JUDGMENT
BNY Mellon Corporate Trustee Services Limited
(Appellant) v LBG Capital No 1 Plc and another
(Respondents)
before
Lord Neuberger, President
Lord Mance
Lord Clarke
Lord Sumption
Lord Toulson
JUDGMENT GIVEN ON
16 June 2016
Heard on 21 March 2016
Appellant Respondents
Robin Dicker QC Mark Howard QC
Stephen Robins Robert Miles QC
Andrew De Mestre
Gregory Denton
-Cox
(Instructed by Allen &
Overy LLP
)
(Instructed by Norton
Rose Fulbright LLP
)
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LORD NEUBERGER: (with whom Lord Mance and Lord Toulson agree)
1. The issue in this case is whether Lloyds Banking Group (“LBG”) is entitled
to redeem £3.3 billion of loan notes which would otherwise carry a relatively high
rate of interest, namely over 10% per annum. The loan notes are contingent
convertible securities (perhaps inevitably known as “Cocos”), and are formally
described as enhanced capital notes, or the ECNs. The ECNs are potentially
convertible into fully paid up shares in LBG, and they were issued in November
2009, at a time when LBG, like many other banks, was in dire need of
recapitalisation in order to protect its capital position and to comply with regulatory
requirements.
2. Before turning to the terms on which the ECNs were issued, it is necessary
to understand a little about the Regulations as at that time, and, in order to understand
the issues on this appeal, it is necessary to set out some of those terms and then
explain a few of the changes effected to the Regulations in 2013 and the way in
which they were applied.
The regulatory position when the ECNs were issued
3. As at the time that the ECNs were issued, the capital requirements of financial
institutions in the EU were governed by a 2006 Directive known as CRD I. This
Directive was inevitably based on the current international banking accord, at that
time the so-called Basel II. The relevant regulatory authority in the United Kingdom
at the time was the Financial Services Authority, the FSA.
4. Under CRD I, the capital of financial institutions was arranged in tiers. The
highest tier of capital was Core Tier 1, known as CT1; the next tier was divided into
Upper Tier 2 Capital and Lower Tier 2 Capital. CT1 included, inter alia, paid up
shares and retained earnings. Lower Tier 2 Capital included dated subordinated debt.
The FSA’s practice was to require a financial institution to maintain a minimum
ratio of CT1 assets and in addition to pass certain “stress tests”, which involved
subjecting the bank’s balance sheet to hypothetical challenging market situations.
5. In November 2008, the FSA issued a Statement which described a “Capital
Framework” which it intended to apply to all financial institutions. The November
2008 Statement explained that the FSA “used as common benchmarks within this
framework ratios of capital to risk weighted assets of total Tier 1 Capital of at least
8% and Core Tier 1 Capital, as defined by the FSA, of at least 4% after the stressed
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scenario”. The November 2008 Statement also stated that the FSA “will be
addressing the longer term capital regime for deposit takers in a discussion paper in
the first quarter of 2009, the expectation being that this document will form part of
the wider review of the global regulatory environment, which the FSA along with
the other regulatory authorities, will be participating in”.
6. From time to time, the FSA issued further Statements and Guidance. Thus,
in May 2009, it issued a Statement indicating that it had “[g]reatly increased the use
of stress tests as an integral element of our ongoing supervisory approach”. The May
2009 Statement also stated that the FSA “expected UK banks to maintain Core Tier
1 Capital, as defined by the FSA, of at least 4% of Risk Weighted Assets after
applying an FSA defined stress test”. The Statement added that “[t]his current
framework will remain in place until the Basel accord, which is implemented
through EU capital requirement directives, has been modified to reflect the lessons
learned from recent events”. The May 2009 Statement also explained that the stress
tests “look forward over five years but with greater detail over the first three” and
that the tests “are used to identify if at any time in the next five years there is a
danger that under the stress scenario the level of capital will fall below the 4% Core
Tier 1 minimum”.
7. In September 2009, in response to transitional legislation issued by the EU to
control the use by financial institutions of hybrid securities as capital, the FSA issued
another Statement making it “clear that the FSA will work to ensure the timing of
the introduction of a new long-term capital regime …”. The September 2009
Statement also stated that “hybrid capital instruments must be capable of supporting
Core Tier 1 by means of a conversion or write-down mechanism at an appropriate
trigger. Instruments with these characteristics could be seen as a form of contingent
Core Tier 1 Capital”.
The issue of the ECNs
8. Meanwhile, in March 2009, the FSA had stress-tested LBG, and had found
that it had a shortfall in its CT1 Capital, in the light of the 4% minimum requirement
referred to in the November 2008 Statement. As a result, the FSA required LBG to
demonstrate that it had raised at least £21 billion which could qualify as CT1 Capital.
