Overview
Lenders and contract drafters will welcome the 18 June 2024 UK Court of Appeal ruling in Yieldpoint vs Kimura1, which overturned a controversial High Court ruling in which the grantor of a participation in a loan was ordered to repay a participant’s capital on default of the underlying borrower. The initial ruling concluded that the inclusion of specific contractual terms and conditions (dubbed the “Frankenstein Slip”)2 was sufficient to convert the original sub-participation agreement to an unsecured fixed-term loan, repayable by the lender irrespective of whether the underlying borrower defaulted.
The case required complex analysis of the terms of the participation agreement and overarching umbrella agreement, but the Court of Appeal ultimately concluded that the High Court had adopted the incorrect approach in completing its interpretation. The Court of Appeal stated that greater focus should have been given to reading the provisions of the agreement together, and some consideration needed to be given to the commercial sense of the agreement. As such, the High Court decision was reversed, and the participant’s investment was lost.
In Depth
Overview of a Participation
Although a sub-participation is a relatively common financial transaction, it has no strict legal meaning in English law. A sub-participation (also known as a participation) is an alternative to a novation and an assignment, enabling a lender to transfer its economic risk in a loan to another party whilst remaining the lender of record. It does not involve the legal transfer of the underlying loan itself, which would require the borrower to agree to the loan being transferred. Instead, a sub-participation creates a new arrangement between the lender of record and the new party (the participant) that is separate to, and distinct from, the underlying loan. The participant, in return for a payment to the lender of record for a share of their loan, receives a share of the interest paid to the lender of record, whilst simultaneously taking on the borrowers’ risk of default for the share of the loan they have taken on.
Background
On 10 December 2019, Kimura Commodity Trade Finance Fund Limited (Kimura) entered into a loan facility (the Facility) extended to Chilean mining company, Minera Tre Valles SPA (MTV). Kimura held 50% of this facility alongside another party, which was fully funded at all times. Subsequent to this, Kimura agreed a Master Participation Agreement for Trade Transactions (the MPA) with Yieldpoint Stable Value Fund LP (Yieldpoint) on 19 February 2021, pursuant to a sub-participation agreement was drafted which allowed Yieldpoint to participate in Kimura’s share of the Facility (the MTV Participation). Yieldpoint paid Kimura US$5million in exchange for a share of (a) the quarterly interest rate of the Facility set at 3-month LIBOR plus 7.5% (0.5% less than Kimura’s entitlement under the Facility); and (b) a pro-rata share of Kimura’s monthly price participation entitlement under the Facility (based on the price of copper). The MPA, and therefore the MTV Participation, proffered by Kimura, were based on the standard form, at the time, made available by the Bankers Association for Finance and Trade, but was slightly amended to include a “Maturity Date of the Participation” dated 31 March 2022 and a special condition providing for Yieldpoint to give 45 days prior notice if it intended to renew its participation.
The Issue
Traditionally, the concept of a maturity date within a participation agreement is “alien” and, due to its general use in referring to the end of a loan period, is in conflict with the essence of a participation agreement. This formed the basis of this dispute and was the issue that received significant attention from the court.
MTV ceased its operations in January 2022 and by 31 March 2022, MTV had defaulted on its payment obligations under the Facility. The company was later declared bankrupt by the Civil Court of Santiago in February 2023.
Yieldpoint provided notice of its intention not to renew its participation in February 2022, as permitted under the MTV Participation agreement. However, Kimura did not repay the claimed US$5million of capital to Yieldpoint. The basis on which this was refused was that Yieldpoint had been exposed to the default risk (as is generally the case in a typical sub-participation) and was therefore not entitled to a repayment.
Yieldpoint contested that the wording of the MPA and the MTV Participation agreement meant that the arrangement was more akin to an unsecured fixed-term loan, which, in the absence of a notification to extend, was repayable in full on 31 March 2022.
The issue was first heard at the High Court, before going to the Court of Appeal.
The High Court Decision
The High Court carefully considered the wording of, and the interplay between, the MTV Participation agreement and the MPA. It found that irrespective of the arguments made by either side, that the MTV Participation agreement was a “[…] mutant or variant, on any view […]”3 rendering parts of the MPA “otiose”4. On Yieldpoint’s analysis the court stated that Yieldpoint “[…] was not staking its capital in any meaningful sense. It was sharing primary default risk on and acquiring equitable recourse for the year’s rent for its money, but nothing else.”5 The court held that this interpretation turned “almost entirely upon the insertion of “Maturity Date of the Participation” by way of adaptation to the Template Offer and insertion of the Special Conditions relating to renewal upon notice.”6.
