More Than One Way to Skin a Cat – Two different approaches to the plight of the legacy CMBS Noteholders result in the same outcome

By Signature Litigation
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Signature Litigation

This article has been published in The Barrister on 19th July 2016 and can be found here.

This article discusses the recent judgments in Hayfin Opal Luxco 3 SARL v Windermere VII CMBS plc and Credit Suisse Asset Management LLC v Titan Europe 2006-1 PLC and others, both concerning the entitlement of the Class X noteholders in notoriously complex legacy CMBS transactions.  We explore the opposing approaches taken by Mr Justice Snowden in the Financial List and the Chancellor of the High Court in addressing the same issues, curiously leading them to arrive at the same result.


Both Windermere and Titan concern the interpretation of complex contractual arrangements comprising legacy CMBS transactions and specifically, the entitlement of the Class X noteholders in those structures.

CMBS structures have been widely cited as a means for financial institutions to reduce their own risk on commercial loans they have made by bundling them together, grouping them by quality, and selling an interest in them to investors by way of a bond.  Noteholders benefit from interest and principal payments from the underlying borrowers, but they are also exposed to the risk of default in the underlying loans.  Selling the debt in this way allows the originator of mortgage loans to relieve some of the pressure on its capital stores and lend more to increase returns.

As the notes are issued in classes with varying levels of seniority, the differing classes of noteholders are exposed to differing levels of risk and return, with the Class A noteholders being exposed to the lowest levels of risk but also entitled to the lowest levels of return.  The Class X notes are something of an anomaly within the structure.  The Class X notes are typically purchased for nominal value by the originators of the underlying loans and predominantly carry the benefit of any excess interest payments collected at loan level over payments made to the other noteholders.  At a basic level, this allows the extraction of any such excess by the originating bank, which would otherwise be retained by the structure.  The purchase monies paid by the Class X noteholder are typically held in a separate, secured account for the Class X noteholder from the outset, so the Class X noteholder is not exposed to the risk of default in respect of payment of principal.  The Class X noteholder enjoys a further advantage by ranking equally with the Class A noteholders and ahead of all other classes for payments of interest.  At this very high level is it apparent that the commercial purpose of the noteholding for a Class X noteholder is different to that of the other classes of notes.

At the heart of the issues in dispute in Windermere and Titan was the correct interpretation of the transaction documentation – which was largely the same in the two transactions – in determining the entitlement of the Class X noteholders to interest payments following large scale defaults on the underlying loans.

The Court

As an initial observation it is notable that Windermere was transferred to the Financial List, whilst Titan was heard in the High Court in front of the Chancellor who also sits as a Financial List Judge.  Being cases involving issues arising out of complex financial structures, each with a suite of bespoke, non-standardised documentation, they are exactly the kind of case which the newly established Financial List aims to address with what it intends to be a specialised approach befitting the issues in question.  It is encouraging that the Financial List took on one of the cases, but given the clear symmetries between the two, it is interesting to note that the other was not, and perhaps especially so given the very different approaches taken in each case to arrive at the same result.

Differing approaches

Determination of the issues, in essence, demanded the application of the broad principles of contractual interpretation.  The latest authorities establish that the words in the document are the starting point for questions of interpretation: “The exercise of interpreting a provision involves identifying what the parties meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision.”1  Alongside this general principle, the Court must also take into consideration a number of other factors: of particular pertinence here are commercial common sense and the overall purpose of the contract.

Balancing these principles is not always straightforward.  A strict application of the natural and ordinary meaning of the relevant clause(s) in a contract could well be at odds with an application of commercial common sense enshrined in a purposive approach. The courts do not easily accept that parties have made linguistic mistakes, particularly in formal documents,2 and yet time and again commercial common sense draws the courts away from a more linguistically focussed interpretation of contractual provisions.  Previously, the courts have held that “if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense“.3 However, the Supreme Court has more recently made clear that “the reliance placed in some cases on commercial common sense and surrounding circumstances … should not be invoked to undervalue the importance of the language of the provision“.4  The case law exhibits a continuing oscillation between these two principles.  As the Chancellor in Titan articulates in his judgment, each of the cases within the usual cohort of authorities can be, and usually is, cited in argument for its use of slightly different language or emphasis, depending upon the particular facts and the argument the party wishes to emphasise.

The difficulty of the task before judges seeking to make a ruling as to how a contractual provision should properly be interpreted is well demonstrated by considering the Windermere and Titan cases together.  When comparing these two cases, what is perhaps most striking is not that the judges each favoured prioritising a different consideration at an almost inevitable expense to the others in cases of this kind, but that in doing so, they arrived at the same result on predominantly the same facts.

It is beyond the scope of this article to discuss the issues at stake in the two cases in full, so the approach of the two judges is analysed in the context of one particular issue addressed in both cases – that of default interest.