After considering alternative options, LBG decided to raise £13.5 billion by issuing
new fully paid-up shares through a rights issue, and £8.3 billion through the medium
of the ECNs, to be issued in exchange for existing securities. These ECNs were
intended to be Cocos which would satisfy what was said in the passage in the
September 2009 Statement quoted at the end of para 7 above.
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9. This decision was duly implemented. The terms of the £8.3 billion ECNs
were described in a so-called Exchange Offer Memorandum. The exchange invited
in that Memorandum was taken up, and the ECNs were issued and subscribed in a
number of different series in December 2009.
10. The ECNs were loan notes whose terms were contained in a Trust Deed,
which included in Schedule 4 detailed Terms and Conditions (“T&Cs”). In very
broad terms, the ECNs (i) carried interest at varying rates depending on the series,
but averaging about 10.33% per annum, (ii) subject to points (iii) and (iv), were
redeemable only at certain specified dates under clause 8(a) of the T&Cs, which,
depending on the series, varied between 2019 and 2032, but (iii) could be redeemed
early by LBG, albeit only on a so-called “Capital Disqualification Event” under
clauses 8(e) and 19 of the T&Cs, and (iv) were in the meantime potentially
convertible into paid up shares in certain specified circumstances described in clause
7(a) of the T&Cs.
11. Clause 7 of the T&Cs was concerned with “Conversion” of the ECNs. Clause
7(a) was headed “Conversion upon Conversion Trigger”, and clause 7(a)(i) provided
that “[i]f the Conversion Trigger occurs at any time, each ECN shall … be converted
… into … Ordinary Shares credited as fully paid”. The “Conversion Trigger” was
defined as occurring at any time when “LBG’s Consolidated [CT1] Ratio is less than
5 per cent”. The 5% figure was 1% above the minimum 4% ratio required at the time
by the FSA, as explained in the Statements cited in paras 5 and 6 above. The
remainder of clause 7 was concerned with consequential machinery.
12. Clause 8 of the T&Cs was headed “Redemption and Purchase”. Clause 8(a)
provided for the ECNs to be redeemed on the relevant “Maturity Date” (which was
a date which varied between 2019 and 2032 depending on the particular series of
the ECN) “[u]nless previously converted, redeemed or purchased and cancelled as
provided in these Conditions”. Clause 8(e) provided that “[i]f … a Capital
Disqualification Event has occurred and is continuing, then [LBG] may … redeem
… all, but not some only, of the ECNs at [a specified price]”.
13. Clause 19 of the T&Cs was headed “Definitions”. It provided that “a ‘Capital
Disqualification Event’ is deemed to have occurred”:
“(1) if at any time LBG … is required under Regulatory
Capital Requirements to have regulatory capital, the ECNs
would no longer be eligible to qualify in whole or in part (save
where such non-qualification is only as a result of any
applicable limitation on the amount of such capital) for
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inclusion in the Lower Tier 2 Capital of LBG … on a
consolidated basis; or
(2) if as a result of any changes to the Regulatory Capital
Requirements or any change in the interpretation or application
thereof by the FSA, the ECNs shall cease to be taken into
account in whole or in part (save where this is only as a result
of any applicable limitation on the amount that may be so taken
into account) for the purposes of any ‘stress test’ applied by the
FSA in respect of the Consolidated Core Tier 1 Ratio.”
14. Certain other definitions in clause 19 of the T&Cs are also of some relevance.
“Core Tier 1 Capital” was defined as “core tier one capital as defined by the FSA as
in effect and applied (as supplemented by any published statement or guidance given
by the FSA) as at 1 May 2009”. “Tier 1 Capital” and “Lower Tier 2 Capital” were
each defined as having the “meaning given to it by the FSA from time to time”.
“Regulatory Capital Requirements” was defined as meaning “any applicable
requirement specified by the FSA in relation to minimum margin of solvency or
minimum capital resources or capital”. The “FSA” was defined elsewhere in the
Trust Deed as including any “governmental authority in the United Kingdom …
having primary supervisory authority with respect to LBG”.
15. The effect of this arrangement was that (a) the ECNs counted as Lower Tier
2 Capital so long as they were neither redeemed under clause 8 nor converted under
clause 7, and (b) if the ECNs were converted under clause 7 they would count
towards the CT1 Capital. That is because, as explained in para 4 above, CT1 Capital
included paid up shares and Lower Tier 2 Capital included dated subordinated debt.
If conversion was avoided, the current shareholders did not have their shareholdings
diluted, but the ECN holders received a good rate of interest. And the conversion
under clause 7 would only occur when LBG’s CT1 Capital fell below 5% of risk
weighted assets – ie when it was getting near the minimum 4% set by the FSA.
Subsequent relevant regulatory developments
16. With effect from 1 April 2013, the FSA was replaced as the body responsible
for the regulation and supervision of UK financial institutions by the Prudential
Regulation Authority, the PRA (which is wholly owned by the Bank of England).
