Anthracite Rated Investments (Jersey) Ltd v Lehman Brothers Finance SA ((in Liquidation))
| Jurisdiction | England & Wales |
| Judge | Mr Justice Briggs |
| Judgment Date | 15 July 2011 |
| Neutral Citation | [2011] EWHC 1822 (Ch) |
| Docket Number | Case No: HC10C04780 |
| Court | Chancery Division |
| Date | 15 July 2011 |
[2011] EWHC 1822 (Ch)
Mr Justice Briggs
Case No: HC10C04780
Case No: HC11C00593
Case No HC10C04780
Case No HC11C00593
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
Royal Courts of Justice
Strand, London, WC2A 2LL
Appearances
Mr Mark Phillips QC and Mr Stephen Robins (instructed by Clifford Chance LLP) for the Claimant
Mr Jonathan Russen QC and Ms Rosanna Foskett (instructed by Field Fisher Waterhouse LLP) for the Defendant
Mr Mark Hapgood QC and Mr Jasbir Dhillon (instructed by Sidley Austin LLP) for the Claimant
Mr Jonathan Russen QC and Ms Rosanna Foskett (instructed by Field Fisher Waterhouse LLP) for the First Defendant
Mr Jeremy Goldring (instructed by Clifford Chance LLP) for the Second Defendant
Hearing dates: 4 th– 6 th July 2011
INTRODUCTION
This judgment follows the combined trial, on agreed facts, of two closely related Part 8 claims. The main common dispute which underlies each claim concerns the meaning and effect of early close-out provisions in two cash settled put options granted by Lehman Brothers Finance S.A. ("LBF") with a guarantee from its ultimate parent company Lehman Brothers Holdings Inc. ("Holdings"), both of which incorporated, with similar (but not quite identical) additions and amendments, the 1992 ISDA Master Agreement. I shall refer to them as "the Derivative Agreements".
The Derivative Agreements each formed an important part of two large and complex structures, devised and marketed by Lehman Brothers International Europe ("LBIE"). Each was in essentially similar terms. Unfortunately for the purposes of concise description, there are both relevant differences in the precise terms and substantial differences in nomenclature. In a nutshell, each structure defined and regulated the issue of instruments (variously described as Bonds and Notes) by a single purpose vehicle issuer having the following features. They were euro denominated, linked to a portfolio of underlying investments, limited recourse but secured, and principal protected. One of the structures also provided a limited degree of interest (or coupon) protection, but it is common ground that this additional feature makes no difference to the issues which I have to decide.
The function of the Derivative Agreements in each structure was to provide that principal (and in one structure interest) protection. As investment advisers are taught to warn their clients, investment portfolios can go down in value as well as up. Principal protection is designed to ensure that (subject only to the credit risk of the principal protection provider and any guarantor of its obligations) the investor will on maturity of the instrument receive not less than its original purchase price, even if the value of the underlying portfolio has by then fallen below that level.
Principal protection performs at least two important functions in the market. First, it enables a risk-averse investor such as a pension provider to invest in a higher risk (and therefore potentially higher return) portfolio than would otherwise be appropriate, because of the insurance against under-performance provided by the principal protection. Secondly, it enables institutional investors such as banks to invest in types of portfolio which, without principal protection, would attract a credit rating insufficiently high to satisfy Basel II capital adequacy requirements. The investor in one of the structures before the court was a pension provider for Italian workers. The investor in the other structure was a bank. In each case LBF provided the principal protection, guaranteed by Holdings, and the Derivative Agreement constituted the contractual means whereby that principal protection was provided, by a contract with the issuer and, by a charge, to the investors.
In functional terms, the two structures were each designed to operate as follows. First, the subscription price for the instruments paid by the investor to the issuer was (subject to a deduction to which I shall return) to be used for subscription for redeemable preference shares in another single purpose vehicle ("Balco"). Balco was to apply the subscription price in the acquisition of the underlying investment portfolio consisting largely, but not entirely, of hedge fund type investments.
