)

US Agency securities, Including Federal National Mortgage Association ("Fannie Mae"), Federal Home Loan Banks ("FHLB"), Federal Home Loan Mortgage Corporation (Freddie Mac), Tennessee Valley Authority and any agencies that are backed by the full faith and credit of the United states Government;

and any Successors thereto.

"Reference Entity Current Percentage Limits" means for category 1 above, the Current Percentage in respect of any Reference Entity shall be no more than 40% (of the Accreted Amount), subject to a maximum of 100%;

The recitals to the Security Agreement of 17 January 2003 refer to the Credit Linked Deposit Agreement (the ADA) and the agreement by UBS to procure a deposit of a portfolio of securities in the Collateral Account with a charging of that portfolio in favour of SNCB “to secure all the present and future obligations and liabilities of UBS under the Confirmation and the Agreement”. “The Agreement” refers to the ADA.

By Clause 2 of the Security Agreement, the portfolio of securities lodged in the Collateral Account was charged and pledged in favour of SNCB by way of first fixed security, as were all the rights relating to the portfolios, as a continuing security. There is no reference to cash as such as security in the Security Agreements, though this appears in clause 3 of the ADA and clause 11 of the former specifically catches the proceeds of sale of charged assets. The later Security Agreement is in materially identical terms.

It is submitted by SNCB that the final Term Sheet, sent on 23 November and 7 December 2001was part of the contractual documentation and/or can be used as an aid to construction of the ADA. It provided that it was “subject to and should be read in conjunction with the Deposit Agreement and Security Agreement” and went on to say that “the Deposit will be entered into between the Depositor and UBS” and that “Documentation will comprise a Deposit Agreement and a Security Agreement prepared by UBS”. It is self evident and common ground that, when the Term Sheet provided that it was to be subject to the Deposit Agreement and the Security Agreement, the latter should prevail in the event of any conflict. When however the Term Sheet refers to the Documentation consisting of a Deposit Agreement and a Security Agreement, it becomes plain that what the parties envisaged was that the Term Sheet would be superseded by the subsequent documentation.

On 23 November, the email sent by UBS to SNCB attached the Term Sheet as a “revised and updated termsheet” which referred to an additional Reference Entity, which UBS hoped was acceptable and saying that the Deposit Agreement should be ready by the end of the day and would be sent by email. On 7 December, a Deposit Agreement was sent by email, “for the trade executed for payment on 19 November for your comments”. The email continued “ for ease of comparison I also attach the latest termsheet” (the same as that sent on 23 November), pointing out a difference in terminology and saying that an attempt had been made to keep the document as short as possible. Clearly the intention was that the Deposit Agreement would supersede the termsheet and was to include all relevant terms, other than those to be contained in the Security Agreement to which it referred. That was the purpose of conducting a comparison.

The Term Sheet was never signed by the parties, whether as a Trade Confirmation or as anything else. There are differences between the provisions of the Term Sheet and the provisions of the ADA and it is clear, in my judgement, that the ADA (dated as of 19 November 2001) and the Security Agreement, both executed in 2003, long after the payment of the $39.75M on 19 November 2001, were intended to encapsulate all of the agreed contractual terms, taking into account, as they did, developments which had taken place between November 2001 and January 2003.

Whilst a Deposit Agreement was executed by UBS at the turn of the 2001-2002 year, it was never executed by SNCB. Miss Lauwereys could not recall why that was and, as a matter of SNCB policy, accepted that, as Treasurer of the Company, she would want to ensure that an agreed document was executed. Her evidence was that the payment of $39.75m was made on 19 November 2001 on the basis of the first indicative Term Sheet dated 14 November 2001 and discussions which followed which led to the final Term Sheet of 23 November 2001, re-sent on 7 December 2001, though this was never signed. She did not say that this final Term Sheet contained the terms discussed and agreed orally. There was therefore no signed document at all which reflected whatever terms were agreed at the time of the payment of the Deposit and the anticipation that formal documents would be executed in the future.

Thereafter various draft Deposit Agreements were provided by UBS to SNCB. Various issues arose between the parties between December 2001 and 2003 whilst these documents were in circulation, but the ADA appears to have been executed at the same time as the Security Agreement of 17 January 2003, the latter being a document which should have been in existence from the outset as providing for a charge over the Collateral provided by UBS in respect of its obligations. No less than seven draft Deposit Agreements were sent by UBS over the interim period of 14 months, and an exchange between the parties in December 2002 shows that SNCB had not executed the current draft because Ms Lauwereys had further comments on it and points she wanted clarified before she was prepared to sign. Her evidence was that the developments which took place over the 14 month period meant that she wanted changes in the Documentation. She effectively accepted that, by the time of the ADA, the transaction was different from that described in the Final Term Sheet. For a payment of some $936,000 by SNCB, agreed around October 2002, changes were agreed in the identity of the Reference Entities referred to in the unsigned versions of the Deposit Agreement furnished by UBS, by eliminating GECC and various investment companies. Hence perhaps the appellation “Amended” in the ADA, since there must have been agreement to the originally specified Reference Entities, as the operation of the agreement proceeded on the basis of UBS selecting the current percentage for each Reference Entity. There must have been therefore some agreement which governed the position before the signature of the ADA, but it is unnecessary to determine whether that was on the terms of the final Term Sheet, the Deposit Agreement executed by UBS alone or some other terms, because all were superseded by the ADA, which contained significant differences as compared to that Term Sheet.

In the first general paragraph of the final Term Sheet, there was provision that, if any of the bonds in the Reference Entity Portfolio (the Collateral Account) suffered a Credit Event, the deposit would partially terminate, without any election on the part of the parties. In the ADA, however, UBS was given the right to terminate on the happening of a Credit Event in respect of any bond of any Reference Entity. Later in the Term Sheet, UBS is given the right to declare a Credit Event, when it becomes aware of any event of default and the Credit Event Date is defined as that date on which UBS determines that a Credit Event has occurred. That too differs from the ADA. As already mentioned the Reference Entities and the permissible limits of holdings in each of them were changed as was the frequency of the provision of the statements of the Collateral Account.

Critically, in the final Term Sheet, Deliverable Obligations are defined as “Any bonds in the Reference Entity Portfolio” and the following wording appears:

“Deliverable Obligations will be bonds in the Reference Entity Delivery Portfolio. However, if following a Credit Event, there are insufficient obligations of the Affected Reference Entity, in the collateral account to cover the delivery required, because the Accreted Face Amount is greater than the market value of the Deposit, UBS may, to the extent of the shortfall only, deliver other obligations of the Affected Reference Entity which meet the Reference Entity Delivery Portfolio criteria. If there are more obligations of the Affected Reference Entity in the collateral account than required, they will be returned to UBS.”

This is wording upon which SNCB sought to rely but the ADA included no such wording at all about delivery of bonds in the Collateral Account following the happening of a Credit Event and the concept involved in this provision in the Term Sheet is inconsistent with any provision for the delivery of the Delivery Portfolio in the ADA. This provision in the final Term Sheet talks of making good a shortfall of bonds of the Affected Reference Entity in the Collateral Account, where the shortfall is assessed by reference to the difference between the Accreted Face Amount and the market value of the Deposit. In the ADA, as is common ground, the obligation is to deliver sufficient bonds of the Affected Reference Entity whose nominal face value equates to the Accreted Amount. The exact terms will be the subject of later discussion in this judgment but the market value of the Deposit is an irrelevance for this purpose, as both parties accepted. Thus, the very point for which SNCB wishes to rely on the Term Sheet illustrates that the Term Sheet had been superseded, so that the construction of the ADA must fall to be determined on its own terms.

By the time that the ADA was signed, this final Term Sheet had long been superseded. It was, in any event, in my judgment, never intended to be a contractual document once the Documentation to which it referred had been executed, which was anticipated to be a Deposit Agreement and Security Agreement. Given all that had occurred between November 2001 and January 2003, with the ADA specifically taking effect as from 19 November 2001, there is no scope to treat the final Term Sheet as a current contractual document, even if it once was. It may have governed the position temporarily, but life had moved on by the time that a Deposit Agreement was drafted and discussed and even more so by the time that the ADA was signed which was in different terms and intended to govern the relationship as from the outset, when the deposit was paid.