Default Interest

In Titan, when considering the question of whether default interest on the underlying loans should be factored into the interest rate payable to the Class X noteholder, the Judge made his determination that it should not be, on the basis that the parties could not have intended, as a commercial consequence, that the Class X noteholder (who is the originator of the underlying loans and also the instigator of the CMBS transaction) receive an increased revenue by virtue of a default on the underlying loans.  In doing so, the Judge strayed away from the text of the relevant provisions, even though he accepted the submissions of the Class X noteholder who argued “forcefully and eloquently” that those provisions, given their natural and ordinary meaning, provided for the inclusion of default interest.  The Chancellor’s determination here reflects his clear inclination to look to what the parties ‘must’ have intended.  This would appear to place less emphasis on the review of the transaction documentation which the senior courts have advised should be the primary step.

By contrast, in Windermere Mr Justice Snowden expressly took the view that “a premium was to be placed on the language actually used in cases concerning tradeable financial instruments“.  Mr Justice Snowden determined that default interest on an underlying loan should not be included in interest amounts payable to the Class X noteholder, but on the basis of a more text-based interpretation of the terms associated with the requisite calculation.

Whilst both judgements conclude that default interest on the underlying loans should not be included in interest payments to the Class X noteholder, the differing reasons given in the judgments exemplify the kind of problems that can arise when considering the commercial purpose of a contract.

As discussed, in Titan the Chancellor made his determination on the basis of what he considered must have been the commercial intention of the parties, or more specifically what could not have been intended by the parties. While the Chancellor did not disagree with the arguments advanced by the Class X noteholder as to the natural and ordinary meaning of the relevant words in the document, he said that the informed reader might, in light of certain contextual factors, understand the natural and ordinary meaning of the words to be something different.  That being so, the Chancellor turned to consider which interpretation might carry the commercial outcome intended by the parties.  The Chancellor reasoned that:

the effect of including default interest in the calculation of the “Net Mortgage Rate” is that the worse the Loans perform the higher proportion of the Loan income is payable to the Class X Noteholder. That is counter-intuitive bearing in mind that the Class X Notes represent the financial reward to the Originator of the structured note offering, which was intended to attract investors on the basis that the Loans were sound and shown to be such by favourable Moody’s ratings for the Notes.

Against that conclusion, other commercial considerations might also be valid, as was argued before the Chancellor.  The Class X noteholder, as originator of the underlying loans, whilst not preferring that the borrowers default any more than the other noteholders would have wanted them to, included provision for default interest to apply on the underlying loans in the event that a default occurred. That the Class X noteholder sought to further minimise their risk of being adversely impacted by any default of the borrowers by means of securitisation should not mean that they lose the right, on the grounds of “commercial common sense” to enjoy additional interest if a default did occur. It is true that a default of the borrowers post-securitisation would not impact upon the payment of principal to the Class X noteholder (since that is protected in a separate account, as aforementioned), however it could adversely affect their reputation in the market and as such, a Class X noteholder might want to be compensated for this.  That such financial gain might encourage banks to structure CMBS transactions in a way that dooms them to fail, in spite of the initial rating assurances indicating the contrary, any more than a lender who applies default interest on a vanilla loan would hope that the borrower defaults, is perhaps improbable.  Determining the commercial intention of the parties is itself an interpretive exercise involving an analysis of the intent of not just the parties to the particular contract, but the market for CMBS transactions as a whole.

The aforementioned is perhaps precisely the kind of uncertainty which arises through  an emphasis on commercial purpose, which the Supreme Court warns against in Arnold v Britton and which Mr Justice Snowden, having due regard to the fact that this case concerned a complex financial product and his brief as a Financial List Judge, was keen to avoid.


In Titan, the Class X noteholder brings its case on the basis of a linguistic interpretation of the clauses and the other documentation. Despite this being a legitimate approach, the Chancellor finds in favour of the other classes of noteholder who rely on commercial common sense to argue to the contrary. In doing so, it is at least implicit that the Chancellor would have come to a different conclusion had he adopted a different approach. However, in Windermere (on slightly different drafting of the relevant provisions) the linguistic approach is relied on heavily but Mr Justice Snowden still finds in favour of the other classes of noteholder. With a range of potentially conflicting tools at a judge’s disposal for the purposes of determining issues embedded in contractual interpretation, the law on contractual interpretation is still seemingly vulnerable to a tail-wagging-the-dog approach whereby an instinctive view of what is commercially ‘fair’ is arrived at, whereupon the Courts then apply the necessary tools to justify that outcome.

Permission to appeal both decisions has been granted, and these issues of contractual interpretation are passing through the courts on a regular basis.  We are certain to see further guidance from the appeal courts emerging.  As always, the best route to avoiding this uncertainty is to close out any ambiguity in the language adopted from the outset and champion transparent and explicit transaction documentation on all issues of import.


1 Lord Neuberger in Arnold v Britton [2015] UKSC 36.

2 Lord Hoffman in Investors Compensation Scheme Ltd. v West Bromwich Building Society [1997] UKHL 28, at 913.

3 Antaios Compania SA v Salen AB (The Antaios) [1985] AC 191.

4 Arnold v Britton [2015] UKSC 36.

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