17. So far as EU regulatory requirements are concerned, CRD I was succeeded
in 2010 and 2011 respectively by CRD II and CRD III, but neither of them made
any changes relevant for present purposes. However, CRD IV, which was published
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in June 2013, and followed the so-called Basel III, made substantial changes. First,
it replaced CT1 Capital with Common Equity Tier 1 capital (“CET1 Capital”),
which is a significantly more restrictive category than was CT1 Capital. Secondly,
it set the minimum core capital ratio at 4% CET1 from 1 January 2014, increasing
to 4.5% CET1 from 1 January 2015. Thirdly, it introduced a new concept, Additional
Tier 1 Capital, (“AT1 Capital”), which included contingently convertible loan stock,
such as the ECNs. It provided that such stock would only qualify as AT1 Capital if
the trigger for conversion was set at a CET1 ratio of at least 5.125%.
18. In March 2013, the Financial Policy Committee of the Bank of England, the
FPC, issued a news release recommending that the PRA should assess the current
capital adequacy of financial institutions in accordance with the CRD IV and Basel
III criteria, albeit subject to adjustments. In particular, it said that by the end of 2013,
banks should hold capital falling within CET1 (as adjusted) equivalent to at least
7% of their risk-weighted assets (a 7% “adjusted CET1 ratio” standard), which was,
according to the evidence, equivalent to requiring LBG to have an unadjusted CET1
Capital ratio of 10%.
19. In June 2013, the PRA announced that LBG needed to raise a total of £8.6
billion further capital in order to meet the new 7% adjusted CET1 ratio standard. In
August 2013, the PRA published a consultation paper, which dealt with the
eligibility of Cocos and other convertible instruments to count as core capital. It
stated that if financial institutions “issue AT1 instruments, the PRA expects them to
set AT1 triggers … at a level higher than 5.125% CET1”.
20. By contrast, and crucially for present purposes, the evidence in this case
establishes that the effect of the terms of the ECNs is that conversion of the ECNs
into fully paid up LBG shares would only be triggered if LBG’s CET1 ratio fell to
1%, which is, of course, far below the minimum required by the PRA under its 2013
Regulatory regime.
21. In December 2013, the PRA published a “Supervisory Statement” effectively
confirming as requirements what had been trailed by the FPC and the PRA earlier
that year.
22. In anticipation of the requirements in the December 2013 Supervisory
Statement, LBG had substantially strengthened its capital position by the end of
2013. This involved a number of steps, including offering to exchange up to a
maximum of £5 billion of the ECNs for new Cocos which would qualify as AT1
Capital, on the basis that they would convert to paid-up shares if LBG’s adjusted
CET1 Capital ratio fell to 7% or lower. As explained in the supporting memorandum
issued by LBG, the 7% conversion trigger was selected because of “statements by
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the PRA … that a conversion trigger of 5.125% … may not convert in time to
prevent the failure of a firm and that it expects major UK firms to meet a 7% CET1
ratio determined in accordance with … CRD IV”. £5 billion of the ECNs were duly
exchanged for these new Cocos in March and April 2014.
23. In April 2014, the Bank of England announced that, in relation to stress
testing, the previous CT1 4% capital ratio would be replaced by a “hurdle rate” of a
ratio of 4.5% of CET1 to risk-weighted assets, although a stress test outcome was
not dependent on a simple “pass/fail” exercise.
24. In December 2014, the PRA reported that LBG’s CET1 ratio at the end of
2013 was 10.1% and that its “minimum ‘stressed’ ratio in the stress test was 5%”.
The ECNs were not taken into account in either assessment. That was inevitable, as
Gloster LJ pointed out in her judgment in the Court of Appeal, “because LBG
remained above the minimum capital threshold in that stress test – in that its CET1
ratio did not fall below 4.5% – by reason of the strength of its capital position without
any need to take into account the ECNs, the conversion trigger point for which was
well below the new CET1 capital pass ratio”.
These proceedings
25. On 16 December 2014, LBG announced that the ECNs had not been taken
into account in the December 2014 stress test and accordingly a Capital
Disqualification Event (hereafter a “CDE”) had occurred under para (2) of the
definition in clause 19 of the T&Cs, and accordingly LBG was entitled to redeem
the outstanding £3.3 billion ECNs in accordance with clause 8(e) of the T&Cs. The
consent of the PRA to the redemption was required and was duly obtained. However,
BNY Mellon Corporate Trustee Services Ltd (“the Trustee”), as trustee for the
holders of the ECNs under the Trust Deed mentioned in para 10 above, challenged
LBG’s claim to be entitled to redeem the outstanding ECNs.