In the definitions part of the Security Agreement, “Security Documents” are said to refer to the Security Agreement itself, “the Confirmations and the Agreement”. The Security Agreement defines “the Agreement” as the ADA but never defines “the Confirmation” or “the Confirmations”. These words could not, in my judgement, refer to the final Term Sheet because it was never signed as a Confirmation would be and it was, for the reasons already given, superseded by the “Documentation”, which, unlike ISDA conditions, which require a Trade Confirmation to set out the main terms, contained a comprehensive body of terms, which did not require reference to any Confirmation document. The ADA was complete in itself, subject only to any need for a Security Agreement.

Accepting therefore, that the Term Sheet is admissible as a contractual document which once governed the position, or even accepting it, merely for the sake of argument, as SNCB submitted in the alternative, as either evidence of background known to the parties or of the genesis and object of a provision in or of the transaction itself (about which there was much scope for, and actual, argument, in the context of inadmissible evidence of negotiations- see Chartbrook Ltd v Persimmon Homes Ltd [2009] 1AC 1101 and Scottish Widows v BGC International [2011] EWCA Civ 607), this Term Sheet cannot assist when it comes to construing the terms of the ADA, where the basis of the deal appears to have changed, no similar term appears and both the terms and the relevant concept are significantly different from this provision.

I heard evidence from Ms Lauwereys, the Treasurer of SNCB, whilst a statement of one of SNCB’s in-house lawyers was read without the need for cross examination. I heard also from Mr Bonomo, the trader engaged by UBS, who, on his evidence, made the relevant decisions in 2010, after consultation with his Line Managers, Mr Poole and Mr Cortesani, to move the Ambac Municipal bonds out of the Collateral Account and sell them, to replace them with cash, to purchase the Ambac Terwin bonds, put them in the Collateral Account and then deliver them to SNCB in purported satisfaction of UBS’ obligations under the ADA. I also heard from Ms Anky Chan, an in-house lawyer employed by UBS. All these witnesses gave evidence which reflected their views of the proper construction and effect of the ADA.

Ms Lauwereys was a shrewd witness, although her evidence as to why contractual documentation was not signed until January 2003 was unsatisfactory and her inadmissible evidence of her beliefs as to the construction of the ADA at its conclusion and thereafter was inconsistent with the documents and the history in 2008-9 in particular and raised as many questions as it answered. Her evidence as to her understanding of the implied terms (if of any relevance) also differed from that in her statement and that pleaded by SNCB. Ms van Cauter’s evidence added nothing of significance.

Mr Bonomo was unnecessarily defensive in cross examination, both generally and on specific subjects. Although frank about UBS’ use of what it perceived to be its contractual rights to advance its own commercial interests, which necessarily were at the expense of SNCB, he was not prepared to accept the obvious inference to be drawn from the documents. It is, in my judgement, plain that, from about February 2010 onwards, UBS considered what it was entitled to do under the ADA and then did it, whilst taking some steps (such as putting cash and the Ambac Terwin bonds into the Collateral Account before transferring them to SNCB) with a view to facilitating that course of action and cutting off various arguments which SNCB might have against it. There was, moreover, a reluctance on his part to accept that the introduction of some $10M-12M into the Collateral Account, following the removal of the Municipal bonds was merely a temporary measure whilst UBS considered whether a Credit Event could be established for the purposes of the ADA (and SNCB possibly convinced of it) and whilst it sought to obtain “cheapest to deliver” Ambac bonds (as it turned out, the Terwin bonds) which it desired to put into the Collateral Account and then deliver to SNCB in lieu of partial repayment. This attitude on his part was, I take it, because SNCB alleged that UBS had manipulated the situation and exploited an arbitrage opportunity at its expense, and had deliberately delayed serving a Credit Event Notice until it could do so. As SNCB eschewed any case that UBS was debarred from relying on the Credit Event Notice on grounds of delay alone, this defensiveness and unwillingness to answer questions directly was completely unnecessary and unhelpful. Apart from this, I had no difficulty in accepting his evidence as to the actions taken and the reason for the sale of the Ambac Municipal Bonds and the timing of the Credit Event Notice. I found Ms Chan to be an honest and considered witness whose evidence was accurate and reliable on matters within her own knowledge. To the extent that it was suggested that either of them acted dishonestly or improperly, with any improper motive, and not in accordance with the rights of UBS as they understood them to be, I reject any such notion.

Ms Lauwereys’ evidence was that the ADA was seen by SNCB as a low risk transaction, concluded in accordance with SNCB’s Financial Policy. I have no doubt that it was seen as low risk at the time it was concluded because, as appears hereafter, SNCB, under its terms, did not rely upon the credit worthiness of UBS but upon the credit worthiness of a basket of Triple A rated Reference Entities and their bonds which were to constitute security for UBS’ repayment obligations. Such Entities were doubtless seen as low risk at the time. It was nonetheless a Credit Linked Deposit Agreement, inasmuch as, on the happening of a Credit Event in relation to one of these Reference Entities, UBS was given the right to deliver bonds of the Affected Reference Entity in place of some of its obligations to repay. The financial terms of the deal reflected this agreement by SNCB to expose itself to the risk of failure of one or more of these Reference Entities rather than that of UBS. Mr Bonomo described this aspect as the sale by SNCB of credit protection to UBS and the settlement mechanism on the occurrence of a Credit Event was seen by UBS as that of a Credit Default Swap (CDS).

At the end of the day, whether the transaction was seen as “low risk” or not, and whether the deal fitted with SNCB’s Financial Policy or not, whether at the outset or subsequently, the court has to construe the contractual documents. The fact is that Ambac failed and it was a Reference Entity on whose credit SNCB relied, as Triple A rated entities. Whether the deal was low risk at the outset, or was seen by SNCB as such, is nothing to the point. Moreover, as already mentioned, other Reference Entities originally agreed, such as GECC, were removed from the deal before signature of the ADA, because of a change of view about their creditworthiness. The risk that SNCB agreed to take was the credit risk of the Reference Entities selected by UBS, within the parameters laid down in the ADA.

From August 2008 onwards, some other Reference Entities were seen as more risky than originally perceived, including Ambac, and there was discussion of, but no agreement on, restructuring that was acceptable to both. There was recognition in correspondence in September 2008 from SNCB’s lawyers of the need for UBS to maintain switching rights and freedom to deal with the collateral.

By July 2009, Ambac’s rating was Caa2. At that time the Ambac Municipal bonds were not in the Collateral Account (only being transferred into it in August and November 2009). Moreover Ms Lauwereys accepted in evidence that, although she wanted it changed, and a side letter was contemplated, she had accepted (as shown by the correspondence in September and October 2008) that UBS was free to put into the Collateral Account any Obligations of any Reference Entity it wished.

Although there was, in 2010, an issue as to whether or not a Credit Event had occurred, it now appears to be common ground that several Credit Events did take place and SNCB’s allegation of “exploitation of an arbitrage opportunity” by UBS focuses on the ISDA Credit Event of March 2010, because it was only after this occurrence that UBS obtained the Terwin Bonds. Ambac’s position was previously known to be dubious, as I have already mentioned and by 3 February 2010, one trader in UBS, Mr Sebek took the view that Ambac was “likely to go down” and that if it did, SNCB would not get the Municipal bonds but the “cheapest to deliver Ambac bonds” in accordance with CDS settlement mechanisms (without any agreed option of a cash settlement based on ISDA auction pricing). On 1 March 2010, UBS put Ambac on its Credit Event Watch List and advised its staff to begin preparations for a possible Credit Event. At this time the Current Percentages allocated by UBS in the credit protection scheme were 40% AIG, 40% Ambac and 20% FSA.

On the 24 March 2010 Ambac established a Segregated Account for some of its liabilities, at the direction of the Wisconsin Insurance Regulator and the Wisconsin state court made an order placing that Account in rehabilitation in order to facilitate an orderly settlement or run-off of the liabilities contained in it, whilst preventing payment of any liabilities until further order. On the 26 March the ISDA Credit Derivatives Determinations Committee decided that these events constituted a bankruptcy credit event for ISDA purposes and that there would be an auction of Ambac derivatives in the segregated account, the date of which was not then known. The Ambac Municipal bonds, which were not part of the Segregated Account, maintained value because of the credit worthiness of the Municipalities involved, the market having already discounted any additional value to be attributed to the Ambac “wrap” (guarantee) of the bonds. By contrast the Ambac bonds in the Segregated Account, including Terwin bonds, did lose a considerable amount of value. Such a situation was unusual.

Both parties considered the position and discussed it, one with the other. On 15 April 2010, UBS emailed SNCB saying that ISDA had determined that a bankruptcy credit event had occurred in respect of Ambac and that in accordance with the ADA, UBS had the right to serve a Credit Event Notice and that its current intention was to do so.

