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England and Wales Court of Appeal (Civil Division) Decisions
You are here: BAILII >> Databases >> England and Wales Court of Appeal (Civil Division) Decisions >> LBG Capital No. 1 Plc & Anor v BNY Mellon Corporate Trustee Services Ltd  EWCA Civ 1257 (10 December 2015)
Cite as:  EWCA Civ 1257
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ON APPEAL FROM THE HIGH COURT OF JUSTICE
THE CHANCELLOR OF THE HIGH COURT
Strand, London, WC2A 2LL
B e f o r e :
LORD JUSTICE BRIGGS
LORD JUSTICE SALES
| (1) LBG CAPITAL NO. 1 PLC
(2) LBG CAPITAL NO. 2 PLC
|BNY MELLON CORPORATE TRUSTEE SERVICES LIMITED
Robin Dicker QC and Stephen Robins (instructed by Allen & Overy LLP) for the Respondent
Hearing dates : Wednesday 26 August 2015
Thursday 27 August 2015
Crown Copyright ©
Lady Justice Gloster:
"Within the Tripartite structure, the FSA was responsible, in consultation with the other two authorities, for determining the appropriate level of capital for each individual institution. In reaching this determination two factors were taken into account:
1. Ensuring that the amount of capital for each institution would sustain confidence in that institution.
2. Ensuring that each individual institution would have a sufficient capital buffer over minimum capital requirements both to absorb losses that might ensue from a recession and to continue lending on normal commercial criteria.
To ensure broad consistency between different institutions, the process included utilisation of a stress test based on some standard assumptions but with weightings tailored to the specific institutions. The FSA used as common benchmarks within this framework ratios of capital to risk weighted assets of total Tier 1 Capital of at least 8% and Core Tier 1 Capital, as defined by the FSA, of at least 4% after the stressed scenario.
It is important to recognise that this methodology was not intended to set new minimum capital ratios. It was adopted in the context of implementing the Tripartite's support package with the intention of securing (1) and (2) above.
As the FSA has already announced, it will be addressing the longer term capital regime for deposit takers in a discussion paper in the first quarter of 2009, the expectation being that this document will form part of the wider review of the global regulatory environment, which the FSA along with the other regulatory authorities, will be participating in."
"This statement clarifies how stress tests have been used within the UK, provides information on the macro-economic parameters currently being used, and describes how the UK approach fits within the EU-wide stress testing exercise on the aggregate banking system being coordinated by the Committee of European Banking Supervisors (CEBS).
The UK authorities have not applied stress in the same way as in the US - a single exercise covering simultaneously the top 19 banks which account for two thirds of the assets of the US banking system. Instead, over the last eight months since the intensification of the financial crisis, the Financial Services Authority (FSA) has:
Greatly increased the use of stress tests as an integral element of our ongoing supervisory approach.
Begun the process of embedding this revised approach in our intensive supervisory regime.
Used stress tests to inform policy decisions such as access to the Credit Guarantee Scheme (CGS) and the Asset Protection Scheme (APS) working closely with the other Tripartite authorities.
The stress tests are used within the context of our current regulatory framework for UK bank capital. On January 19th 2009 we published a statement that we expected UK banks to maintain Core Tier 1 capital, as defined by the FSA, of at least 4% of Risk Weighted Assets after applying an FSA defined stress test. This current framework will remain in place until the Basel accord, which is implemented through EU capital requirement directives, has been modified to reflect the lessons learned from recent events.
The stress tests analyse all the relevant variables which may affect an institution's capital adequacy. These include its revenue generation potential given scenarios for GDP growth and interest rates, the probability of default and possible losses given default within its loan book, and possible declines in the market value of assets held in the trading books, as well as any known firm specific events. The tests have been applied where appropriate at the group level.
The tests look forward over five years but with greater detail over the first three. They are used to identify if at any time in the next five years there is a danger that under the stress scenario the level of capital will fall below the 4% Core Tier 1 minimum. In evaluating the institution's ability to meet the minimum requirement under the stress scenario, the FSA may consider actions that management could propose to take if and when the stress develops. Such actions may include the evolution of the balance sheet size, capital raising and asset sales.
The stress tests used are not forecasts of what is likely to happen but are deliberately designed to be severe. Their purpose is to consider whether an institution would be able to sustain adequate capital and liquidity under conditions which at the time the stress is conducted are considered unlikely to arise. They therefore aid our determination of whether firms are able to comply with our regulatory framework.
Stress testing is necessarily forward looking and therefore involves an element of judgement. This is particularly true given that the most important challenge facing the banking system has changed over the last six months.
In the early stages of the crisis, a crucial concern was the presence on bank balance sheets of specific complex structured securities (sometimes called "toxic assets") whose values were severely depressed, and the accounting for which was sometimes unclear. But significant action has already been taken to reflect legacy asset losses in published accounts, and our stress tests allow for further possible write downs in the event of further price reductions and for variations in accounting practice.