26. Hence these proceedings, in which LBG contends that a CDE has occurred,
so that it can redeem the outstanding ECNs, and the Trustee denies that a CDE has
occurred. LBG argues that a CDE has occurred because para (2) of the definition of
a CDE in clause 19 of the T&Cs (“the Definition”) is satisfied. LBG’s case is that
“as a result of [a change] to the Regulatory Capital Requirements or any change in
the interpretation or application thereof by the FSA”, namely the implementation of
CRD IV through the 2013 Supervisory Statement, “the ECNs [have ceased] to be
taken into account … for the purposes of any ‘stress test’ applied by the [PRA] in
respect of the Consolidated Core Tier 1 Ratio”, as is evidenced by the stress tests
carried out in 2014 in respect of LBG’s financial position as at December 2013.
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27. The Trustee raises two arguments why this contention is wrong. First the
Trustee contends that the December 2014 stress test was not “in respect of the
Consolidated Core Tier 1 Ratio”, as specified in para (2) of the Definition; rather, it
was a stress test in respect of a CET1 ratio. Secondly and alternatively, the Trustee
contends that the fact that the ECNs were not taken into account in the December
2014 stress test when assessing the Tier 1 Ratio is not enough to trigger a CDE; in
order for para (2) of the Definition to apply, the ECNs must be disallowed in
principle from being taken into account for the purposes of the Tier 1 Ratio before
para (2) of the Definition can be invoked by LBG.
28. At first instance, Sir Terence Etherton C, in a clear and careful judgment,
rejected the Trustee’s first argument, but accepted the Trustee’s second argument –
[2015] EWHC 1560 (Ch). Accordingly, he found in favour of the Trustee and held
that the ECNs were not redeemable under clause 8(e) of the T&Cs. For reasons given
in a very full judgment in the Court of Appeal, Gloster LJ agreed with Sir Terence
on the first argument but disagreed with him on the second argument; Briggs LJ
agreed with Gloster LJ for reasons given in a short judgment, and Sales LJ agreed
with Gloster LJ. Accordingly, LBG won in the Court of Appeal, who concluded that
the ECNs were redeemable under clause 8(e) of the T&Cs – [2015] EWCA Civ 1257.
The Trustee now appeals to the Supreme Court.
The proper approach to interpretation
29. Much of the argument before us was given over to the question whether,
when construing the Trust Deed, and in particular the T&Cs, the Court of Appeal
had been entitled to take into account statements in the substantial Exchange Offer
Memorandum and in the lengthy letter from the chairman of LBG which
accompanied it, and indeed the details of the statements and other documents issued
by the FSA in 2008 and 2009.
30. Over the past 20 years or so, the House of Lords and Supreme Court have
given considerable (some may think too much) general guidance as to the proper
approach to interpreting contracts and indeed other commercial documents, such as
the Trust Deed in this case. What, if any, weight is to be given to what was said in
other documents, which were available at the time when the contract concerned was
made or when the Trust Deed in question took effect, must be highly dependent on
the facts of the particular case. However, when construing a contract or Trust Deed
which governs the terms upon which a negotiable instrument is held, as in the
present case, very considerable circumspection is appropriate before the contents of
such other documents are taken into account.
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31. In this connection, it is worth repeating the remarks of Lord Collins (with
whom Lord Hope and Lord Mance agreed) in In re Sigma Finance Corp (in
administrative receivership) [2010] 1 All ER 571, paras 36 and 37. Having pointed
out that the trust deed in that case concerned “debt securities” issued to “a variety of
creditors, who hold different instruments, issued at different times, and in different
circumstances”, Lord Collins, at para 37, said “[c]onsequently this is not the type of
case where the background or matrix of fact is or ought to be relevant, except in the
most generalised way.” More generally, he said:
“Where a security document secures a number of creditors who
have advanced funds over a long period it would be quite
wrong to take account of circumstances which are not known
to all of them. In this type of case it is the wording of the
instrument which is paramount. The instrument must be
interpreted as a whole in the light of the commercial intention
which may be inferred from the face of the instrument and from
the nature of the debtor’s business.”
32. As Mr Dicker QC points out on behalf of the Trustee, the same point was
made by Lord Macmillan when giving the decision of the Privy Council in Egyptian
Salt and Soda Co Ltd v Port Said Salt Association Ltd [1931] AC 677, 682.
Disapproving the trial judge’s reliance on “surrounding circumstances at the time
when the memorandum was framed”, Lord Macmillan said that “the purpose of the
memorandum is to enable shareholders, creditors and those who deal with the
company to know what is its permitted range of enterprise, and for this information
they are entitled to rely on the constituent documents of the company” and that the
“intention of the framers of the memorandum must be gathered from the language
in which they have chosen to express it”. (See also the observations of Lord
Hoffmann to much the same effect in Attorney General of Belize v Belize Telecom
Ltd [2009] 1 WLR 1988, para 36, Homburg Houtimport BV v Agrosin Private Ltd
[2004] 1 AC 715, para 74, and Chartbrook Ltd v Persimmon Homes Ltd [2009] AC
1101, para 40).
