The High Court has recently decided that on an optional redemption of a collateralised loan obligation securitisation (“CLO”), the collateral manager was not entitled to an incentive fee at the expense of junior bondholders. 
17 April 2019
The claim was brought by Deutsche Trustee Company Limited (the “Trustee”) in order to determine the correct interpretation of the bond documentation in which Barings (UK) Limited (the “Collateral Manager”) claimed to be entitled to over €15 million in the form of an incentive collateral management fee (the “Incentive Fee”) following the redemption of the structure by the Class F noteholders.
Collyer Bristow LLP acted for Napier Park European Credit Opportunities Fund Limited (“Napier Park”) as representative of the Class F noteholders.
The bonds were issued by Duchess VI CLO BV (the “Issuer”) in 2006 with a maturity date of 2022. However, in 2018, the Class F noteholders exercised their right to terminate the structure early. Following this optional redemption, the Trustee was undecided as to whether an Incentive Fee was payable to the Collateral Manager and issued Part 8 Proceedings in order to have the question decided by the Court. The substantive argument in the case was between the Collateral Manager and the Class F noteholders, represented by Napier Park.
The Collateral Manager was appointed by the Issuer under a Collateral Management Agreement. Its role was to select which financial assets were to be acquired and generally to manage the portfolio. Performance of the Notes depended to a significant extent on the skill of the Collateral Manager in analysing, selecting and managing the underlying investments. It was entitled to two types of fees, a base fee to cover the day to day management of the portfolio and an Incentive Fee once the Class F Notes had achieved an Internal Rate of Return (“IRR”) of 10% per annum on their investment (the “Secured Income Threshold”).
The Collateral Manager argued that the Incentive Fee became payable under the terms of the Collateral Management Agreement when the structure was redeemed by the Class F noteholders. Napier Park argued that, unlike the position on maturity, the documentation did not provide for the Collateral Manager to be paid an Incentive Fee on an earlier optional redemption.
The first question the court had to consider was whether the Collateral Manager was entitled to an Incentive Fee at all on an optional redemption. Napier Park’s primary argument concerned the definition of the Incentive Fee in the conditions of the notes. This provided for an Incentive Fee to be payable under the payment waterfall which applied on maturity under Condition 3 of the notes but made no reference to the waterfall under Condition 11, which applied on an enforcement or optional redemption.
The Collateral Manager argued that despite the omission of any reference in the definition to payment of the Incentive Fee under the Condition 11 waterfall, that fee was still payable on an optional redemption because the Collateral Management Agreement provided that such a fee was payable on each “Payment Date”, which included that on an optional redemption. This argument was, in the Collateral Manager’s view, supported by the commercial rationale that it would be absurd if an Incentive Fee were payable on every payment date except on an enforcement or optional redemption. Napier Park’s counter-argument was that it was never the intention of the Class F noteholders that the Incentive Fee would be paid on enforcement or optional redemption. The Class F noteholders were making a risky investment with the expectation that they would receive the majority of the funds payable to them by way of interest over the life of the transaction rather than by way of principal repayment on maturity. The Incentive Fee was an ongoing incentive payment intended to reflect the achievement of the performance target of an annual IRR exceeding 10%. It was only because of the financial crisis and the consequent need to use income to pay the senior noteholders that the Secured Income Threshold was not reached before the optional redemption occurred.
The second question for the court was, if an Incentive Fee were payable, had the Secured Income Threshold been reached? The answer to that question depended on whether, under the definition of the Incentive Fee, only the interest received by the Class F noteholders should be used for the threshold calculation or, as the Collateral Manager argued, both interest and principal should be taken into account.
The Chancellor of the High Court, Sir Geoffrey Vos, applied the rules of contractual interpretation as stated in the recent cases of Rainy Sky v Kookmin Bank  UKSC 50, Arnold v Britton  UKSC 36 andWood v Capita Insurance Services Limited  UKSC 24. His interpretation therefore involved an assessment of the parties’ intentions by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”. An understanding of the commercial context and common sense in these circumstances was also critical. Ultimately, however, interpretation should identify what the parties actually agreed and not what the Court thinks that they should have agreed.
The Chancellor decided that, on the proper interpretation of the documents, the wording was unambiguous. The fact that the definition of the Incentive Fee referred only to the maturity waterfall and not to the one applying on an optional redemption was decisive. He concluded that the Collateral Manager was not entitled to the Incentive Fee on the optional redemption.
As a result of the Chancellor’s conclusion that the Incentive Fee was not payable, he did not have to decide whether the Secured Income Threshold had been reached, but in his view, only interest and not principal received was to be used in determining that question.
His conclusion was that the commercial background and the relevant factual matrix known to all parties at the date of the transaction meant that it was not unjust or unexpected that the Collateral Manager should not be rewarded with an Incentive Fee when the noteholders had failed to reach the Secured Income Threshold over 10 years after issue of the notes.
This is another useful example of the iterative approach taken by the courts to contractual interpretation as recommended in Rainy Sky. The Chancellor’s view was that this was a case where the language of the documentation was clear in the context of the transaction. He added that “commercial parties buying into such traded instruments expect to be bound by the language of them. They are entitled to the certainty and predictability that the adoption of a proper contextual interpretation of the language produces”.
 Deutsche Trustee Company Limited v (1) Duchess VI CLO BV (2) Barings (UK) Limited (3) Napier Park European Credit Opportunities Fund Limited  EWHC 778 (Ch)