On 7 October 2015, Mr Justice Henderson handed down his judgment in CBRE Loan Servicing Limited v Gemini (Eclipse 2006-3) Plc and others. In these proceedings, CBRE Loan Servicing Limited (the “Servicer”) sought directions from the court on the correct allocation of amounts to principal and interest for the purposes of the priority of payments for the Gemini (Eclipse 2006-3) Plc CMBS transaction (“Gemini”).
The judgment in Gemini is to be contrasted with the judgments in Deutsche Trustee Company Limited v Cheyne Capital (Management) UK (LLP) (“DECO 15”) and US Bank Trustees Limited v Titan Europe 2007-1 (NHP) Limited (“Titan (NHP)”), where the court was also concerned with questions of contractual interpretation in relation to CMBS transactions. In DECO 15 and Titan (NHP), the court reached its decision by giving precedence to the wording of the contractual documents over the commercial expectations of noteholders. In Gemini, the court was able to be more commercial in its analysis, due to the lack of specific provisions in the contractual documents covering the question before it.
In Gemini, Gemini (Eclipse 2006-3) Plc (the “Issuer”) issued commercial mortgage floating rate notes (the “Notes”) in a total amount of £918,862,500 in five classes from Class A to Class E. The proceeds of the issue of the Notes were used to purchase a loan made to borrowers in the Propinvest Group (the “Loan”) that owned a portfolio of 36 properties (the “Properties”), which provided security for the Loan.
The Issuer appointed the Servicer to service and manage the Loan on its behalf. The role of the Servicer included collecting monies due on the Loan and also enforcing the security over the Properties that was granted in relation to the Loan.
The transaction contemplated that amounts received by the Issuer in relation to the Loan would, once other costs and expenses of the Issuer had been paid, be used to pay interest on the Notes each quarter and to repay principal on the Notes when the Loan was repaid. Prior to a note event of default, these matters were governed by a cash management agreement (the “Cash Management Agreement”) between (amongst other parties) the Issuer, The Bank of New York Mellon as the cash manager (the “Cash Manager”) and the Servicer and also the terms and conditions of the Notes (the “Conditions”).
The Cash Management Agreement directed that “Available Issuer Income” should be applied pursuant to the “Pre-Acceleration Revenue Priority of Payments” (the “Revenue PP”), under which interest on the Notes was paid, and that “Available Issuer Principal” should be applied pursuant to the “Pre-Acceleration Principal Priority of Payments” (the “Principal PP”), which covered payments of principal on the Notes. The Revenue PP and the Principal PP each provided for the Class A Notes to be paid first in priority to the other classes of Noteholders, with payments then being made to the Class B Noteholders and so on. There was no provision to make up shortfalls under either the Revenue PP or the Principal PP with monies that were to be applied pursuant to the other priority of payments; they were mutually exclusive. For example, no shortfall of interest could be made up from amounts that were to be applied pursuant to the Principal PP.
It was the role of the Servicer to allocate amounts received in relation to the Loan as either interest or principal and according to this allocation amounts were then characterised either as Available Issuer Income or Available Issuer Principal.
Default and acceleration of the Loan
At the time of origination of the Loan in August 2006, the Properties were valued at £1,143,335.000 but their value declined to £437,500,000 by March 2012. In addition, the rental income on the Properties also declined, so that it became insufficient to pay interest on the Loan. As a result, the Loan went into default and was accelerated in August 2012. Enforcement action was then taken in relation to the Loan and the security over the Properties, with administrators being appointed over the key borrower entities and receivers being appointed over the Properties.
In addition to the decline in the value of the Properties, recoveries on the Loan were also impaired by substantial termination payments in relation to the associated interest rate swap transactions. Therefore, only the Class A Noteholders are likely to receive any repayment on their Notes and even then at substantially less than par.
Following acceleration of the Loan so that its entire balance became due, both the principal amount of the Loan and the interest that accrued on the Loan were payable. However, as there would be insufficient recoveries on the Loan to pay all of the outstanding amounts, there would be only partial payment of the principal and interest that was outstanding. The question of how to allocate the proceeds from enforcement of the Loan between these two outstanding amounts gave rise to the issue considered in the proceedings.
The issue in the proceedings
As described above Available Issuer Revenue is to be applied pursuant to the Revenue PP and Available Issuer Principal is to be applied pursuant to the Principal PP. However, in the circumstances following acceleration of the Loan, there was insufficient guidance in the transaction documents (including the Cash Management Agreement and the Conditions) for the servicer to ascertain which amounts received in relation to the loan were interest, and so Available Issuer Revenue, and which were principal, and so Available Issuer Principal. In particular, the terms interest and principal were not defined.