33. In the present case, the Trust Deed, and in particular those parts of clauses 7,
8 and 19 of the T&Cs which fall to be construed, cannot be understood unless one
has some appreciation of the regulatory policy of the FSA at and before the time that
the ECNs were issued. That is self-evident from the provisions of clause 19 which
are set out in paras 13 and 14 above. Accordingly, I consider that at least the general
thrust and effect of the FSA regulatory material published in 2008 and 2009 can be
taken into account when interpreting the T&Cs. That would also accord with good
sense: while the individual purchasers of the ECNs may not by any means all have
been sophisticated investors, it is appropriate to assume that most of them would
have had advice from reasonably sophisticated and informed advisers before they
purchased such moderately complex financial products. The Exchange Offer
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Memorandum and the letter from the LBG chairman present more difficulties, and
the answer may depend on whether such documents would have been known about
or in the minds of subsequent purchasers of the ECNs, a point on which there was
no evidence, so far as I am aware.
34. As it is, I do not consider that the terms of the Exchange Offer Memorandum
or the letter from the LBG chairman take matters any further in this case. In my
view, once one has in mind the general thrust and effect of the FSA regulatory
approach in 2009, as summarised in paras 4 to 7 above, coupled with the commercial
purpose of the ECNs as summarised in para 15 above, it is simply unhelpful on the
facts of this case to cast one’s eyes further than the T&Cs when resolving the issues
on this appeal. I now turn to those two issues.
The first issue: did the possibility of a CDE fall away following CRD IV?
35. I have no hesitation in agreeing with Sir Terence Etherton and the Court of
Appeal in their conclusion that the reference to “the Consolidated Core Tier 1” in
para (2) of the Definition should, in the events which have happened, be treated as
a reference to “its then regulatory equivalent” – ie in the current context the Common
Equity Tier 1 Capital. Etherton C and the Court of Appeal considered that this
conclusion involves a departure from the strictly literal meaning of the definition of
“Core Tier 1 Capital” in clause 19, but they concluded that such a departure was
justified because it was “clear that something has gone wrong with the language and
[it was] clear what a reasonable person would have understood the parties to have
meant”, applying the test laid down by Lord Hoffmann in Chartbrook, para 25.
36. The reasons given by Gloster LJ in para 85 of her judgment for departing
from what she considered was the literal meaning of the closing words of para (2)
of the Definition were based on the arguments of Mr Miles QC. They were, in
summary, that (i) it was notorious at the time of the issue of the ECNs that the
regulatory requirements as to financial institutions’ capital would be “strengthened
and changed”, (ii) it was envisaged in the T&Cs, in particular in clause 19, that
expressions such as “Regulatory Capital Requirements” and “Core Tier 1 Capital”
could change their meaning; (iii) indeed, it was inherent in the terms of the
Definition that this was so; (iv) it was obvious that changes of substance might lead
to changes of nomenclature; and (v) one of the essential features of the ECNs was
that, if necessary, they could be converted into LBG core capital, whatever
expression was used to define it.
37. Gloster LJ concluded that, given these points, coupled with the existence of
the ECN maturity dates, it made no commercial sense to limit the reference to “Core
Tier 1 Capital” in para (2) of the Definition to CT1 Capital, as opposed to holding
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that it could, in the events which had happened (as summarised in paras 16 to 20
above), apply to CET1 Capital. She also considered that the error would “have been
obvious to a reasonable addressee of the Exchange Offer Memorandum”. She
referred in this connection to another observation of Lord Collins in Sigma, where,
in para 35, he said that in complex documents such as the Exchange Offer
Memorandum, “there are bound to be ambiguities, infelicities and inconsistencies”
and had gone on to warn against an “over-literal interpretation of one provision
without regard to the whole”, which may “distort or frustrate the commercial
purpose”.
38. Subject to one point, I have no hesitation in agreeing with the analysis as
summarised in paras 35 to 37 above. My only doubt is as to whether this conclusion
really does involve a departure from the literal meaning of the closing words of para
(2) of the Definition, not least in the light of the definitions of “Core Tier 1 Capital”
and “Tier 1 Capital” in clause 19. It may involve a departure from the literal
meaning, but, if it does, it is on the basis of a rather pedantic approach to
interpretation. I do not, however, propose to discuss the point further: it is
completely arid.
39. I would add, however, that if the Trustee’s argument was correct, it seems to
me that LBG would have had a powerful basis for saying that this appeal should be
dismissed rather than allowed. That is because, as a matter of language at least, LBG
could say that para (2) of the Definition applied on the grounds that the ECNs had,
on any view “cease[d] to be taken into account … for the purposes of any ‘stress
test’ applied by the FSA in respect of the Consolidated Core Tier 1 Ratio”, because
that ratio was no longer being used by the FSA.
The second issue: have the ECNs “ceased to be taken into account”?
