Judgments - February 9, 2016

CMBS transactions - whether to treat receipts as principal or interest, and what to do where a ratings agency will not provide a required confirmation

CBRE Loan Servicing Ltd. v. Gemini (Eclipse 2006-3) PLC and others [2015] EWHC 2769 (Ch)

The dispute in this case was, in reality, between the holders of Class A notes issued by the defendant issuer on the one hand and the holders of the subordinated notes in Classes B to E on the other. The proceeds of issue of the notes were used to acquire a loan secured upon a portfolio of commercial properties. The Claimant (CBRE) was the "Special Servicer" in respect of that loan. The income derived by the borrowers from the portfolio was to be used in order to service the loan. This would also allow the issuer to service the notes. The loan was accelerated on 6 August 2012, such that the full amount became payable by the borrowers. There was, however, no default by the issuer in relation to the notes.

At the time of the hearing before Henderson J, some of the property portfolio had been sold in accordance with a disposal programme, and CBRE continued to collect rent in respect of the remainder. Henderson J was asked to decide whether CBRE should treat as income or principal receipts from the following sources: (a) rents received; (b) the proceeds of sale of the properties; and (c) any surrender premiums paid by the tenants of the properties.

This question was important because the way in which receipts were applied in practice, under a Cash Management Agreement (CMA), depended on CBRE's characterisation of them. The CMA provided for two discrete "waterfalls" of payment - if the receipts were treated as interest, there was a specific order in which they should be applied, interest due to the Class A noteholders being paid in priority to interest due to the subordinated noteholders. If, however, the receipts were treated as principal, then the subordinated noteholders would not be entitled to receive anything from them (including by way of interest) until the principal due to the Class A noteholders had been fully paid. The CMA was silent on the question of how CBRE was to distinguish between principal and interest.

The Class A noteholders accepted that rental income from the unsold properties should be treated as interest. It argued, however, that the proceeds of sale of properties, and any surrender premiums, should be treated as principal. This argument was advanced on the basis of various provisions of the CMBS transaction documents, and was consistent with the subordination of other classes to the Class A notes. The holders of the subordinated notes relied on a provision of common law (that was accepted by the Class A noteholders to be correct, albeit inapplicable), that a payment is to be applied to the discharge of interest before principal, unless the debtor or the creditor has appropriated it otherwise.

Henderson J considered this issue as a matter of contractual construction, holding that the receipts should be characterised as principal or interest depending on their source and the role they played in the context of the loan. He held that it would be inappropriate to require the kind of close analysis of the receipts that would be necessary in the context of deciding on their tax treatment. On that basis, he agreed with the Class A noteholder that the proceeds of sale and surrender premiums should be treated as principal, and that rental income should be treated as interest. The key element in Henderson J's reasoning appears to have been that he felt the debtor/creditor analogy to be inapposite to the question of how CBRE ought to characterise the relevant sums.

Henderson J's approach to this issue should be relevant in the context of other CMBS transactions, and his conclusions may also be relevant where the contractual drafting is materially similar.

Deutsche Trustee Co Ltd v. Cheyne Capital (Management) UK (LLP) and another [2015] EWHC 2282 (Ch)

This judgment, of Arnold J, also relates to difficulties in relation to a CMBS transaction (the judgment provides a useful summary of the nature and key features of such transactions generally).

In this case, the subordinated Class G notes were agreed to be the "Controlling Class" for the purposes of the transaction. This entitled Class G (represented by Cheyne as operating adviser to the Controlling Class) to exercise certain rights. Specifically, Cheyne had notified the claimant trustee of the issue (Trustee) that it wished to replace the Special Servicer appointed in relation to defaults that had occurred in the underlying loan. The difficulty with this request was that the Issuer Servicing Agreement (which was the relevant agreement for these purposes) provided that no termination of the appointment of the Special Servicer would take effect unless (in effect) each of Moody's, Fitch and S&P had been informed of the identity of the proposed replacement, and had confirmed that such replacement would not result in a downgrade of the notes. Alternatively, each class of noteholders could approve the replacement by extraordinary resolution. There was no difficulty in practice in obtaining the required confirmations from Moody's or S&P but, consistent with a general policy statement made in 2012, Fitch indicated that it would not respond to any request for confirmation of this kind.