Therefore, the Servicer, as the party responsible for making the allocation between interest and principal, applied to the court for a direction to resolve the uncertainty that existed under the transaction documents. In order for the different interests of the various Noteholder classes to be represented, a Class A Noteholder and a Class E Noteholder were joined to the proceedings to represent the Class A Noteholders and the Class B to E Noteholders (the “Junior Noteholders”) respectively.
In addition to the representative Noteholders, the liquidity facility provider (the “Liquidity Facility Provider”) that had entered into a liquidity facility with the Issuer (the “Liquidity Facility”) was also joined to the proceedings. The reason for this was that amounts had been drawn down under the Liquidity Facility to pay interest on the Notes due to the shortfall in interest received in relation to the Loan, so that the Liquidity Facility Provider was owed amounts by the Issuer. However, only the Revenue PP provided for the payment of amounts due to the Liquidity Facility Provider and so if amounts received in relation to the Loan were allocated as principal, they were not available to repay the Liquidity Facility Provider.
During the course of the proceedings, the Liquidity Facility Provider entered into a settlement with the Issuer at the direction of the Class A Noteholders that meant that its position was to some extent protected regardless of the outcome of the proceedings. As a result of that settlement, the Liquidity Facility Provider took no further part in the proceedings.
Key provisions of the transaction documents
Before turning to the arguments put forward by each of the representative Noteholders, it is useful to set out the key parts of the definitions of Available Issuer Revenue and Available Issuer Principal. The relevant extract from the definition of Available Issuer Revenue is as follows:
“All monies . . . (other than Prepayment Fees, Break Costs and principal (save to the extent that such principal represents any amount to be paid to the Special Servicer as a Liquidation Fee)) to be paid to the Issuer under or in respect of the Credit Agreement less the amount of any expected shortfall in such amount as notified by the Master Servicer or the Special Servicer, as the case may be, to the Cash Manager . . . .”
The definition of Available Issuer Principal consisted of a number of further definitions. The key defined term within Available Issuer Principal was Principal Recovery Funds, which were defined (so far as material) as follows:
“Principal Recovery Funds means the aggregate amount of principal payments received or recovered by or on behalf of the Issuer following the acceleration of the Loan or as a result of actions taken in accordance with the enforcement procedures in respect of the Loan and/or its Related Security . . . and Available Principal Recovery Funds means, in respect of any Calculation Date, the Principal Recovery Funds received or recovered by or on behalf of the Issuer during the Collection Period then ended . . . .”
As can be seen, both these defined terms use the undefined term “principal”, with such principal amounts being excluded from the definition of Available Issuer Revenue and included within Principal Recovery Funds.
The arguments of the Class A Noteholders
The primary argument of the Class A Noteholders was that the proceeds of sale of the properties should be characterised as principal and the rental income from the properties should be characterised as interest. This argument was advanced on a number of bases. First, it would recognise the subordination of the Junior Noteholders, which was reflected in the ratings given to their Notes and the higher rates of interest that were payable on them.
Second, the overall structure of the transaction documents showed that rental income was to be treated as interest, with the object of providing an income stream to pay interest on the Notes, while sale proceeds were to be treated as repayments of principal on the Loan, with the object of funding repayments of principal on the Notes. This interpretation was supported by the provisions of the transaction documents that applied prior to the enforcement and acceleration of the Loan, whereby the proceeds of sale from the Properties were directed to repay principal on the Notes.
Third, the reference to the Liquidation Fee to be paid to the Servicer not being part of “principal” showed that there needed to be a carve out from “principal” in relation to this fee, which was based on the net proceeds of sale of a Property, so that the relevant amounts would be applied as Available Issuer Revenue to be paid to the Servicer pursuant to the Revenue PP.
The alternative argument advanced by the Class A Noteholders was that all amounts received in relation to the Loan (i.e. rental income and sales proceeds) should be applied pro rata according to the amount of principal and interest outstanding on the Loan at the time of receipt. Such an application would lead to the vast majority of amounts received being applied as principal.
The arguments of the Junior Noteholders
The primary argument of the Junior Noteholders was that, as the parties had failed to specify whether amounts received in relation to the Loan are principal or interest, the common law rules as to appropriation should apply. Those rules provide for a presumption that interest is to be paid first and only when all interest is paid will amounts of principal begin to be paid. In effect, the Junior Noteholders contended that the parties must be taken to have been satisfied with the common law position and it was for that reason that the transaction documents did not specify how amounts were to be allocated to principal and interest.