Mr Bonomo’s evidence was that he believed that an ISDA Credit Event had occurred but that legal advice was needed. There was a potential issue whether or not it constituted a Credit Event for the purposes of the ADA. UBS needed time to establish that a Credit Event had occurred within the meaning of the ADA but by this stage he had decided, in consultation with Mr Poole, that the Municipal bonds in the Collateral Account should be sold regardless. He also decided that a cash settlement should be made with SNCB, if they were agreeable, in relation to the Credit Event by reference to ISDA Auction Terms, although there was no provision for that in the ADA. Failing that, after consultation with the in-house legal team, the formal process of the ADA would have to be followed with a delivery of the cheapest to deliver Ambac bonds in accordance with UBS’ construction of the ADA. I accept the evidence of Mr Bonomo and Ms Chan that he was the senior Trader responsible for these decisions, after consulting his line manager.

The 15 April email suggested discussion of a proposed cash settlement, outside the terms of the ADA, replacing the Physical Settlement procedure set out in it. That cash settlement would be at a price which reflected the ISDA auction which was due to take place at a date in the future in respect of bonds in the Segregated Account. It was the uncontradicted evidence of the UBS witnesses that cash settlements were commonly used in preference to physical settlements and that, because of the confidence that a fair market price was best determined in ISDA auctions, cash settlement agreements were frequently made on the basis of such ISDA auction prices before the auction occurred and the actual prices were determined. (Whilst the date of the auction was then unknown to either of the parties, it in fact occurred on 4 June 2010.) In the email, UBS reserved its right to serve a Credit Event Notice and a Notice of Portfolio (due 30 days thereafter) on SNCB in respect of Ambac and to physically settle the Ambac Credit Event in accordance with the ADA. I accept the evidence of Ms Chan that, given UBS’ position, which (it is accepted) it had expressed to SNCB, prior to 3 February 2010, that it was entitled to settle with “cheapest to deliver” qualifying Ambac bonds and its continuing view of that entitlement, it saw the cash settlement offer as one which might be attractive to SNCB, for the reasons expressed in the email.

On the 27 April Mr Bonomo gave instructions for removal of the Ambac Municipal Bonds from the Collateral Account and for their replacement with cash. I accept that this was his decision. Belatedly, a Collateral Deposit Statement as at 31 March 2010 was also sent on 27 April also to SNCB, which showed that the Ambac Municipal bonds were held in the Collateral Account as at 31 March. On the 30 April 2010, UBS informed SNCB of its intention to replace the Ambac Municipal bonds in the Collateral Account with cash and then sent a Collateral/Deposit statement as at that date indicating that they had been replaced with USD $9.2M. Mr Bonomo’s evidence, which I accept, was that he removed the Ambac Municipal Bonds from the Collateral Account so that he could sell them. He wished to sell them because they were illiquid and UBS was exposed on them without any hedge or any realistic hedging possibility. As revealed in cross examination on the documents, UBS had Credit Default Swap exposures on Ambac bonds also. UBS was at risk of any market movement in the Ambac Municipal Bonds whose value depended on the creditworthiness of the Municipality concerned. Mr Bonomo of the Structured Credit Trading Team was not familiar with Municipal Bonds as such and decided to sell them to reduce the exposure. This was a commercial decision, taken in what were seen as UBS’ best commercial interests.

90% of these bonds were sold in a period of 5/6 days thereafter with a further 10% on 8 June 2010, some at a profit and some at a loss. The date of the auction was not yet known but some at UBS thought it would be early June. UBS considered it was in a position to serve a Credit Event Notice, according to Ms Chan, on the basis of the ISDA decision that Ambac had suffered a Credit Event, but did not do so, since it had made a proposal for a cash settlement which SNCB would need time to consider. In her experience negotiation of a cash settlement often required more than 30 days and serving a Credit Event Notice would set in chain the process by which UBS would have to serve a Notice of Portfolio within 30 days, setting out the bonds which it would deliver and would have to physically settle those bonds (which customarily took 3 days) thereafter. Whilst Mr Bonomo considered it generally best not to delay in serving a Credit Event Notice, because of the daily increase in the Accreted Amount, to which the face values of the bonds to be delivered would have to match, UBS was prepared to wait for SNCB’s response to the cash settlement offer and it did not purchase any of the “cheapest to deliver” Ambac bonds at that stage.

It was suggested in cross examination to Mr Bonomo that there was a strategy to sell the Municipal Bonds and put cash into the Collateral Account to buy time until the ISDA auction, following which UBS would go out into the market to buy the “cheapest to deliver” Ambac bonds to constitute the Delivery Portfolio, and thus take advantage of what was described as an “arbitrage opportunity”. He denied this but, although he said he must have had a good reason at the time to put cash into the Collateral, as opposed to other bonds, he could not recall what the reason was. Whilst I accept that he had good commercial reasons to sell the Municipal Bonds and to deliver “cheapest to deliver bonds”, as he considered he was entitled to do, the input of cash as opposed to securities into the Collateral must have been done with a view to holding the position on a temporary basis, as actually happened. If a cash settlement was agreed without a Credit Event Notice, then there would be no need to deliver Ambac bonds in a Delivery Portfolio, but if a Credit Event Notice were to be served or treated as if served, with either cash settlement or delivery of Reference Entity securities in lieu of partial repayment, there would be a need to adjust the Collateral Account to match the MTMV of the remaining repayment obligations. Moreover, as, in due course, the cheapest to deliver Ambac bonds were placed in the Collateral Account (with a view, in my judgment, to scotching or reducing the risk of a successful argument that the ADA required Collateral Account securities to be delivered as the Delivery Portfolio), it is a fair inference that the cash collateral was always intended as a temporary measure, facilitating adjustment and/or replacement with the Terwin Bonds. At this stage however, a cash settlement offer was still on the table, which Mr Bonomo hoped would be accepted and no purchase of “cheapest to deliver” bonds was immediately in view.

Mr Bonomo was not trying to buy time to improve UBS’ position at the expense of SNCB as such, but he did need time to acquire other cheap Ambac bonds which fulfilled the requirements of the Delivery Portfolio provisions, as he accepted in cross examination. He sold the Ambac Municipal bonds because he considered that UBS was entitled to do so, and always intended to deliver “cheapest to deliver” Ambac bonds, should Physical Settlement be required. There was thus no strategy to do down SNCB as such, but there was an intention to exercise UBS’ rights for its commercial interests and benefit, which, if the contract allowed UBS to do what it did, would inevitably inure to SNCB’s detriment.

On 4 May, SNCB said that it was considering the cash settlement proposal but asked UBS for an explanation of its claim that there had been a Credit Event. On 10 May UBS replied, saying that there had been a bankruptcy event of default in respect of Ambac.

On the 11 May 2010 SNCB’s solicitors wrote a long letter in which they asked for an explanation as to the basis upon which it was contended that a Credit Event had occurred. Specifically, SNCB asked UBS to identify which Obligations of Ambac had suffered an event of default, as opposed simply to some Ambac bonds being put into a Segregated Account. The letter stated that SNCB saw no basis for saying that a Credit Event had occurred, but wished, nonetheless to understand the cash offer made. In that connection it had to evaluate it as against a physical settlement and asked what the make up of the bonds to be delivered as the Delivery Portfolio would be. SNCB stated that it was entitled to receive delivery of Collateral Securities and referred to clause 4.1 of the ADA and to Annex A of the Final Term Sheet in support of this contention. The letter also asked why UBS had replaced the Ambac Municipal bonds with cash and asked what the contractual justification was for doing so.

The evidence of the UBS witnesses was that they did not see this letter as closing the door to a cash settlement. Ms Chan said that in the previous 2 years, SNCB had raised issues with UBS which showed a lack of understanding of the transaction which had subsequently been resolved. As already mentioned, there had been prior discussion of the liberty of UBS to switch both the Collateral Securities and the Reference Entities and SNCB, whilst at one time looking for some change in that, had then appeared to accept the position, as set out by UBS. This letter of 11 May was the first intimation from SNCB that, not only did it challenge the Credit Event but also contended that UBS was required to deliver Reference Entity bonds from the Collateral Account as the Delivery Portfolio. The letter betrayed, to the collective mind of UBS, a misunderstanding by SNCB of its contract rights, as it considered that it was entitled to deliver “cheapest to deliver” bonds of the Affected Reference Entity, whether inside or outside the Collateral Account. Ms Chan did not see it as her task to persuade SNCB that UBS was correct in the view it held, but thought that SNCB’s stance could change.