The court went on to conclude that, despite the “difficulties”, the problems faced were “surmountable” but “not without some discomfort”7. The arguments made indicated that there was no common mistake in preparing and reaching the binding agreement, and the court’s task was to ascertain the meaning and effects of the agreement that was dubbed a “Frankenstein’s Slip”8. As such, Yieldpoint’s analysis was favoured, and the contract was held to be a hybrid agreement containing both a fixed term loan and a participation. Kimura was therefore liable in debt for US$5million plus interest.
Kimura appealed this ruling to the Court of Appeal.
The Court of Appeal Decision
The Court of Appeal reversed the High Court decision and found in favour of Kimura. It held that the MTV Participation was in fact a conventional sub-participation. As a result of this conclusion and the fact that the company had defaulted prior to the maturity date, it was held that Yieldpoint was not entitled to be repaid its US$5million investment.
In coming to this decision, the Court of Appeal agreed with the High Court in its assessment of the fact that the labelling of an agreement did not establish the legal rights and duties created by the drafting of the contract9. The decision did however come down to the construction of the agreement and was a question of law10, and the interpretation needed to follow the established principles in Rainy Sky SA v Kookmin Bank11 and Wood v Capita12 focussing, in particular, on:
- The application of an iterative process by which each suggested interpretation is checked against the provisions of the contract and its commercial consequences as a means of completing the contractual interpretation process.
- The admissibility of evidence that provided the factual background known to the parties at or before the genesis of the contract including the origins and objective aim of the transaction (noting that parties’ intentions and negotiations were inadmissible).
In applying this process, the Court of Appeal concluded that the MTV Participation agreement only made sense if read together with the MPA which contained the express terms of the overarching transaction. With this in mind, the court considered it unlikely that the MTV Participation agreement, despite its amendments and special conditions, could not have represented anything other than a traditional sub-participation. If the intention had been for Yieldpoint to enter into a fixed term loan, the overarching terms of the MPA would have been abandoned.
When considering the inclusion of the “Maturity Date of the Participation”, and whether this wording was sufficiently strong to depart from the MPA provisions and intentions, it held that the wording did not do enough to overturn the core provisions. Instead, the Court of Appeal held that this approach to interpretation was incorrect and that “The right approach was first to seek to read all the contractual provisions together, in order to reach a coherent interpretation of the entire contract which conforms with commercial sense.”13 The court added that it was only when this method was “not possible that it [was] necessary to determine which provisions should be given priority and which given a modified reading or overridden altogether.”14 With this in mind, the court concluded that “If that approach had been adopted in this case, it [was] difficult to see that the MTV Participation, in the context of the MPA, would be read as anything other than a conventional sub-participation agreement with early redemption.”15
Finally, the court added that when considering the commercial sense of the MTV Participation agreement in the context of the competing interpretations, that the lower court was wrong to “discount the fact that Yieldpoint’s proposed interpretation was highly uncommercial”16 and that Kimura would likely not have “agreed to transfer most of its benefit from US$5m of its part of the Facility without Yieldpoint exposing its capital.”17 It was acknowledged that courts were generally wrong to consider whether the consideration given by one party to a contract was adequate or to consider the commercial motives, but that in this case it was a “strong factor”18, which, if applying Yieldpoint’s interpretation of the agreement, “undermine[d] the commercial sense of the structure set out in the MPA.”19
As a result, the Court of Appeal found in favour of Kimura and allowed the appeal, and concluded that, Yieldpoint was not entitled to be repaid its US$5million investment on MTV’s default, and Yieldpoint was exposed to the underlying credit risk of the Borrower as would be the case in ordinary sub-participation agreements.
Comment
Lenders and contract drafters will welcome this decision, which restores the orthodox view that an agreement subject to an umbrella agreement should be read, first and foremost, in its entirety, whilst also considering the commercial sense and understanding of the proposed terms. This concern was well founded given the High Court judgment found that the inclusion of a single term was sufficient, albeit with “some discomfort”, to subvert the general terms of an agreement. While the reversal is welcomed, it poses the question of where the boundary lies for a court to hold that the changes to a sub-agreement are sufficient to alter the meaning of an umbrella agreement, enough to significantly alter the overall commercial intentions. From a commercial perspective, the decision of the Court of Appeal was a welcome one given the widespread use of sub-participation agreements by lenders in the credit market seeking to de-risk positions.
The contrary decision at first instance also underlines the importance for contracts to address clearly each significant potential outcome. This was recognised by Lord Justice Philips in his comments that: “Parties discussing a trade often focus on what will occur if all goes to plan, without addressing what they no doubt consider to be the unlikely situation of default or non-performance, leaving that to the written terms”.20 Forethought and clear drafting are particularly crucial where there may be a significant transfer of wealth from one party to another if a relevant event has occurred, and which, as a result, could well become contentious.
*Nicholas Hunt (trainee) contributed to this article.
