Napier Park European Credit Opportunities Fund Ltd v Harbourmaster Pro-Rata Clo 2 B.V. & Ors

Interpreting a tradable financial instrument requires an iterative process. The court must test rival meanings against the instrument as a whole and evaluate their commercial consequences. Commercial considerations help determine whether language is open to question; they are not merely a safeguard against absurdity.

A requirement that notes “have not been downgraded” may refer to their current status when the requirement must be satisfied. Where the transaction treats restoration of a rating as removing the consequences of a downgrade, a historic downgrade does not permanently prevent reinvestment after the original rating has been restored.

A collateralised loan obligation financed a loan portfolio through several classes of notes. After the contractual Reinvestment Period, unscheduled principal proceeds could be reinvested only if specified Reinvestment Criteria were satisfied. One criterion required that the Class A1 Notes “have not been downgraded below their Initial Ratings”.

The notes had been downgraded from AAA to AA in 2010, but restored to AAA in 2012. The Chancellor of the High Court held that the historic downgrade made the criterion permanently incapable of satisfaction. A junior noteholder appealed. The central issue was whether the criterion referred to any downgrade in the notes’ history or only to a downgrade continuing at the date of proposed reinvestment.

1. Appeal allowed unanimously. The contractual criterion was capable of satisfaction after restoration of the Class A1 Notes to their Initial Rating. Lord Justice Lewison gave the judgment, with which Lord Justice Floyd and Lord Justice Longmore agreed.

2. The interpretation of a tradable financial instrument is an iterative exercise. Rival meanings must be checked against the other provisions and their commercial consequences. Commercial considerations form part of determining whether language is open to question. They are not confined to operating as a safeguard against absurdity. Where the exercise produces a clear answer, however, the court must be wary of substituting its own view of commercial sense.

3. The wording of such an instrument is paramount because rights may pass to creditors who lack knowledge of particular external circumstances. The commercial intention and setting must therefore be inferred principally from the instrument as a whole and the general nature of the transaction.

4. The present-perfect construction “have not been downgraded” was capable in ordinary English of describing a continuing state or a past event having a continuing effect. The relevant question was asked at the date of proposed reinvestment. It was therefore linguistically possible to read the criterion as requiring comparison between the notes’ current rating and their Initial Rating.

5. The transaction’s structure supported that construction. Elsewhere, a downgrade followed by restoration did not have permanent consequences. A restored rating could prevent an Effective Date Rating Event or terminate its effects. A downgrade also had no contractual effect on reinvestment during the Reinvestment Period. The obligation to reinvest unscheduled principal proceeds continued as a unitary obligation until October 2015.

6. Accordingly, a historic downgrade did not spring back into effect after the Reinvestment Period once the AAA rating had been restored. Treating it as permanently decisive would give it a predominance inconsistent with the basic scheme of the transaction. The appeal from the Chancellor’s contrary construction was allowed.

1. Court of Appeal (Civil Division): The court allowed the appeal unanimously and held that a past downgrade followed by restoration to the Initial Rating did not permanently prevent satisfaction of the Reinvestment Criteria: [2014] EWCA Civ 984.

2. High Court, Chancery Division: The Chancellor of the High Court held that the criterion was incapable of satisfaction once the Senior Notes had at any time been downgraded below their Initial Ratings. No neutral citation for that decision is stated in the judgment.