She did not think that anyone internally thought that this was an issue to be dealt with. The issue that they did grapple with, on the evidence of the UBS witnesses, was the existence of a valid Credit Event which had been challenged. Investigations immediately began to ascertain whether they could establish the existence of Ambac bonds where defaults had occurred, to satisfy the request made by SNCB, in contradistinction to mere reliance on the ISDA determination that a Credit Event had occurred. As is plain from reading between the lines of the exchanges, and as appeared from Mr Bonomo’s and Ms Chan’s evidence, UBS was taking legal advice and considering whether or not a Credit Event could be established.

On 18 May, UBS wrote to SNCB’s solicitors to say that no Credit Event Notice had yet been served, that the Ambac securities in the Collateral Account had been replaced with cash and that it was entitled to do so “at its absolute discretion”. That collateralised cash was security for UBS’ repayment obligations under the ADA. Within a week, additional cash had been placed in the Collateral Account, making a total of $12.2M. It was not that costly to do this at the time. The letter said that a response to the other matters raised in the SNCB letter of 11 May would be forthcoming.

On the 4 June 2010 the Ambac ISDA auction took place which established levels of trading for Ambac CDSs.

Whilst the date was unclear, during oral evidence it seemed that UBS had gone out into the market and purchased Ambac Countrywide bonds which led to the discovery on 9 June that a default had occurred on them on 25 March 2010. A letter from UBS’ solicitors stated that a purchase by UBS of $100,000 of Ambac Countrywide bonds on 2 June which led to the ability to enquire of the Trustees of the bonds as to a default on them. Thus UBS became aware of the default on 9 June. Ms Chan accepted that, at this point, UBS could have served a Credit Event Notice, but it seems, that UBS was still considering its position. On the 17 June, 21 July and the 5-6 August 2010, UBS purchased Ambac Terwin bonds which had an outstanding principal amount of over $19M. Approximately $3M was paid for them.

On 24 June 2010, SNCB’s solicitors wrote in response to UBS’ letter of 11 May, noting that UBS had said that no Credit Event Notice had been served and that UBS had said that it would respond to the SNCB letter of 11 May. SNCB’s solicitors made it clear that SNCB did not consider that a Credit Event had taken place for ADA purposes and that it was now too late to serve a Credit Event Notice in respect of events in March 2010. (It is now accepted that UBS would be entitled to serve a Credit Event notice within a reasonable time of any Credit Event). The letter sought confirmation that no Credit Event had taken place to date and/or that UBS would not serve a Credit Event Notice in respect of such events.

It was on the 12 July 2010 that UBS served a Credit Event Notice upon SNCB by solicitor’s letter in which reliance was placed upon two Credit Events relating to Ambac. One of those was a default by Ambac on the bonds issued by Countrywide (which had been ascertained by UBS on 9 June). The other Credit Event relied on was a default in respect of Las Vegas Monorail Project bonds on the 1 July 2010. Once again cash settlement was suggested as an alternative.

On the 20 July 2010 SNCB’s Solicitors asked UBS for details of the bonds which it intended to deliver and the amount of cash settlement which UBS had suggested, without naming a figure, though that would undoubtedly be based upon ISDA auction levels. A week later, on the 27 July, UBS replied saying that it anticipated serving a Notice of Portfolio on 30 July 2010, setting out the bonds which it would deliver but its current intention was to deliver Ambac Terwin bonds and Ambac Ownit bonds (which it had purchased or was in the process of purchasing). UBS also said that any cash settlement would be determined by a dealer poll of the Obligations that would have been contained in the Delivery Portfolio but, failing agreement on a cash settlement, it would proceed with Physical Settlement.

It was on the 9 August 2010 that UBS did serve a Notice of Portfolio, specifying Ambac Terwin bonds alone and, with a transfer effected on that date, the bonds settled in SNCB’s account on the 12 August as the Delivery Portfolio, with consequent Partial Early Termination of the Deposit in respect of the Ambac percentage for which the ADA provided. Those bonds had been transferred into the Collateral Account in the 8 days before transfer to SNCB with the removal of $9.95M of cash from that account in the same period. The value of the Ambac Terwin bonds on the 12 August, on delivery to SNCB, was approximately $2M.

The 23 page letter before claim dated 1 December 2010 raised a number of complaints, challenging the validity of the Credit Event Notice and the Notice of Portfolio because of the nature of the bonds. The only allegation made in the letter which found its way into its Statement of Case was that UBS’ exercise of its discretion in replacing the Ambac Municipal bonds in the Collateral with cash and then selling them was impermissible and a breach of contract. None of the other implied terms nor the “purpose” said to lie behind the discretion were relied on.

The pleaded case has also evolved with deletion of implied terms in paragraph 9 of the Re Amended Particulars of Claim and the replacement a week before trial with others. Previously SNCB alleged that UBS could only move Collateral out of the Account on the last day of the month and only if and to the extent that there was an excess value over 100% of the MTMV of the Deposit. The only purpose of UBS’ discretion as to the make-up of the Collateral was to enable it to ensure the 100% equivalence of the MTMV in the Account and to transfer Obligations or cash into it, if needed to achieve that.

The changes in SNCB’s case suggest before and during the trial, so UBS submits, that SNCB has worked backwards from the result it wants to achieve, constructing implied terms with that in view, and jettisoning and finding others, when persuaded that the current version did not work. It seems to me that there is force in this criticism.

Despite skirmishes in the skeleton arguments about the approach to construction of the ADA and the Security Agreement, there cannot really be much issue between the parties in the light of decisions of the highest court of the land on the subject, including in particular Rainy Sky SA v Kookmin [2011] 1 WLR 2900. The court must consider the language used and ascertain what a reasonable person would have understood the parties to have meant, assuming that reasonable person to have all the background knowledge which would reasonably have been available to the parties in the situation in which they stood at the time of contracting. Construction is a unitary exercise where regard is to be paid to the overall language and structure of the document concerned and the commerciality of any rival interpretations advanced. If there are two possible constructions of a commercial contract, the preferable construction is the one which more closely accords with commercial common sense, as gleaned from the relevant surrounding circumstances. If a semantic analysis of the words used in a commercial contract leads to a conclusion which flouts common sense, this would indicate that it is a most unlikely construction which may be rejected. The overall scheme of the document is important and the individual clauses, sentences and phrases in it must be read in the overall context. Many authorities stress the importance of context and commercial purpose when construing a commercial contract and the need to test the consequences of competing interpretations against the tenor of the whole document, and business common sense.

So far as the “background knowledge which would reasonably have been available to the parties” is concerned, sometimes described as “the factual matrix”, there are limitations upon what the court considers admissible or helpful. It is clear that evidence of a party’s subjective intentions when concluding the contract, evidence of its belief as to its meaning or of its aim, and evidence of the parties’ negotiations leading up to the contract, are not admissible as aids to construction. Evidence of a party’s objectives is equally inadmissible. The parties may have different subjective intentions, different objectives, different beliefs as to the meaning and aim of the contract and may negotiate a form of words which is acceptable to both but to which each ascribes a different meaning. The court then has to ascertain what is the true meaning of those words in the context of the contract as a whole on the basis of what a reasonable person with the necessary background knowledge would have understood the parties to have meant.

There was evidence in the Witness Statements and oral evidence was given which crossed the boundaries of what was admissible as an aid to construction. Ms Lauwereys’ evidence of her belief that the ADA required UBS to hold, in the Collateral Account, bonds of the Reference Entities in approximate proportion to the Current Percentage relating to the credit risk provisions and her stated belief in the impermissibility of changing the collateral after a Credit Event had occurred is one example of such inadmissible evidence.

Once again, although the parties differed in emphasis, the decision of the Judicial Committee of the Privy Council in Attorney General of Belize v Belize Telecom Ltd [2009] 1WLR1988, as endorsed and clarified by the Court of Appeal in The Reborn [2009] 2 Lloyd’s Report 639 and by Aikens LJ in Crema v Cenkos [2010] EWCA Civ 1444, sets out the approach which is to be adopted, in the light of the authorities referred to, whether or not all those decisions are technically binding on me. Paragraphs 16-27 of the Opinion of the Judicial Committee (and the cases referred to therein) and Paragraphs 8-18 of the judgement of Lord Clarke MR in the Reborn, by reference to that Opinion, the decisions of the House of Lords in Trollope & Colls Ltd v NW Metropolitan Regional Hospital Board [1973] 2 A11 ER 260, of the Judicial Committee in BP Refinery v Shire Hastings (1977) 180 CLR 266 and of the Court of Appeal in Phillips Electronique v British Sky Broadcasting [1995] EMLR 472 set out the criteria to be applied.

