Securitisation Alerter: A Matter of Principal
The Gemini (Eclipse 2006-3) CMBS transaction has provided another example of short-comings in pre-crisis commercial loan and securitisation structures; this time the court1 had to decide what constitutes revenue and principal for the purposes of the structure's payment waterfalls.
In 2006, Barclays Bank plc ("Barclays") refinanced a portfolio of UK commercial properties owned by a number of Guernsey-registered limited partnerships. The senior loan was in turn refinanced and securitised through Barclays' Eclipse CMBS platform, under which Gemini (Eclipse 2006-3) Plc (the "Issuer") issued floating rate notes (the "Notes") divided into classes A to E, the class A notes being the most senior. Following the financial crisis, the underlying properties securing the loan significantly decreased in value and the borrowers had significant reductions in the rental income which was needed in order to service the loan. In addition, the interest rate swap with Barclays which hedged the rate of interest on the loan became significantly in-the-money to Barclays. In 2012, the loan was accelerated and various administrators and receivers were appointed over the portfolio. CBRE, as special servicer, entered into an arrangement with Barclays whereby the latter agreed not to terminate the interest rate swap provided that Barclays' exposure under was paid down over time from proceeds from the disposal of the underlying properties.
The intercreditor agreement entered into with respect to the loan (as well as a junior loan and the interest rate swaps) provided for amounts to be paid to the swap provider ahead of the senior loan. Unusually, however, neither the credit agreement for the senior loan nor the intercreditor agreement went on to provide for how amounts to be paid to the senior debt holder would be allocated as between principal, interest or expenses due under the credit agreement.
Due to reduced rental income, the loan had significant amount of unpaid interest and default interest.
Whilst the loan had defaulted and had been accelerated, the Notes had not defaulted as the Issuer was able to draw upon a liquidity facility to meet interest payments on the Notes. The Notes have still not been accelerated. In common with other CMBS transactions, the Notes had two pre-acceleration payment waterfalls: a revenue waterfall (for meeting interest payments on the Notes) and a principal waterfall (for making payments of principal on the Notes).
The issue was how the proceeds of disposals of properties, once Barclays' hedging exposure was paid down in full, were to be characterised for the purposes of the Note waterfalls and, in turn, distributed to noteholders and the liquidity provider. The class A Notes would be better served if the payments flowed through the principal waterfall and the lower classes of Notes (and liquidity provider) would be better served if the proceeds (or at least some of them) flowed through the revenue waterfall. The Cash Management Agreement read: "The Master Servicer [CBRE] will on or before each Calculation Date identify funds paid under the Credit Agreement and any Related Security, as principal, interest and other amounts on the relevant ledger in accordance with the respective interests of the Issuer and the Seller (if any) in the Loan." The Cash Management Agreement gave no indication as to how the funds were to be identified and neither of the terms "principal" and "interest" were defined. The relevant ledgers were the "Revenue Ledger" and the "Principal Ledger", to which the receipts in question were to be allocated on the basis of a correct understanding of the nature of the receipts as either principal or interest.
The arguments of the noteholders
The parties in the litigation seemed to accept that rental income on the underlying properties should be characterised as interest – so that the debate centred on the treatment of sale proceeds (and surrender premiums). Amongst other things, the senior noteholders argued that, under the credit agreement, prior to default property disposal proceeds and surrender premiums were to be applied in repayment of the loan and that this treatment should continue post-acceleration and similarly be carried through to the Notes. They also argued that this interpretation was consistent with economic subordination of the junior Notes to the senior Notes. If this argument was rejected, they argued that all receipts - including rental income - should be characterised as principal and interest pro rata to the amount of outstanding principal and interest on the loan at the time of receipt. The junior noteholders argued that, since the parties had failed to specify whether the relevant receipts were principal or interest, the common law presumption should operate – namely that receipts are to be applied as interest first, and only when all arrears of interest have been discharged as principal. This also corresponds to the prioritisation of payments in standard LMA loan documentation. They further argued that it made good commercial sense for all receipts (including capital receipts) to be allocated to the continuing payment of interest on the Notes, in priority to providing any return of principal, until such time as the Notes themselves were redeemed or accelerated.
In reaching its decision the court applied the usual principles of contractual for resolving matters of interpretation in complex transactions, and where it is not unusual for every possible scenario to be fully provided for in the documentation. These principles are:
- the court must have regard to all the relevant surrounding circumstances and, if there are two possible constructions, the court is entitled to prefer the construction that is consistent with business common sense and to reject the other;
- the court's approach must be iterative, involving checking each of the rival meanings against other provisions of the documentation and investigating its commercial consequences;
- detailed semantic analysis must give way to business common sense; and
- it is generally unhelpful to look for ambiguities.
In light of these principles and on the basis that the court considered that the Cash Management Agreement envisaged that the process of identification of funds by the Master Servicer should be a relatively routine matter which could be performed without undue difficulty or delay, the court decided that disposal proceeds were to be regarded as principal payments in the hands of the Issuer and so should be applied to the principal waterfall alone. The court considered that the common law rule relating to the appropriation of payments made by a debtor to his creditor did not apply to the question of how receipts should be characterised in the present case.
Once again the court has filled in a documentation gap in a complex transaction based on what it considered to be most appropriate in view of the intended economics of the transaction, at least as between the noteholders. However, one questions whether even that is correct. We wonder whether, in fact, the most commercially sensible solution would have been to first apply receipts and recoveries (of whatever kind) first towards unpaid interest and then towards principal in the usual way that applies to loans like this and which could presumably therefore have been what the parties might have intended had they addressed their minds to the fact that the loan documentation was silent on the point. This approach would also be consistent with what would have happened if there had been mandatory prepayment of the loan on a disposal prior to acceleration as the credit agreement provided for the proceeds to be applied in repayment "together with accrued interest". So even on a regular disposal there would always have been an interest component, even if a small one. It is not clear from the judgment whether this point was considered by the court. Whilst the primary category of receipts under consideration were disposal proceeds the court found that the same outcome applied to premia paid for the surrender of leases in the portfolio. There seems to be no consideration of the fact that these, in fact, represent pre-payments of rental income, or compensation for rental income that would be given up. It will be interesting to see what happens if and when the Issuer succeeds with its claim brought against CBRE for negligent valuation of the property portfolio at the outset of the transaction. Another class of receipt will need to be routinely allocated as principal presumably. An issue for another day perhaps.
1 CBRE Loan Servicing Limited v Gemini (Eclipse 2006-3) Plc and others 2015 - click here for a link to the judgment.