40. The critical question raised by the second issue is whether, as LBG contends,
in the light of the regulatory changes and events as described in paras 17-24 above,
“the ECNs [have] cease[d] to be taken into account in whole or in part … for the
purposes of any ‘stress test’ applied by the [PRA] in respect of [what I will call the
Tier 1] ratio”. To put the point slightly differently, the question is whether the
implementation of CRD IV by the PRA through the new Capital Requirements
summarised in paras 17 to 21 above, and applied as described in paras 23 and 24
above, entitle LBG to say that a CDE has occurred because para (2) of the Definition
has been satisfied.
41. The nature of the dispute on this second issue was very well expressed by
Briggs LJ in para 114 in the Court of Appeal, in these terms:
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“In order to resist early redemption of the ECNs is it sufficient
that they continue to be taken into account for some purpose or
purposes in the stress-test now applied by the [PRA], which in
my view they do, or must they play a part in enabling LBG to
pass that test, which they clearly no longer do, because of the
change in the Regulatory Capital Requirements which had the
effect of elevating the pass ratio to a level above the Conversion
Trigger.”
42. I also agree with what Briggs LJ said in the next paragraph of his judgment,
namely that this is a difficult question to resolve, and I find it unsurprising that Sir
Terence and the Court of Appeal took different views, and indeed that there is a
difference of view in this court.
43. LBG argues that the essential point is that “the Regulatory Capital
Requirements” changed in 2013 with the consequence that the ECNs could no
longer be taken into account in assisting LBG in passing the stress test, because the
conversion trigger under the terms of the ECNs was at a level lower than the
minimum required by the PRA, as explained in para 20 above, and, in any event, the
PRA did not in any way rely on the ECNs when conducting its stress tests on LBG
in 2014.
44. By contrast, the Trustee’s argument is that, notwithstanding the regulatory
changes in 2013, the ECNs can continue to be taken into account as part of the Tier
1 Capital by automatically converting into paid-up shares in LBG, albeit that this
would only occur when the CET1 Capital ratio fell to 1%.
45. I prefer LBG’s argument, as advanced by Mr Howard QC, for the following
reasons. First, it appears to me that the Trustee’s argument does not give full weight
to the phrase “any ‘stress test’ … in respect of the [Tier 1] Ratio”. I accept that,
under the new Regulations introduced in 2013, the ECNs could be taken into account
in a “stress test”, and I accept that there could be circumstances in which the ECNs
could convert into ordinary shares so as to become part of Tier 1 capital. However,
if and when a stress test is applied to see if LBG satisfies the Tier 1 Ratio, it appears
to me that the vital point is that, under the Regulations introduced in 2013, the ECNs
cannot be taken into account so as to do the very job for which their convertibility
was plainly designed, namely to enable them to be converted before the regulatory
minimum Tier 1 Ratio is reached. That, to my mind, is what the expression “taken
into account … for the purposes of any ‘stress test’ … in respect of the [Tier 1]
Ratio” is concerned with.
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46. Secondly, the question which has to be asked under para (2) of the Definition
is whether the ECNs have “cease[d] to be taken into account” for the specified
purpose. This is in marked contrast with the wording of para (1) of the Definition,
where the question is whether the ECNs are “no longer … eligible to qualify” for
the purpose specified in that paragraph. It seems to me that eligibility to qualify
depends on what the Regulations say, whereas being taken into account depends
more on what happens in practice – no doubt pursuant to the Regulations. That view
is reinforced by the fact that para (1) is based simply on the requirements of
“Regulatory Capital Requirements”, whereas para (2) is also based on “any changes
to the Regulatory Capital Requirements or any change in the interpretation or
application thereof”. It seems to me that the way on which the Trustee puts its case,
as summarised in para 44 above, is ultimately concerned with the eligibility of the
ECNs for the purpose described in para (2) of the Definition, whereas LBG can
fairly rely on the fact that the ECNs were not, as a matter of fact (and it does not
signify whether it was due to the terms of the 2013 Regulations, or the PRA’s
application of those Regulations) invoked for the purpose described in para (2) – see
para 24 above.
47. Thirdly, if the Trustee’s interpretation is correct, it is very difficult to
envisage circumstances in which it could have been thought that para (2) of the
Definition could ever be invoked. The notion that fully paid up share capital could
ever be excluded from the definition of Tier 1 Capital (whether CT1, CET1, adjusted
CET1 or any other possible definition) seems fanciful. Accordingly, it is hard to see
how the parties could have envisaged that a Coco, ie a loan note which automatically
converted into paid-up share capital, could be excluded, in the sense that the
Trustee’s case requires, from being “taken into account … for the purposes of any
‘stress test’ … in respect of the [Tier 1] Ratio”.
48. While some of them are not without force, the arguments which have been
raised against LBG’s case do not persuade me the other way. There is, I accept, some
force in the point that, if LBG’s reading of para (2) of the Definition is correct, it
must have been foreseeable when the ECNs were issued that a CDE would be likely
to occur in the not-too-distant future. That is because it was well known that the
capital requirements of financial institutions were to be strengthened (see paras 5 to
7 above), and so, runs the argument, it must have been appreciated that the minimum
permitted Tier 1 Ratio was likely to go above the equivalent of a CT1 ratio of 5%.
