The Supreme Court decided whether Lloyds Banking Group could redeem early £3.3 billion of enhanced capital notes carrying interest of more than 10 per cent a year. The notes, issued in 2009, were redeemable if regulatory changes meant they ceased to be taken into account in a stress test of the bank’s core capital ratio. By a majority, the Court held that later reforms had that effect, so a capital disqualification event had occurred and the notes were redeemable.
In 2009 Lloyds Banking Group needed to strengthen its capital and meet regulatory requirements. It raised part of the required capital by issuing enhanced capital notes, a form of contingent convertible security, in exchange for existing securities. The notes carried interest averaging about 10.33 per cent a year. Unless converted or redeemed earlier, they matured between 2019 and 2032. They counted as Lower Tier 2 capital while outstanding. If the bank’s consolidated Core Tier 1 ratio fell below 5 per cent, they converted into fully paid ordinary shares and would then count as core capital. That trigger sat one percentage point above the 4 per cent minimum then required by the Financial Services Authority.
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The terms also allowed early redemption of all the notes if a capital disqualification event occurred and continued. One limb of that definition applied if, because of a change in regulatory capital requirements or in their interpretation or application, the notes ceased to be taken into account, in whole or in part, for any stress test applied in respect of the consolidated Core Tier 1 ratio. The exception for a mere limit on the amount that could be counted is not material here.
Later regulation and the bank’s claim
From 2013 the regulatory regime changed substantially. Core Tier 1 capital was replaced by the more restrictive Common Equity Tier 1 measure, minimum ratios rose, and contingent convertible instruments generally had to convert at a Common Equity Tier 1 ratio of at least 5.125 per cent if they were to qualify as Additional Tier 1 capital. The Prudential Regulation Authority, which had succeeded the Financial Services Authority, expected major firms to meet a higher standard. On the notes’ own terms, conversion would occur only if the bank’s Common Equity Tier 1 ratio fell to 1 per cent, well below the new minimum. In a 2014 stress test of the position at the end of 2013, the notes were not taken into account. The bank’s Common Equity Tier 1 ratio was 10.1 per cent and its minimum stressed ratio was 5 per cent; it remained above the hurdle without them.
The bank said that a capital disqualification event had therefore occurred and, with the regulator’s consent, that it could redeem the outstanding £3.3 billion of notes. About £5 billion had already been exchanged for new instruments with a 7 per cent conversion trigger. The trustee for the noteholders disputed the claim.
The two issues
The trustee’s first argument was that the 2014 exercise was a test of a Common Equity Tier 1 ratio, not of the consolidated Core Tier 1 ratio named in the definition, so the redemption clause could no longer apply. Sir Terence Etherton C and the Court of Appeal rejected that argument. They treated the reference as extending, in the events that had happened, to the then regulatory equivalent. Lord Neuberger, with whom Lord Mance and Lord Toulson agreed, reached the same conclusion. It was known when the notes were issued that capital rules would be strengthened and might change in substance and name. The commercial function of the notes was to be capable of becoming core capital, however that capital was described. Whether this was a departure from a strictly literal reading or merely a realistic one did not matter: limiting the clause to the old label would defeat its purpose. Lord Neuberger also noted that, if the trustee were right that the old ratio had simply disappeared, the notes would on any view have ceased to be taken into account in a stress test of that ratio.
The second issue was what “ceased to be taken into account” required. The trustee said that the notes still counted in principle, because they would convert into shares if the ratio fell to 1 per cent. It was not enough that a particular test had not in fact relied on them. Sir Terence Etherton C accepted that argument and held that the notes were not redeemable. The Court of Appeal disagreed. Briggs LJ framed the choice as whether it was enough that the notes continued to be taken into account for some purpose in a stress test, or whether they had to play a part in enabling the bank to pass the test. The Court of Appeal preferred the latter and held that the notes were redeemable.
The majority’s reasons
Lord Neuberger agreed with the Court of Appeal. The relevant words were directed to a stress test of the Tier 1 ratio. Under the 2013 regime the notes could no longer convert in time to do the job for which their convertibility was designed: increasing core capital before the regulatory minimum was breached. Being “taken into account” also differed from the neighbouring limb of the definition, which asked whether the notes were still “eligible to qualify” as Lower Tier 2 capital. Eligibility turned on what the rules said. Being taken into account depended more on what happened in practice, including the regulator’s application of the rules. In 2014 the notes were not invoked for the specified purpose.
The majority also considered that the trustee’s reading made the clause difficult to operate. Fully paid share capital was unlikely ever to be excluded from top-tier capital, so a note that automatically became such capital would rarely, if ever, cease to be eligible in the sense urged by the trustee. Foreseeable tightening of capital rules did not make early redemption surprising. The new rules need not have raised the minimum above the old 5 per cent equivalent; they might have created an intermediate tier, as Additional Tier 1 capital in fact was. Redemption was in any event only an option for the bank. The phrase “capital disqualification event” fairly described the loss of the notes’ ability to support the ratio before the minimum was reached. Arguments that the result depended on one test, or on the regulator’s practices, did not help: the clause itself referred to any stress test and to the regulator’s application of the requirements. The contra proferentem principle was a last resort and was unnecessary.
The dissent
Lord Sumption, with whom Lord Clarke agreed, would have held that the notes were not redeemable. In his view, “taken into account” meant that the regulator would still treat the notes as top-tier capital if the conversion trigger were reached, so that a stress scenario could be modelled on that basis. It did not mean that the notes had to affect the outcome of an actual test. Even in 2009 the bank might have passed or failed regardless of conversion. Making redemption depend on a particular test would also be uncertain, because stress testing depends on assumed conditions, the hurdle chosen and regulatory judgment. The long maturity and high coupon were important to investors, and the notes still served their function of being available if capital fell below the conversion trigger. Whether that function remained as useful to the bank was, on this view, irrelevant.
Verdict: The trustee’s appeal was dismissed by three votes to two. The majority held that a capital disqualification event had occurred and the notes could be redeemed early. Lord Sumption and Lord Clarke dissented.
Source: BNY Mellon Corporate Trustee Services Limited v LBG Capital No 1 Plc and another [2016] UKSC 29
