LB Re Financing No. 3 Ltd v Excalibur Funding No.1 Plc & Ors

Factual and Procedural Background

This Part 8 claim brought by the administrators of Company A raises issues regarding the true construction of Conditions in a securitisation Trust Deed dated 23rd May 2008, relating to Class A and Class B Notes originally due in April 2054. Company A is the holder of the Class B Notes. The first Defendant, Company B, is the Issuer of the Notes. The second Defendant, The Bank, holds the majority of the Class A Notes. The third Defendant, The Trustee, acts as trustee under the Trust Deed.

The dispute centers on whether an Event of Default under Condition 10(a)(iv) ("Inadequate Par Coverage") had occurred and was continuing when The Trustee served a Notice of Acceleration on 8th February 2011, which, if valid, would render both classes of Notes immediately due and repayable. The Bank and The Trustee assert that such an Event of Default had occurred and persisted. Company A denies both the occurrence and continuation of such an Event of Default at that time.

There is no factual dispute; the issue turns solely on the interpretation of the Conditions, particularly Condition 10(a)(iv).

Company B is a special purpose vehicle formed solely to issue the Notes, which securitised a portfolio of collateral debt obligations ("CDOs") acquired from Lehman group companies, mainly comprising real estate, loans, and mortgage-backed securities across various European countries ("the Portfolio"). Company A initially purchased all the Notes, acquiring Class A Notes at par and Class B Notes at a discount. Company A transferred the Class A Notes to another Lehman entity under a repurchase financing arrangement, which in turn pledged most of these Class A Notes as security to The Bank. Following that entity's insolvency in late 2008, The Bank took possession of the Class A Notes.

The Conditions provided no mechanism for early redemption by Class A Noteholders absent an Event of Default. Redemption was envisaged to occur pro rata over time upon maturity of underlying CDOs, subject to Class B Noteholders' qualified rights to require reinvestment in substitute collateral. Class A Notes paid a floating rate coupon quarterly, while Class B Noteholders held the residual equity interest subject to Class A's prior rights.

The securitisation structure was devised internally within the Lehman group to enable use of Class A Notes as security for Euro borrowing. The first arm’s length transaction occurred when the bulk of Class A Notes were pledged to The Bank.

The Conditions included detailed provisions for the receipt, handling, and distribution of monies from the Portfolio, requiring multiple accounts (Collection, Principal, Interest, and Payment Accounts) and setting out priority payment schemes ("waterfalls") for interest and principal. The Trustee was authorised to invest account balances in short-term eligible investments, ensuring liquidity for upcoming payment dates.

Two Coverage Tests were relevant: the Class A Par Value Test (set at 110%) and the Inadequate Par Coverage test (set at 100%), the latter constituting an Event of Default if failed. The key dispute concerned the construction of the Inadequate Par Coverage test, particularly whether balances in the Principal Account should be included in the Par Coverage Numerator.

On 25th January 2011 (a Measurement Date), the Principal Account held approximately €140.6 million from CDO realisations since the previous payment date. The Collateral Administrator excluded these balances from the Par Coverage Numerator under a literal reading of Condition 10(a)(iv), resulting in a ratio of 99.5%, triggering an Event of Default. If included, the ratio would have been above 100%. The Trustee served a Notice of Acceleration on 8th February 2011. By 25th April 2011, the ratio had recovered above 100%.

Legal Issues Presented

1. Whether an Event of Default under Condition 10(a)(iv) ("Inadequate Par Coverage") had occurred on 25th January 2011.
2. Whether such an Event of Default was continuing on 8th February 2011 when the Notice of Acceleration was served.
3. The proper construction of Condition 10(a)(iv), particularly the exclusion of Principal Account Balances from the Par Coverage Numerator.
4. Whether the literal interpretation of the Conditions produces commercially absurd results requiring reinterpretation.
5. Whether the phrase "and is continuing" in Condition 10(c)(i) should be interpreted flexibly in the context of the Inadequate Par Coverage Event of Default.