There are, however, two answers to this point. First, it was by no means certain that
the increased capital requirements would involve increasing the minimum Tier 1
Ratio above the equivalent of a CT1 ratio of 5%. Apart from anything else, the new
requirements could have retained or only slightly increased this minimum, while
introducing a new intermediate tier between what was CT1 and Upper Tier 2: that
that is not a fanciful possibility is demonstrated by the actual introduction of the new
concept of AT1 Capital (see para 17 above). Quite apart from this, the notion that it
must have been perceived as likely that the ECNs would be redeemable well before
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their respective maturity dates is not a particularly surprising proposition, especially
as clause 8(e) operated not as an automatic redemption, but merely gave rise to an
option in LBG to redeem.
49. The expression “Capital Disqualification Event” does not strike me as an
inapt description of what has happened on LBG’s case. Thus, the effect of the
change in the Regulations in 2013 and the application of those changed Regulations
in 2014 can fairly be said to have “disqualified” the ECNs from having the
potentially saving effect on the Tier 1 Ratio which they were intended to have, and
could properly have had under the Regulations as they stood in 2009.
50. The argument that the 2013 Regulations have not made any difference
because the ECNs might not have ensured that LBG had a sufficiently high Tier 1
Ratio even under the 2009 Regulations appears to me to involve a
mischaracterisation of LBG’s case. That case is not that the convertibility of the
ECNs could be guaranteed to save the day under the 2009 Regulations. It is that their
convertibility could be invoked to increase the Tier 1 Ratio before that ratio had
fallen below the minimum under the 2009 Regulations of a CT1 Capital ratio of 4%.
Thus, in 2009, the convertibility of the ECNs had the ability to enable LBG to keep
above the minimum Tier 1 Ratio, whereas that was no longer possible under the
2013 Regulations. The force of the point is underlined by the PRA’s requirement in
2013 that the Tier 1 Ratio conversion trigger for any qualifying Cocos should be at
least 5.125% (see paras 17 and 19 above).
51. I am also unimpressed with the point that, on LBG’s argument, the ECNs
may be redeemed under clause 8(e) because they have “cease[d] to be taken into
account” on one stress test (as in 2014), notwithstanding that they might have been
taken into account on a subsequent stress test. Such a possibility is inherent in para
(2) of the Definition, whatever meaning one gives it. Thus, if para (2) is simply
concerned with the ECNs’ eligibility to convert into Tier 1 Capital, as the Trustee
contends, and the Regulations were changed to provide that they could no longer do
so (highly improbable to say the least, as already pointed out), it could always be
said that the Regulations might change back.
52. It is said that LBG’s case leads to arbitrary results, as it may depend on the
practices and assumptions of the PRA when applying a particular stress test or set
of stress tests. There are two answers to that. The first is that, on the facts of this
case, that is not a fair charge: given that the minimum Tier 1 Ratio has changed so
that the ECNs cannot convert to Tier 1 capital until that capital has fallen below,
indeed substantially below, the permissible minimum as a result of the changes
effected by the 2013 Regulations, para (2) of the Definition applies. Quite apart from
that, given the reference to the “application” of the Regulations “by the FSA … for
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the purposes of any ‘stress test’ applied by the FSA”, it is inherent in para (2) that
the PRA’s practices could determine whether the paragraph is satisfied.
53. Finally, there is also some force in the argument that the wording of para (2)
of the Definition is not wholly clear and that, in the event of doubt, it should be
construed against LBG, as the person responsible for drafting the Trust Deed, the
proferens. The closing words “in respect of the … Tier 1 Ratio” are inherently
imprecise: identifying the precise ambit of the expression “in respect of” frequently
leads to arguments. However, the contra proferentem rule is very much a last refuge,
almost an admission of defeat, when it comes to construing a document, and, in this
case, for the reasons which I have attempted to give in paras 45-52 above, I do not
think that it is necessary, or indeed appropriate, to resort to it in this case.
Conclusion
54. Accordingly, I would dismiss the Trustee’s appeal, on the basis that I
consider that a Capital Disqualification Event has arisen under para (2) of the
Definition of that expression in clause 19 of the T&Cs.
LORD SUMPTION: (dissenting) (with whom Lord Clarke agrees)
55. This case is of considerable financial importance to the parties but raises no
questions of wider legal significance. There is therefore no point in dissenting at any
length. But since I would have held that that these securities are not redeemable, I
should, however briefly, explain why.
