BNY Mellon Corporate Trustee Services Limited v LBG Capital No 1 Plc and another

Terms governing negotiable debt securities are construed primarily from the instrument as a whole and its apparent commercial purpose. External background requires considerable circumspection, although generally known regulatory policy may be considered where the instrument cannot be understood without it.

Where regulatory changes prevent contingent convertible notes from converting soon enough to support the capital ratio tested by the regulator, the notes may have ceased to be taken into account for that purpose. Their theoretical ability to convert at a lower ratio does not preclude that conclusion. The practical application of the regulatory requirements is relevant where the instrument refers to changes in their interpretation or application.

Lloyds Banking Group issued contingent convertible enhanced capital notes under a trust deed in 2009. The notes carried high interest and could convert into shares if the group’s core capital ratio fell below 5%. They were also redeemable early following a Capital Disqualification Event.

Regulatory changes replaced the former capital measure with a more restrictive measure and imposed a minimum ratio above the notes’ effective conversion trigger. Lloyds contended that the notes had consequently ceased to be taken into account for regulatory stress-testing purposes and could be redeemed.

The Chancellor rejected the trustee’s challenge concerning the replacement capital measure but held that the notes remained eligible in principle and were not redeemable: [2015] EWHC 1560 (Ch). The Court of Appeal reversed that conclusion: [2015] EWCA Civ 1257. The issues were whether the contractual reference extended to the successor capital measure and whether the notes had ceased to be taken into account for the relevant stress tests.

1. By a majority, the appeal was dismissed. Lord Neuberger, with whom Lord Mance and Lord Toulson agreed, held that a Capital Disqualification Event had occurred under paragraph (2) of the definition in clause 19. Lloyds was therefore entitled to exercise its contractual option to redeem the notes.

2. The wording governing negotiable debt securities was paramount. Background material unavailable to all holders required considerable circumspection. The trust deed could not, however, be understood without some appreciation of the Financial Services Authority’s published regulatory policy in 2008 and 2009. Its general thrust and effect, together with the commercial purpose apparent from the notes, could therefore inform construction. The exchange memorandum and chairman’s letter added nothing material: paras 30–34.

3. The reference to the Consolidated Core Tier 1 ratio extended to its regulatory successor, the Common Equity Tier 1 ratio. The terms anticipated changes to regulatory requirements and terminology. Limiting the provision to the former measure would frustrate its commercial operation. If this involved correcting the literal wording, it was clear both that the language had gone wrong and what a reasonable addressee would have understood the parties to mean: paras 35–38.

4. The notes had ceased to be taken into account for stress-testing the relevant capital ratio. Their convertibility had been designed to increase core capital before the regulatory minimum was reached. Under the new regime, they could convert only after capital had fallen substantially below that minimum. Their theoretical eligibility to convert at a lower ratio did not enable them to perform their intended protective function: paras 40–50.

5. Paragraph (2) referred not merely to regulatory eligibility but also to changes in the interpretation or application of regulatory requirements. It therefore permitted attention to what occurred in practice. The regulator’s practices could determine whether the notes were taken into account. The possibility of different treatment in a later stress test did not prevent the event from occurring: paras 46 and 51–52.

6. The contra proferentem rule was a last resort. Despite some imprecision in the wording, the majority could determine its meaning without invoking that rule: para 53.

7. Lord Sumption, with whom Lord Clarke agreed, dissented. In his view, the provision concerned whether the notes remained eligible in principle to function as contingent capital, rather than whether they helped the bank pass a particular stress test. The notes retained that eligibility, and a construction dependent on an actual stress test would produce uncertainty. He would therefore have allowed the appeal: paras 55–62.

1. United Kingdom Supreme Court: By a majority of 3–2, dismissed the trustee’s appeal and affirmed that a Capital Disqualification Event had occurred: [2016] UKSC 29.

2. Court of Appeal: Allowed Lloyds’ appeal and held that the enhanced capital notes were redeemable under clause 8(e) of the terms and conditions: [2015] EWCA Civ 1257.

3. High Court, Chancery Division: Sir Terence Etherton C held that the notes had not ceased to be taken into account in the required sense and were not redeemable: [2015] EWHC 1560 (Ch).