Second, the issuer was to enter into the Derivative Agreement with LBF, whereby the issuer was to enjoy a put option in relation to its shares in Balco, exercisable upon final maturity of the instruments if the net proceeds of redemption of the Balco preference shares fell short of the original subscription price for the instruments. Since the put option was cash-settled, LBF would thereby become liable to make good that shortfall to the issuer.
Third, in preparation for the redemption of the instruments upon maturity, Balco would realise the investment portfolio, and pay the net proceeds to the issuer by way of redemption of its preference shares. Upon maturity of the instruments, they would be redeemed by payment by the issuer to the investor of the proceeds of the redemption of the issuer's preference shares in Balco, together (if necessary to make good any shortfall against the original subscription price) with any payment received from LBF upon exercise of the put option in the Derivative Agreement.
Fourth, the quid pro quo for the issuer's put option under the Derivative Agreement was the payment by instalments of premium to LBF, funded from cash flow derived from preference share dividend payments by Balco to the issuer. One of the structures made provision for a cash reserve for that purpose, but it was not in the event put in place.
Fifth, the issuer's obligations, both to the investor and to LBF under the Derivative Agreement were limited recourse but secured. Thus, pursuant to a series of interrelated trust deeds, the issuer charged all its interest in its preference shares in Balco, and in the Derivative Agreement (and in any cash reserve) to a Trustee, to be held upon trust as security, first for the issuer's obligations to LBF under the Derivative Agreement and secondly as security for the issuer's obligations to the investors. Both the trust deeds and the final terms of the instruments made provision for a reversal of priority (a 'flip') as between LBF and the investors, in the event of a termination of the Derivative Agreement by reason of LBF's default.
Thus, the principal protection to the investor consisted in form of the issuer's promise to pay, on maturity, no less than the original subscription price for the instruments. In substance it lay in the investor's security interest in the issuer's rights against LBF under the Derivative Agreement. Save only as mortgagees under a common security structure, there existed no privity between the investor and LBF. The only parties to the Derivative Agreement were the issuer and LBF. The terms of the instruments expressly excluded third party rights.
The two series of instruments were issued in 2006 and 2007 respectively, maturing in 2017 and 2023 respectively. I shall refer to them as Series 38 and Series 26. Both structures made detailed bespoke provision for early redemption of the instruments in four specified types of circumstance, namely:
i) the occurrence of a specified tax liability affecting the issuer;
ii) termination of the Derivative Agreement "for any reason";
iii) illegality of performance of its obligations by the issuer, or illegality of its hedging arrangements; and
iv) an event of default by the issuer.
Collectively, those circumstances may loosely be described as matters sufficiently destructive of the ongoing efficacy of the structure as an investment vehicle to warrant its unwinding prior to maturity.
Two invariable consequences of early redemption of the instruments were that the investors would lose their principal protection and that the Derivative Agreements would (to use a neutral phrase) come to an end. These two outcomes were achieved in contractual terms by the omission in the formula defining the amount of the issuer's obligation to make an early redemption payment of any requirement to pay a minimum amount equivalent to the original subscription price for the instruments, and by the insertion within the Derivative Agreement of a provision for "Mandatory Early Termination", triggered by the redemption of all outstanding instruments prior to their maturity date. Thus, even if by the time of early redemption the value of the underlying investment portfolio had fallen below the original subscription price for the instruments, the investors would be exposed to that shortfall, without recourse in respect of it either to the issuer, to LBF or to the security property.
Mindful that early redemption of the instruments (triggering Mandatory Early Termination of the Derivative Agreements) would cut short a potentially profitable premium income stream, LBF obtained provision for it to receive compensation for the consequence of early redemption in the form of an "Early Termination Cash Settlement Amount" ("ETCSA"), to be paid by the issuer and funded from deductions which the issuer was required to make from the net proceeds of redemption of its Balco preference shares, before onward payment to the investors. The ETCSA under each structure consisted of three elements, namely (i) any arrears of premium; (ii) compensation for early termination; and (iii) LBF's costs of termination. The formula for calculation of the early termination compensation in (ii) above differed radically under each of the two...
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