56. The notes are contingent share capital. Their immediate purpose as far as
Lloyds Banking Group was concerned was to enable it to satisfy the FSA at the time
of their issue that it would have a ratio of Consolidated Core Tier 1 Capital to riskweighted assets of at least 4% in a hypothetical stressed scenario. Consolidated Core
Tier 1 Capital included ordinary shares but not loan notes. The issue of these notes
did not therefore actually strengthen the Bank’s Tier 1 Capital. But because they
would automatically convert to ordinary shares if in the hypothetical stress scenario
the ratio fell to within one percentage point above the then minimum, they assisted
the Bank to satisfy its regulators. The effect of the subsequent regulatory changes
was that the definition of top tier capital was tightened up and the required ratio of
adjusted top tier capital (“Common Equity Tier 1”) to risk weighted assets was
increased to 7%. This meant that the notes were no longer as useful to the Bank,
because if its affairs deteriorated it would fail a stress test long before the trigger for
conversion was reached. From the investors’ point of view, however, that did not
matter, provided that the Bank remained solvent. The attraction of the notes for them
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lay in their long maturity date and high coupon, both features that were critical to
their market value.
57. The notes are redeemable if as a result of regulatory changes they “cease to
be taken into account” for the purposes of any stress test in respect of the
Consolidated Core Tier 1 Ratio (for which, now read the Common Equity Tier 1
Capital ratio). The question is whether being “taken into account” means (i) that in
the hypothetical stress scenario they would convert and play a part in enabling the
Bank to pass the stress test; or (ii) that they must be eligible, in the sense that
notwithstanding their status as Lower Tier 2 Capital the regulator would treat them
as top tier capital in the hypothetical event of the Bank’s affairs deteriorating to the
point where the conversion trigger was attained, so that the stress scenario can be
modelled on that basis. The difference is that (i) depends on how the Bank fared in
an actual stress test, whereas (ii) turns on the regulator’s rules and practices for
conducting such tests.
58. Sir Terence Etherton concluded that (ii) was correct, because the definition
“is not looking at the happenstance of the particular strength of LBG’s capital and
the particular composition of its capital at any one particular moment of time in the
context of a particular stress test imposed by the regulator at that time”, but at the
position as a matter of principle (para 46). I think that he was right.
59. In the first place, it was always implicit in the terms that the notes might be
irrelevant to the Bank’s ability to pass a stress test. Whether or not there were
changes to the regulatory capital requirements, the Bank’s capital position might be
strong enough to meet the minimum top tier capital ratio even if the notes did not
convert. Or it might be so weak that the notes would not save the situation even if
they did convert. If the notes would not necessarily play a part in enabling the Bank
to pass a stress test in the situation obtaining when they were issued, I cannot see
why it should be supposed that the parties intended to allow early redemption if the
same situation obtained as a result of a change in regulatory capital requirements.
The situation introduced by such a change is no different in principle from the
situation that existed before. The change might make it more or less likely that the
notes would be critical to the outcome of a stress test, but there is no change in the
way that the scheme works.
60. Secondly, a test dependent on how the notes affected the outcome of an actual
stress test would be wholly uncertain. Stress testing is not a fixed or ascertainable
concept. Its outcome will depend not just on the rules and practises of the regulator,
but on what the hypothetical conditions assumed in a particular stress test are, on
where the regulator pitches the stress test hurdle (not necessarily the same as the
minimum regulatory top tier capital ratio), and what is the value and composition of
the Bank’s assets at the time of the test. Moreover the hypothetical stress scenario
Page 17
will test the strength of the Bank’s capital over a substantial period of time, during
which it may fail the test throughout or for a day or two. The significance of that
will be a question of regulatory judgment. It is not just a simple question of pass or
fail. Of course, the regulatory changes which actually occurred mean that the notes
will in practice make little difference to the outcome on any reasonably foreseeable
view about these matters. But although it was anticipated that there would be a
tightening of the capital adequacy requirements, the details were not known at the
time that the securities were issued, and the terms cannot be construed in the light
of the subsequent changes.
61. Thirdly, nothing in the definition of a “Capital Disqualification Event”
supports the suggestion that it was intended to depend on the part played by the notes
in enabling the Bank to pass an actual stress. The clause’s title is concerned with
“disqualification”, ie with a state of affairs in which the notes are no longer eligible
in principle to perform their function as contingent capital. As regards Lower Tier 2
Capital, dealt with in sub-clause (1), this is clear from the reference to capital being
“eligible to qualify”. The only reason why the word “eligible” is not used in subclause (2) of the definition, dealing with top tier capital, is that whereas the status of
Lower Tier 2 Capital depends simply on whether it satisfies the relevant regulations,
the status of top tier capital depends on the practices and judgments of regulators as
well, a context in which it was appropriate to speak of the securities being taken into
account, rather than being eligible.
62. These were long-dated securities, which cannot have been intended to be
redeemed early except in some extreme event undermining their intended function
and requiring their replacement with some other form of capital. The function of the
notes was to be available to boost the Bank’s top tier capital in the hypothetical event
that the ratio of top tier capital to risk-weighted assets fell below the conversion
trigger. They have always served that function and still do. Whether that function
remains as important to the Bank as it was in 2009 is irrelevant.