It seems to me that the judgment of Lord Clarke MR in the Court of Appeal may provide a gloss on the earlier Privy Council decision, by stressing one element- that of necessity for the implication of a term. The perceived need to stress that element may have arisen because it was being suggested in some quarters that, by assimilating the processes of construction and implication of terms, Lord Hoffman had diluted that requirement. Lord Clarke went to some lengths to explain that he had not.

It is clear from the authorities, that the court has no power to improve upon the instrument which it is called upon to construe. It cannot introduce terms to make it more fair or more reasonable. Its concern is only to discover what the instrument means and it is the meaning which the instrument would convey to a reasonable person having all the background knowledge which would reasonably be available to the parties, with which the court is concerned (Lord Hoffman at paragraph 16). To this extent the exercise has the same objective as that of construction.

The question of implication arises when the instrument does not expressly provide for what is to happen when some event occurs. The most usual inference in such cases is that nothing is to happen. If the parties had intended something to happen, the instrument would have said so. This point is made by Lord Hoffman at paragraph 17 and stressed by Lord Clarke at paragraph 10 of the Court of Appeal decision.

There are however cases where the reasonable person to whom the meaning of the instrument is to be conveyed would understand that the only meaning (emphasis added) which is consistent with the overall provisions of the instrument, read against its relevant background, is that something is to happen which will affect the rights of the parties, even though the instrument does not expressly say so. The implication of the term is not an addition to the instrument but spells out the true meaning of the instrument in the situation for which it does not expressly provide (Lord Hoffman paragraph 18).

All the various ways in which the test has been expressed in prior authorities, are not to be seen as different or additional tests to the basic question which is “what the instrument read as a whole against the relevant background would reasonably be understood to mean” in the situation which obtains (Lord Hoffman paragraphs 21-27). The proposed implied term must spell out what the contract actually means. Thus to say that the implied term must be “reasonable and equitable” or “necessary to give business efficacy to the contract” or “so obvious that it goes without saying”, that it must be “capable of clear expression” and that it “must not contradict any express term of the contract” is to add nothing to the central idea that the proposed implied term must spell out what the contract actually means. Though these formulations may assist in considering whether or not it does so, there are dangers in taking them as the litmus test.

Lord Clarke predicted that the analysis of Lord Hoffman would be as much referred to as his approach to the construction of contracts in Investors Compensation Scheme v West Bromwich Building Society [1998] 1WLR896 pages 912-913. I have no doubt that prediction is correct and the further comments of Lord Clarke are intended to be helpful in bringing about a more focused approach. What appears from Lord Clarke’s judgement is that he understood Lord Hoffman’s quotation of the different ways of expressing the test as being ways of saying much the same thing but that Lord Hoffman was not in any way resiling from the often stated proposition that it must be necessary to imply the proposed term. It is never sufficient that it should be reasonable, a point he reinforced by reference to the decision of the House of Lords in Liverpool City Council v Irwin [1977] AC 239 (which is still binding on me) – see paragraph 15 in the Court of Appeal Judgement.

He drummed this point home by reference to other Court of Appeal authority and in particular the judgement of Sir Thomas Bingham in the Phillips case where the latter said that the implication of contract terms involved a different and more ambitious undertaking than that of contractual interpretation of express terms. The interpolation of terms to deal with matters for which the parties had made no provision was essentially so intrusive that the law had to impose strict constraints on the exercise of its power. Part of Sir Thomas Bingham’s speech was quoted and I further quote it here in relation to the difficulty in implying terms in cases different from the paradigm example of the implied term that a surgeon will exercise all reasonable care and skill in carrying out his profession.

“But the difficulties increase the further one moves away from these paradigm examples……… It is much more difficult to infer with confidence what the parties must have intended when they have entered into a lengthy and carefully-drafted contract but have omitted to make provision for the matter in issue. Given the rules which restrict evidence of the parties’ intention when negotiating a contract, it may well be doubtful whether the omission was the result of the parties’ oversight or of their deliberate decision; if the parties appreciate that they are unlikely to agree on what is to happen in a certain not impossible eventuality, they may well choose to leave the matter uncovered in their contract in the hope that the eventuality will not occur.

The question of whether a term is to be implied, and if so what, almost inevitably arises after a crisis has been reached in the performance of the contract. So the court comes to the task with the benefit of hindsight and it is tempting for the court then to fashion a term which will reflect the merits of the situation as they then appear. Tempting, but wrong. ………. A term can only be implied if it is necessary in the business sense to give efficacy to the contract; that it is, if it such a term that it can confidently be said that if at the time of the contract was being negotiated someone has said to the parties, “what will happen in such a case” they would both have replied, “of course, and so will happen; we did not trouble to say that; it is too clear” unless the court comes to some such conclusion as that, it ought not to imply a term which the parties have not themselves expressed………..

And it is not enough to show that had the parties foreseen the eventuality which in fact occurred they would have wished to make provision for it, unless it can also be shown that one of several possible solutions would without doubt have been preferred…

The significance of both Liverpool CC v Irwin and the Phillips Electronique case is that they both stress the importance of the test of necessity. Is the proposed implied term necessary to make the contract work? That seems to me to be an entirely appropriate question to ask in considering whether a term should be implied…”

There is perhaps thus a difference in emphasis between Lord Hoffman’s judgement in the Privy Council and that of Lord Clarke in the Court of Appeal but the question of “necessity” which Lord Clarke stresses tallies with Lord Hoffman’s statement in paragraph 18 that the reasonable person, with the relevant background knowledge, assessing the meaning of the contract has to consider that there is only one provision which is consistent with the other provisions of the instrument in the circumstances which prevail and that this provision is not an addition to the instrument but merely a spelling out of what the instrument means. As he expressed the point in paragraph 22, when discussing the formulation “necessary to give business efficacy”, it is not enough for a court to consider that the implied term expresses what it would have been reasonable for the parties to agree to; the court must be satisfied that it is what the contract actually means. Whilst the contract may be workable in the sense that both parties can perform their express obligations without the implication of the term, the implication is necessary “to give effect to the reasonable expectations of the parties” in the situation in question, because this is what the contract taken as a whole must, on its proper reading, be taken to mean (paragraphs 22-24). Although it is not necessary in Lord Hoffman’s view for the need for an implied term to be immediately apparent on a superficial consideration of the terms of the contract against the relevant background, it must be obvious, after a careful consideration of the express terms and the background, that only one answer is consistent with the rest of the document and this must be the meaning of the contract.

SNCB relied heavily on the decision of the House of Lords in Equitable Life v Hyman [2002] 1 AC 408, where the House was concerned with the implication of a term in relation to the exercise of a discretion of the mutual insurer to declare bonuses in relation to GAR policies, the policies being subject to the rules of the Society. Lord Steyn distinguished between the processes of construction and implication and emphasised that the legal test for implication of a term was “strict necessity”. He held that the test of strict necessity was met because a term had to be implied into the policy provisions for discretionary bonuses that the discretion could not be exercised “in conflict with the contractual rights of the GAR policyholders”. The nature of the GAR policy could not be undermined by the exercise of that discretion, however widely drawn. He referred to the “reasonable expectations of the parties” and held that the implied term was essential to give effect to those reasonable expectations.

Mr Dhillon accepted that when Lord Steyn and Lord Hoffman referred to this expression (“the reasonable expectations of the parties”), they meant the objective expectations to be spelt out from the contract itself and not the subjective expectations of either party. He agreed that what was being said was that a term is only to be implied if it is required to give effect to the objective purpose of the contract. The term is to be implied only if it is necessary in the light of all the other provisions of the contract, against the same background admissible in construction, to reflect the real meaning of the contract.

In these circumstances the emphasis on necessity in The Reborn clarifies Lord Hoffman’s judgement, although there may be a difference between Lord Clarke and Lord Hoffman as to the “officious bystander” test and whether it is the response of the parties to his question, or his own knowledgeable view of the meaning of the contract that is significant (cf Lord Hoffman at p 1995 and Lord Clarke at p 643-644 by reference to the authorities he cites there). Regardless of that difference, Lord Hoffman understood that test as one which “vividly emphasises the need for the court to be satisfied that the proposed implication spells out what the contract would reasonably be understood to mean”.