Cheyne submitted (in summary) that the relevant provisions of the Issuer Servicing Agreement did not contemplate a situation in which a ratings agency refused on principle to provide confirmations. On that basis, Cheyne said that the agreement should be construed as requiring confirmation to be provided by such of the ratings agencies as were willing in principle to provide them.

The Trustee argued that this was not what the Issuer Servicing Agreement said. The agreement required that all three agencies provide confirmation, and provided a solution (the recourse to an extraordinary resolution of noteholders) if that was not possible. The drafting of the CMBS documents meant that, in practice, an extraordinary resolution of Class A noteholders would bind the other classes anyway, making the use of that route as an alternative to ratings agency confirmation less onerous than it might appear. In addition, the Trustee said that the agreement specifically contemplated a situation where Moody's was unwilling to provide a confirmation - on that basis, it could not be said that the draftsman had ignored contingencies of that kind.

Arnold J agreed with the Trustee's interpretation. He held that Cheyne's preferred construction of the document effectively ignored the terms in which it was actually drafted, whereas the Trustee's interpretation accorded with the ordinary meaning of the language used. He was also unpersuaded by Cheyne's argument that a decision in the Trustee's favour would produce a commercially absurd result.

The judgment is likely to be significant to other transactions of this kind, as Fitch's policy in relation to confirmations is of general application, and this is unlikely to be the only transaction in which the contractual drafting will not achieve the result that the Controlling Class (usually the most subordinate noteholders) would wish. In addition, the judgment is interesting in the context of U.S. Bank Trustees v. Titan (Europe). In that case, the judge held that it would make no commercial sense for the Special Servicer to have to remain in post because of a general policy of Fitch. The relevant contractual wording was, however, different in a number of respects, including the omission of the option for an extraordinary resolution. The Deutsche Trustee judgment will be appealed.

Status of money left in the hands of a paying agent once notes are redeemed, and appointment of a receiver by way of equitable execution

Merchant International Company Limited v. Natsionalna Aktsionerna Kompaniia Naftogaz Ukrainy [2015] EWHC 1930 (Comm)

The Claimant (MIC) got judgment against Naftogaz in February 2011. The amount currently outstanding under that judgment is almost US$25 million, which Naftogaz has not paid. MIC's application was for a receiver to be appointed by way of equitable execution in respect of (in summary) any and all of Naftogaz's rights in relation to a sum of US$25 million held by BNY Mellon.

This money was the remainder of a larger sum paid by Naftogaz to BNY Mellon, in order that BNY Mellon (as paying agent) could distribute it to the holders of notes issued by Naftogaz. A previous, unsuccessful attempt by MIC to obtain a third party debt order in relation to these funds led to a judgment of Blair J in 2014 (upheld by the Court of Appeal), that there was no debt due or accruing due to Naftogaz from BNY Mellon in respect of the money. In other words, BNY Mellon was not obliged to repay the money to Naftogaz in the same way that, for example, a banker would normally be obliged to repay money on deposit to a client. The status of funds like this, held by security trustees and paying agents for onward distribution to noteholders, can often be the subject of dispute where the issuer of the notes is also a judgment debtor.

In this case, between the judgment of Blair J and the present application, the relevant notes were redeemed and cancelled, although BNY Mellon still retained the balance of funds transferred to it. The judge accepted that, on the evidence, there were indications that BNY Mellon would repay this sum if asked to do so.

MIC said that in the circumstances, a receiver should be appointed because: (a) BNY Mellon had an express obligation as Naftogaz's agent to act in good faith and that, once the notes had been redeemed, there was no purpose in BNY Mellon holding the money, which it would therefore have to repay; (b) BNY Mellon must account to Naftogaz for the money in order to avoid being unjustly enriched; and (c) BNY Mellon had absolute discretion whether to account to Naftogaz for the money or...