Arguments of the Parties

Appellant's Arguments (Company A)

• The language of Condition 10(a)(iv) is flawed and produces commercially absurd results if Principal Account Balances are excluded from the Par Coverage Numerator.
• It is irrational to exclude cash or equivalent assets known to be used imminently to reduce the Principal Amount Outstanding of Class A Notes.
• Suggested two alternative constructions: either treat the parenthetical phrase as a drafting error or treat redemption amounts certified but unpaid as already paid for the purpose of the ratio.
• Proposed a third alternative based on an earlier securitisation precedent, interpreting the phrase "clauses (c)" as a mistaken reference to "clause (b)" relating to Discount Obligations, which are more rational to exclude.
• Argued that even if an Event of Default occurred on 25th January, it was no longer continuing by 8th February due to the redemption payment restoring the ratio.

Respondents' Arguments (The Bank and The Trustee)

• There is no commercial absurdity in excluding Principal Account Balances, as their use is uncertain and may be needed for purposes other than redemption, such as meeting interest shortfalls or hedging costs.
• The phrase "without regard to clauses (c) of such definition" is unambiguous and cannot be ignored or reinterpreted as referring to clause (b).
• Recourse to drafting history and forensic examination of prior securitisations is not a legitimate interpretative tool.
• Redefining Principal Amount Outstanding to treat certified but unpaid redemption amounts as paid would cause double counting and distort the related Class A Par Value Test.
• An Event of Default under Condition 10(a)(iv) continues until the next Measurement Date; it cannot be regarded as remedied before then.
• A flexible interpretation allowing cure between Measurement Dates would create unacceptable uncertainty.

Table of Precedents Cited

Court's Reasoning and Analysis

The court acknowledged that the phrase "without regard to clauses (c) of such definition and the provisos to such definition" in Condition 10(a)(iv) contained drafting errors (plural "clauses" and nonexistent provisos). However, absent proven commercial absurdity, these errors did not justify ignoring the phrase entirely.

The court found a rational commercial basis for excluding Principal Account Balances from the Par Coverage Numerator, given that those funds might be used for purposes other than redemption (e.g., interest shortfalls, hedging costs). Including all balances could artificially inflate collateral value.

The court rejected the appellant's suggestion to reinterpret the phrase based on an earlier securitisation, deeming such forensic analysis of drafting history illegitimate for construction purposes.

Regarding the exclusion of redemption amounts certified but unpaid from the Principal Amount Outstanding (the denominator), the court recognized the literal wording precludes deduction until payment occurs, despite the commercial awkwardness.

However, the court found it commercially absurd that the structure would allow an Event of Default solely because collateral proceeds were held for a short period (three business days) before redemption payment. This would expose the securitisation to premature termination triggered by timing rather than genuine collateral inadequacy.

To resolve this, the court declined to reinterpret the definition of Principal Amount Outstanding differently for this test but instead adopted a flexible interpretation of the phrase "and is continuing" in Condition 10(c)(i). The court held that an Inadequate Par Coverage Event of Default occurring on a Measurement Date, which is automatically remedied by redemption payment three business days later, does not continue beyond that Payment Date.

This approach ameliorates the commercial absurdity by allowing the Event of Default to be treated as fleeting in such circumstances, avoiding premature acceleration. The court noted practical reasons why acceleration notices would unlikely be served during this brief period.

Accordingly, the court concluded that although an Event of Default occurred on 25th January 2011, it ceased upon payment on 28th January 2011 and was therefore not continuing on 8th February 2011 when the acceleration notice was served.

Holding and Implications

The court held that an Event of Default under Condition 10(a)(iv) occurred on 25th January 2011 but did not continue beyond the Payment Date of 28th January 2011.

As a result, there was no continuing Event of Default on 8th February 2011 when the Notice of Acceleration was served, rendering the acceleration invalid.

The decision directly affects the parties by preventing early acceleration and repayment of the Notes under the disputed interpretation. It does not establish a new general precedent but clarifies the application of commercial common sense and flexibility in interpreting "continuing" defaults within complex securitisation documentation.