There are a number of authorities which set out implied terms limiting the exercise of a contractual discretion, preventing its use for purposes inimical to the contract, its use for improper purposes or its use other than in good faith. I was referred to Brooke LJ in Ludgate Insurance Co Ltd v Citibank [1998] Lloyds Rep IR 221 at p239 and Rix LJ in Socimer International Bank v Standard International Bank [2008] 1 Lloyd’s Rep 558 at 577, where he said this:

“It is plain from these authorities that a decision maker’s discretion will be limited, as a matter of necessary implication, by concepts of honesty, good faith and genuineness and the need for the absence of arbitrariness, capriciousness, perversity and irrationality. The concern is that the discretion should not be abused. Reasonableness and unreasonableness are also concepts deployed in this context, but only in a sense analogous to Wednesbury unreasonableness….”

Lord Cooke in Equitable Life, at pages 460-462, whilst agreeing with Lord Steyn’s implication of the specific implied term, stated that the same conclusion could be reached by referring to the principle that no legal discretion could be exercised for purposes contrary to those of the instrument by which it was conferred. The insurance policies and the powers given by the Rules of the Society had to be read together when ascertaining the policyholders’ contractual rights. However wide the powers apparently given by the contractual discretion, those powers could not be exercised in such a way as to subvert the basis of the contract in question. He held that the exercise by the directors of their powers to allot reduced bonuses to holders of GAR policies was inconsistent with the purpose for which the power of granting bonuses under the GAR policies was given. The powers had to be exercised in the light of the terms of those policies.

In Paragon Finance v Nash [2002] 1WLR 685, Lord Justice Dyson at paragraph 36 held that loan agreements which contain variable interest clauses, where the bank had discretion to set the rate, included implied terms that the rates of interest would not be set dishonestly, for an improper purpose, capriciously or arbitrarily. He said that such an implied term was necessary in order to give effect to the reasonable expectations of the parties and was one of which it could be said that “it goes without saying since, if asked at the time of making the agreement whether the discretion could be exercised dishonestly, for an improper purpose, capriciously or arbitrarily, the lender would have said ‘of course not’”. It appears that he there equated honesty with good faith.

There is, in my judgment a clear distinction between “good faith” on the one hand and “utmost good faith” on the other. The latter concept is familiar in the context of insurance, with its concomitant duties of full disclosure, but has been held in other contexts, when used in commercial contracts, to impose “a contractual obligation to observe reasonable commercial standards of fair dealing, faithfulness to the agreed common purpose and consistency with the justified expectations” of the other party. (See e.g. Morgan J in Berkeley Community Villages v Fred Daniel Pullen [2007] EWHC 1330 (Ch)). The content of the “utmost good faith” obligation may well vary with the context or contract in which it is found, but in my judgment, it is an expression which has conveyed a meaning beyond “good faith” for a very long period of time. A duty to exercise “good faith” in doing something is one which is usually to be contrasted with a duty to exercise reasonable care. It connotes subjective honesty, genuineness and integrity, not an objective standard of any kind, whether reasonableness, care or objective fair dealing. It cannot be equated with “utmost good faith” and although its exercise in practice may involve different actions or restraint, the concept is not one which goes beyond the notion of truthfulness, honesty and sincerity.

Unlike some bodies of foreign law, commercial contracts are not subject to general duties of good faith and fair dealing and it is trite law that a party does not have to exercise his contractual rights, once properly ascertained, reasonably. If he has rights, the law will not concern itself with the motivation or rationale lying behind his exercise of them – see White and Carter (Councils) v McGregor [1961] AC 413.

Here the position is said to be different by reason of the implication of terms, although any allegation of actual dishonesty was specifically eschewed by SNCB. The implication of terms that the discretion should not be used inconsistently with the aims of the contract objectively construed, or for an improper purpose, or in bad faith is said to be necessary as a result of the granting of the discretion in the context of the ADA as a whole, its underlying objectives and the express obligations of good faith in particular clauses in it.

Clause 1 sets out the basic provisions of SNCB’s Deposit and the obligation of UBS to repay sums in accordance with the Repayment Schedule in Annex 1. The essence of the credit protection provisions are in clause 2 and those of the collateral provisions in clause 3.

The frontispiece to the ADA sets out, in bold type, the nature of the credit risk taken by SNCB in relation to the Deposit. “The Credit Risk of the Deposit is that of the Reference Entities. Principal is at risk on the Deposit if there is a Credit Event in respect of bonds of a Reference Entity”.

On the happening of a Credit Event, which was defined as any event of default in respect of any Obligation of any Reference Entity (whether there were any bonds of that Reference Entity in the Collateral or not) UBS had the right (but not the obligation), on giving notice, to Deliver the Delivery Portfolio in substitution for partial repayment of the Scheduled Repayments provided in Annex 1. The Delivery Portfolio was to consist of Obligations of the Affected Reference Entity with a face value equivalent to the appropriate percentage of the Accreted Amount determined by the Current Percentage applicable at the date of the Credit Event to the Affected Reference Entity. It is notable that the Delivery Portfolio is not described as consisting of bonds of Reference Entities in the Collateral Account.

Repayment by UBS is excused to the extent that it chooses to rely upon any default by a Reference Entity that has been selected by it as a Reference Entity, within the parameters provided by the ADA, to the tune of the Current Percentage. The frontispiece made it plain that, if a Credit Event occurred, the Deposit would be the subject of early partial termination to the extent of the Current Percentage of the Affected Reference Entity and that, in those circumstances, SNCB would receive Obligations in lieu of repayment, which were likely to have a market value below face value. The effect of the ADA is therefore that SNCB takes on the credit risk of the Reference Entities, rather than the credit risk of UBS’ inability to repay. Its effect is akin to that of a Credit Default Swap.

The collateral provided by Clause 3 was to take the form of “Collateral Securities or US$ cash”, whilst the Collateral Securities were to consist of “Obligations” which are bonds of any of the Reference Entities that rank at least equal in priority of payment with its senior unsecured debt obligations. “The Deposit is a secured obligation of UBS and is secured by way of a first priority continuing security interest over the Collateral in accordance with the Security Agreement.” The collateral thus provided is expressly given as security for “the Deposit”, namely the obligations of UBS to make repayment of the Deposit on the terms of the ADA in accordance with the provisions of Annex 1.

If the collateral is maintained in accordance with the ADA, its mark to market value (MTMV) will always match the MTMV of the Deposit (Clause 3.2). In the event of a default by UBS, Clause 12 provided that SNCB could terminate the ADA and the Collateral would be delivered to it so that it could go out into the market and sell / use that Collateral to purchase a substitute Agreement on the same terms. The collateral provisions in respect of UBS’ obligations to repay are such that the bonds of the Reference Entities, on any actual default by UBS (but not a failure of a Reference Entity) will be of such value as to provide for the purchase of a substitute deposit agreement.

The nature of this arrangement is of vital importance when considering the proper construction of the ADA, in particular, when considering whether there is a link between the Collateral provisions of the ADA and the Credit Event provisions:-

Thus far, as UBS submits, the ADA does not provide for any link at all between any bonds of the defaulting Affected Reference Entity which are held in the Collateral Account (a segregated account consisting of Obligations of Reference Entities and/or US dollars cash, and which constitutes security for UBS’ repayment obligations) on the one hand and the bonds of the Affected Reference Entity which fall to be delivered as part of the Delivery Portfolio on the happening of a Credit Event, should UBS elect to exercise its right to deliver such bonds in lieu of partial repayment, on the other. As already pointed out, there is no requirement for UBS to hold bonds of the Affected Reference Entity in the Collateral Account at all. As a matter of commercial management of its business, UBS might well hold bonds of Reference Entities in the Collateral Account which approximated to the Current Percentage of the Accreted Amount, but it had no obligation to do so, the only requirement being that the Reference Entity bonds in the Collateral should equate in value at the end of the month to the MTMV of the Deposit. It would in such circumstances be very odd (and would require an express provision to this effect) for UBS to be obliged to deliver to SNCB bonds of the Affected Reference Entity which it did happen to hold in its Collateral Account.