The Junior Noteholders submitted that this interpretation of the transaction documents was coherent and would make good business sense, as the Notes would remain outstanding and would bear interest until all the Properties were sold. In those circumstances, amounts received on the Loan should be used to pay the continuing obligations as to interest on the Notes first, until the Notes were accelerated following a note event of default or they reached maturity.
The Junior Noteholders also relied on the fact that the Revenue PP provided for payments to the Liquidity Facility Provider, whereas the Principal PP did not. Allocating amounts to principal would, absent the settlement entered into between the Issuer and the Liquidity Facility Provider, mean that the Liquidity Facility Provider would not be repaid amounts due to it, which did not reflect the purpose of the Liquidity Facility as a mechanism to cover short term income deficiencies of the Issuer.
The Junior Noteholders’ secondary argument was that the transaction documents should be construed so as to provide for monies to be allocated as interest and so Available Issuer Revenue first, as this would make good business sense in the overall context of the securitisation transaction.
Decision of the Judge
Before addressing the respective arguments of the parties, the Judge proceeded to make a number of preliminary observations:
- First, the Servicer did not have an unfettered discretion to allocate receipts and instead the allocation was to be made on the basis of a correct understanding of the nature of the relevant receipts as either interest or principal
- Second, the language of the Cash Management Agreement indicated that the focus of the enquiry was on the Loan
- Third, the process of identification by the Servicer was to be a relatively routine matter to be performed without undue difficulty or delay
- Fourth, the fact that the terms “principal” and “interest” were left undefined suggested that the determination was not envisaged to be one requiring any legal sophistication but merely the application of commercial common sense
Having made these observations, the Judge considered the answer to be that receipts should be characterised as principal or interest depending on their source and the role which they play in the context of the Loan, viewed as a matter of commercial common sense. Adopting this approach, the Judge determined that rental income should be characterised as interest, whereas the proceeds of sale should be characterised as principal, as they represent the realised capital value of the Properties that stand as security for the Loan. While the position in relation to surrender premia was more debatable, the Judge considered that the type of surrender contemplated was where the premium that was paid represented the capital value of the remaining term of the lease and so should be characterised as principal.
The Judge then tested this conclusion by considering its consequences in the context of the overall structure of the transaction. Here, the Judge accepted the submissions of the Class A Noteholders, in that the treatment of sales proceeds as principal was in line with what the parties might reasonably be expected to have contemplated when the securitisation was put in place. In particular, the Judge noted that this treatment of sales proceeds was consistent with the treatment prior to default on the Loan.
The Judge rejected the submissions of the Junior Noteholder, as there would be a lack of symmetry if sales proceeds were treated as revenue, given that those proceeds represented the underlying capital value of the Properties. Rental income would still be available to pay interest to the Junior Noteholders and although there would be a shortfall it was caused by the financial crisis and the collapse of the cash flow model underlying the securitisation, not as a result of a mischaracterisation of receipts derived from the Properties.
The judgment in Gemini is notable, as the Judge took a broad view of the relevant transaction documents and did not seek to look too deeply at the detailed contractual provisions. Instead, the Judge sought to answer the question before the court by looking at the issues commercially. He was able to take this approach as the transaction documents were silent on the key point – what was meant by “principal” and “interest”. Therefore, the judge was able to arrive at a conclusion that may have been more consistent with market expectations as to the commercial intent.
Gemini is to be contrasted with DECO 15 and Titan (NHP), where noteholders may have been surprised by outcomes that were not necessarily consistent with their commercial expectations. In those cases, the court looked very closely at the relevant contractual provisions and sought to reach a conclusion based on a legally driven interpretation. In other words, the court looked to find the answer in the transaction documents and so broader commercial arguments held less sway. The approach in those cases was determined by the fact that the transaction documents were not obviously lacking and so the court was compelled to keep its reasoning within the four corners of the documents.
Whether a question of contractual interpretation will be determined by a predominantly legal or commercial approach will be dependent on the particular circumstances of each case and the specific contractual provisions in question. Noteholders often assume their commercial expectations will weigh heavily in the analysis, but that is not always borne out by the decisions of the court. Whilst Gemini is an example where noteholders’ expectations may have proven correct, it does not establish a general principle that they will always sway the court. Instead, it shows the types of cases where commercial arguments may prevail.
 For example, in Titan (NHP) the argument that the transaction documents should be construed so that they were consistent with the disclosure in the offering circular (and so the commercial expectations of noteholders) was rejected, as the offering circular was not a contractual document.