The last sub-clause of Clause 4 makes it plain that the exposure of the Scheduled Repayments and the Accreted Amount to the Reference Entities is to the extent of their respective Current Percentages, as defined, and not to the bonds of the Reference Entity in the Collateral Account at the time of a Credit Event. Notwithstanding the submissions of SNCB, I am unable to attribute to this last sub-clause any other meaning than that which I have just outlined. Not only does the ADA not require bonds of any particular Reference Entity, nor bonds of the Affected Reference Entity to be held in the Collateral Account, at the time of a Credit Event or Credit Event Notice, it makes it plain that this is not required, because the Credit Event Notice triggers partial termination to the extent of the Current Percentage of the Affected Reference Entity, not to the extent of any Reference Entity bonds in the Collateral Account. Bonds in the Collateral Account must therefore be seen as distinct from the bonds of the Affected Entity which must be delivered as part of the Delivery Portfolio since the credit risk relates to the default of the Affected Reference Entity to the extent of the Current Percentage selected by UBS, not to bonds in the Collateral Account. What is held by UBS in the Collateral Account, whether including or excluding bonds of the Affected Reference Entity, is irrelevant. It is thus mere happenstance, if there are bonds are the Affected Reference Entity in the Collateral Account at the time of the Credit Event and it is a matter of choice for UBS as to what bonds of the Affected Reference Entity it delivers as part of the Delivery Portfolio as long as they correspond to the other requirements of Clause 4.

UBS submits that the commercial basis of the ADA can be identified from these terms inasmuch as SNCB assumed the risk of default in the Reference Entities and agreed that it would receive delivery of bonds of the Affected Reference Entity of the applicable face value in place of its right to the Scheduled Repayments, to the tune of the Current Percentage. The credit protection provisions of the ADA operated somewhat like those of a Credit Default Swap because UBS agreed to make the scheduled repayments in consideration for the credit protection provided by the Reference Entities and the current percentage mechanisms set out in Clause 2. The ADA was of course a Deposit Agreement, with the collateral of the Reference Entities provided in case of default by UBS in making repayments, but there were these two elements inbuilt in it. That is why it was referred to by the parties as a Credit Linked Deposit. Given the nature of the credit protection provided, ‘cheapest to deliver” bonds would be perceived as the norm for delivery of bonds in physical settlement, as in CDSs. I accept UBS’ submissions on this.

Clause 3 of the ADA provided that UBS should open a segregated Collateral Account to secure “the Deposit”, which, in this context, as is common ground, means UBS’ obligations to repay under the ADA. SNCB was to have a continuing security interest over the Collateral which was to consist of “Collateral Securities or US$ cash”. “Collateral Securities”, in accordance with the relevant definitions, meant Obligations of the Reference Entities, namely bonds of appropriate seniority in those Reference Entities. Under Clause 3.2, the MTMV (determined by UBS acting in good faith) of the Collateral was to equate to 100% of the MTMV of the deposit, namely the cost of replacing the repayment obligations under the ADA. The MTMV of the Collateral therefore was not to relate to the MTMV of the Accreted Amount but the MTMV of the Deposit, which in itself is significant in the light of the contentions of the parties about the purpose of the Collateral. From January 2003 onwards, by Clause 3.3, UBS had to ensure that, on the last business day of each month, the correct amount of Collateral was held in the Collateral Account by transferring Collateral to that account or removing Collateral from it. On the same day of each month, UBS was also to provide a statement to SNCB of the MTMV of the Deposit and to specify the contents of the Collateral Account and its MTMV, so that SNCB could monitor the position.

There is nothing in the ADA which provides that the Collateral Account, which consists of bonds of the appropriate kind of the Reference Entities or cash in US$ is to be security for the credit risk accepted by SNCB in respect of the Reference Entities themselves. It would indeed be odd to provide security in the shape of bonds issued by Reference Entities in respect of any default of Reference Entities.

Not only does Clause 3 specifically say that it is the Deposit (UBS’ repayment obligations) which is secured by the Collateral but the amount of security specifically relates to the amount required for SNCB to remedy default by UBS in its repayment obligations. Clause 12 of the ADA provides for delivery of the Collateral in the event of any default by UBS in making payments of any sum due or performing any obligations which remain unremedied for 30 days (or any act of insolvency on its part). Moreover, the Security Agreement, to which Clause 3 of the ADA refers, provides for enforcement of the security in Clause 8 (the 17 January 2003 Security Agreement) and Clause 9 (the 15 January 2009 Security Agreement), where an Early Termination Date has occurred with UBS’ concomitant obligation to make a payment under Clause 12 of the ADA. There is no intimation in the Collateral provisions of the ADA, nor in the Security Agreements, of any requirement for the Collateral to be used to satisfy the requirements of Clause 4 of the ADA when delivering the Delivery Portfolio.

The high point of SNCB’s case on construction is the definition of “Deliver” in the ADA. Clause 4 of the ADA provides for UBS to have the right, following the occurrence of a Credit Event, to “Deliver the Delivery Portfolio in lieu of partial repayment of the Scheduled Repayments”. I have already referred in this judgment to the definition of the Delivery Portfolio which makes no reference to delivery of bonds in the Collateral Account, but simply to bonds of the Affected Reference Entity of appropriate priority. The definition of “Deliver” states that the word “Deliver” means the transfer, assignment or sale, as appropriate, “in the manner customary for the settlement of the applicable Collateral Securities... in order to convey all right title and interest in the Collateral Securities comprising the Delivery Portfolio… free and clear of any and or liens, charges, claims or encumbrances…. . The words “Delivery” and “Delivered” are to be construed accordingly.”

The word “Deliver” appears in Clause 4 in relation to Credit Events. The word “delivered” appears in Clause 12 in the provisions for termination of the ADA as a result of a default by UBS. Although there is a difference between the use of capitals and small letters at the beginning of the relevant words in the two clauses, it is clear that the concept of “delivery” (whether with a small or a large “d”) applies to both clauses. When therefore consideration is given to the definition of “Deliver”, regard must be had to both Clause 4 and Clause 12. It is plain from the other terms of the ADA, including the definition of the “Delivery Portfolio” that, notwithstanding the reference in the definition of “Deliver” to conveyance of all interest in “the Collateral Securities comprising the Delivery Portfolio”, that Portfolio does not have to include bonds of the Affected Reference Entity which are held in the Collateral Account. The ADA gives total freedom to UBS to choose the make- up of the bonds in the Collateral Account, as long as they are bonds of Reference Entities. The bonds in the Collateral Account may or may not include any bonds of the Affected Reference Entity at all. On the face of the definition of “Deliver”, all the “Delivery Portfolio” would have to be made up of Affected Reference Entity bonds in the Collateral Account, whether or not there were any such bonds in that Account or insufficient bonds there at the time of the Credit Event. That creates an impossible situation and SNCB recognises this by saying that conforming bonds can be delivered from elsewhere if needed to make up the appropriate amount. This illustrates the fact that the wording used cannot be definitive of the contents of the Delivery Portfolio, which has its own definition.

The definition of “Deliver” cannot import a requirement, contrary to the other provisions of the ADA, that the Collateral Account should consist of the same percentage of Reference Entity bonds as make up the Current Percentage selected by UBS for the purpose of the credit risk provisions set out in Clauses 2 and 4 of the ADA. Since the Current Percentage relates to the Accreted Amount, whilst the Collateral required relates to the MTMV of the Deposit, exact matching is not in any event likely or possible, unless the Accreted Amount and the MTMV of the Deposit happen, fortuitously to coincide. Nor, therefore, can it import an obligation to deliver that percentage of bonds of the Affected Reference Entity which constitutes the Current Percentage, in the Collateral Account, nor any particular bonds held in the Collateral Account as part of the “Delivery Portfolio”. The governing provision in this respect as to what must be delivered must be the definition of the “Delivery Portfolio”, not the terms relating to the mechanisms of delivery.

Insofar as the definition of “Deliver” refers to the delivery of “applicable Collateral Security” and “Collateral Securities comprising the Delivery Portfolio” it must therefore only refer to the position where UBS chooses to deliver bonds of the Affected Reference Entity which happen to be in the Collateral Account, which might or might not be the case, and which, where they are, would be likely to be bonds of limited worth, (which UBS might be happy to convey). Such bonds must be delivered in the manner customary for physical settlement.

Similarly the Physical Settlement provisions must be read in the same light, when reference is made to representations as to title in the Collateral Securities Delivered, to the applicable Collateral Securities, a point which is reinforced in sub-clause (c)(ii) where provision is made to excuse a failure to deliver or accept delivery of “the Delivery Portfolio or Collateral Securities” (emphasis added) on the ground of force majeure or illegality. Whilst the wording of the definition of “Deliver” and of the Physical Settlement Provisions is infelicitous and gives rise to the argument which SNCB makes, the governing provisions of the ADA are directly contrary to their submissions and the distinction drawn between delivery of the Delivery Portfolio on the one hand and of Collateral Securities on the other, in the Physical Settlement Provisions, mean that SNCB’s submissions on construction cannot prevail.

SNCB’s reliance on clause 5 of the ADA does not assist it. The suggestion is that, on its construction, it would know the contents of the Delivery Portfolio immediately on the happening of a Credit Event and so could calculate what it might have to pay to exercise its clause 5 rights, whereas on UBS’s construction it would not, until the Notice of Portfolio was served. This carries little weight, even if true, but this would not be the case unless there was an obligation to match the Reference Entity Bonds in the Collateral Account with the Current Percentage, since without this, there might be no bonds of the Affected Reference Entity there (or insufficient), and the market value of the latter’s bonds would be just as unknown. In practice, regardless of either party’s construction, the bonds of the Affected Reference Entity, save in unusual circumstances such as the present case, would inevitably be of very limited value because of the failure of the entity and if “cheapest to deliver” bonds can make up the portfolio, the parties can work on that basis (whether by reference to an ISDA auction price or otherwise).

In paragraph 103(4) of SNCB’s Skeleton Argument, SNCB responded to UBS’s argument that UBS did not have an obligation to have any or any specific Collateral Securities in the Collateral Account, by suggesting that it was a reasonable expectation of the parties that the Collateral Account would contain Collateral Securities which broadly reflected the Current Percentages applicable to the various Reference Entities prior to a Credit Event. No good reason was given for such an expectation, and, in closing, SNCB said that, if necessary, it would rely on an unpleaded implied term that there should at all times be Reference Entity securities in the Collateral Account which matched approximately the Current Percentage allocated by UBS for the purposes of the credit protection provisions, though no such term was actually formulated. I return later to this in a different context (that of implied terms) but the recognition of the absence of any express obligation of this kind is fatal to SNCB’s case on construction. SNCB submitted however that the ability of UBS to choose which Collateral Securities to use prior to a Credit Event did not affect SNCB’s right to be delivered the Obligations of an Affected Reference Entity which were actually held in the Collateral Account at the time of a Credit Event. However the original concession (necessarily made), made by SNCB as to the choice which lies with UBS in selecting the Collateral Securities, does give the lie to the basis of its argument, since it will be mere happenstance whether there are any Obligations of an Affected Reference Entity in the Collateral Account at the time of a Credit Event, and the Delivery Portfolio must consist of bonds of the Affected Reference Entity, which would have to come from outside the Collateral Account if none were held in it. In such circumstances to seek to import an obligation to deliver such bonds of the Affected Reference Entity which are to be found in the Collateral Account, is hopelessly optimistic in the absence of an express and clear provision to that effect. There is none.

An unusual situation arose in the present case, where there were bonds of the Affected Reference Entity in the Collateral Account (the Municipal Bonds) which retained much of their value because they were Municipal bonds guaranteed by Ambac, with value because of the creditworthiness of the Municipalities concerned, whilst other bonds guaranteed by Ambac in the Segregated Account constituted on 24 March 2010, such as the Terwin Bonds lost 90% of their value as a result of the Ambac default. Thus, here it mattered whether or not UBS chose to deliver Reference Entity bonds held in the Collateral as part of the Delivery Portfolio or to deliver other bonds of that Entity which were available to it.

Regardless of the likelihood or unlikelihood of this happening - a situation which the Treasurer of SNCB had not seen before nor contemplated - the rights of the parties, under the ADA, must be assessed by reference to the contractual documentation and its requirements relating to the Delivery Portfolio which UBS was bound to deliver on the occurrence of a Credit Event. Regard must also be had to the specific freedom given to UBS to select and change the make-up of the Collateral Account, without any limitation (save for what the ADA expressly provided) and without reference to the Current Percentage selected for the purpose of the Credit Risk. The Collateral Account has nothing to do with the Credit Risk, since the Collateral is there as security for UBS’ failure, not as security in respect of the default of any Reference Entity.

It is clear from Clause 3 of the ADA that the Collateral Account was to consist of Collateral Securities or US$ cash which must amount in value to the MTMV of the Deposit; i.e. UBS’ repayment obligations. It was to be a “first priority continuing security interest” for those obligations. It is also clear from Clause 3.3 that UBS could transfer Collateral in and out of the Collateral Account and had to do so to maintain the appropriate level of security on a monthly basis, providing statements of its contents to SNCB under clause 3.4 so that it could monitor the position. No distinction is drawn between the senior bonds of the various Reference Entities in the composition of the Collateral and there is no restriction on the use of US$ cash. The central obligation of UBS in relation to the Collateral is to ensure that it equates to the MTMV of the Deposit, but it otherwise has discretion to choose the make up of the Collateral, whether cash or Collateral Securities as defined.

Clause 3 also provides for the security interest over the Collateral to be in accordance with the Security Agreement which, in its recitals, refers to UBS’ agreement to deposit in the Collateral Account “from time to time” a portfolio of securities and to charge it in favour of SNCB. Whilst the Security Agreement does not in itself create a charge over cash, the ADA does so by clause 3.1- as continuing security. Both cash and securities are to be in the Collateral Account that is, by definition, a segregated account with UBS, as custodian.

There can be no distinction drawn between Collateral Securities and US $ cash for this purpose. If UBS could choose what Obligations to put in the Collateral Account, it could also decide how much cash it could put in. As a matter of construction of the ADA and Security Agreement, UBS had freedom to populate the Collateral Account with any percentage of any one or more Reference Entity Obligations or with cash, including 100% of either, should it so choose.

The essential implied terms for which SNCB contended were those set out in paragraph 9 (4)(A) of the Re- Amended Particulars of Claim, namely:

Here SNCB seek to rely on a conversation of which Ms Lauwereys gave evidence to show that there was an agreed basis or objective which lay behind the provision of the discretion. At paragraph 38 of her witness statement she said that she had a conversation with Mr Ackerman of UBS in the period 14-23 November 2001 about the reason UBS wanted the ability to post cash as collateral. She said she thought it odd that UBS should desire this facility because tying up cash in this way would not assist UBS in achieving the Accretion Yield. UBS were bound to maintain collateral in a value equivalent to the MTMV of the Deposit and she thought it important that the Collateral Account should contain bonds of the Reference Entities. Her recollection was that Mr Ackerman gave her 2 reasons for wanting the facility to put cash into the Collateral Account. The first and primary reason was to enable UBS to ensure that the Deposit was adequately secured during the initial period when UBS went out into the market to purchase bonds of the Reference Entities which would be placed in the collateral. (The Collateral Account would have to consist largely or totally of cash in the first place, as it actually did, as notified to SNCB on 21 December 2001). The second reason was to allow UBS to make up any shortfall in the collateral on a temporary basis if UBS was unable to post sufficient bonds in the collateral from the Reference Entities within the time limits provided (initially semi-annually and subsequently monthly) in the ADA. (It seems that there were short periods of time when cash did appear in the Collateral Account, but the reasons for that were not explored in evidence).

In cross examination she accepted that Mr Ackerman had spoken of his intention to use cash in that way but without expressing any limitation on the right of UBS to utilise cash in the Collateral Account. Reasons for the inclusion of cash as well as bonds in the Collateral Account were given. The intention was expressed to use cash in the Collateral Account on a temporary basis but there was no agreement to any restriction on UBS rights which, as the ADA clearly expressed, entitled it to constitute the Collateral in any way it wished with bonds of the Reference Entities (within the parameters permitted) and/or US dollars cash. Moreover, if it had been her understanding or that of SNCB that UBS was not entitled to put cash into the Collateral Account, she accepted that she and it would have objected to this taking place, but it did not do so, when it happened and never contradicted UBS’ statements in correspondence that it was entitled to decide on the composition of the Collateral “in its absolute discretion”. In a letter before claim on 12 February 2009 (on other matters), SNCB referred in terms to the definition of Collateral in the ADA, saying it “can also include cash in US$ as well as Collateral Securities”.

There was no suggestion of a collateral oral agreement or oral variation of the terms relating to the Collateral Account and its constitution. The ADA was concluded long after the events of November 2001, in any event, and it reflected the comprehensive terms agreed in January 2003, regardless of anything that might have been orally agreed in 2001.