The key challenge now is that the weakness of the financial system has produced an economic situation which may in future produce significant loan losses and further impair the strength of banks and building societies in an adverse feedback loop. The crucial issue for stress testing is not therefore, as it is sometimes suggested, to 'identify the bad assets on the bank's balance sheets', but to identify future potential loan losses even among loans which currently would not be considered impaired on an accounting basis.
Since the FSA's use of stress tests has not been a one-off exercise, but instead embedded in our regular supervisory processes, the FSA will not, as a matter of practice, be publishing details of the stress test results. Furthermore given that the application of the tests has and will continue to evolve, the precise parameters used have changed and will change over time.
But we believe it is useful to provide information on the key macroeconomic parameters used in stress tests conducted over the last four months currently being used today. These parameters were used, for instance, in the stress tests applied to those banks considering utilisation of the APS, and in the analysis of the Dunfermline Building Society which identified future potential threats to capital adequacy. The banks participating in the APS have in addition submitted to HMT full details of the specific assets proposed for inclusion in the scheme and further detailed analyse of the assets determined the design and pricing of the scheme.
The current stress scenario models a recession more severe and more prolonged than those which the UK suffered in the 1980s and the 1990s and therefore more severe than any other since the Second World War. It assumes a peak-to-trough fall in GDP of over 6%, with growth not returning until 2011 and only returning to trend growth rate in 2012. It models the impact of unemployment rising to just over 12% and, crucially, the impact of a peak-to-trough fall in house prices and a 60% peak-to-trough fall in commercial property prices.
The UK approach to stress tests is similar to that followed in most countries, other than the US, which have applied stress tests to inform decisions on specific institutions and as part of intensified supervisory process, rather than as a one-off, system wide and publicly disclosed process. CEBS has, however, now committed to co-coordinating a Europe-wide stress testing exercise to inform assessments of the aggregate health of the banking system. This exercise will use common approaches and scenarios and aims to increase the level of aggregate information available to policy makers in assessing the European financial system's resilience to shocks." [Emphasis added.]
i) On 1 May 2009, the FSA wrote a letter to the British Bankers' Association confirming the definition of CT1 capital ("the May 2009 Letter") which banks should use for specific reporting and disclosure purposes. This set out which assets were to be included in, and which assets were to be excluded from, CT1 capital.
ii) In its Handbook of the same date, the FSA described Tier 1 capital as follows:
"Tier one capital typically has the following characteristics:
(1) it is able to absorb losses;
(2) it is permanent;
(3) it ranks for repayment upon winding up, administration or similar procedure after all other debts and liabilities; and
(4) it has no fixed costs, that is, there is no inescapable obligation to pay dividends or interest.
The forms of capital that qualify for Tier one capital are set out in the capital resources table and include, for example, share capital, reserves, partnership and sole trader capital, verified interim net profits and, for a mutual, the initial fund plus permanent members' accounts. Tier one capital is divided into core tier one capital, perpetual non-cumulative preference shares, permanent interest bearing shares (PIBS) and innovative tier one capital".
The handbook went on to describe upper and lower tier 2 capital as follows:
"Tier two capital includes forms of capital that do not meet the requirements for permanency and absence of fixed servicing costs that apply to tier one capital. Tier two capital includes, for example:
(1) capital which is perpetual (that is, has no fixed term) but cumulative (that is servicing costs cannot be waived at the issuer's option, although they may be deferred- for example, cumulative preference shares); only perpetual capital instruments may be included in upper tier two capital;
(2) capital which is not perpetual (that is, it has a fixed term) or which may have fixed servicing costs that cannot generally be either waived or deferred (for example, most subordinated debt); such capital should normally be of a medium to long-term maturity (that is, an original maturity of at least five years); dated capital instruments are included in lower tier two capital;"
iii) On 7 September 2009, the Bank for International Settlements ("BIS") issued a press release stating that the oversight body of the Basel Committee on Banking Supervision ("BCBS") had met on 6 September 2009 to review a comprehensive set of measures to strengthen the regulation, supervision and risk management of the banking sector. The press release said the Committee would:
"issue concrete proposals on these measures by the end of the year. It will carry out an impact assessment at the beginning of next year, with calibration of the new requirements to be completed by end-2010. Appropriate implementation standards will be developed to ensure a phase-in of these new measures."
iv) On 16 September 2009, the EU introduced transitional legislation restricting the use of hybrid securities as banks' capital: see Directive 2009/111/EC (known as "CRD II"). This limited the extent to which hybrid instruments could count as part of a bank's own funds. In its feedback Statement 09/3 "A regulatory response to the global banking crisis", published in September 2009, the FSA indicated that it was working on a new definition of capital, with specific emphasis in the nearer term on hybrid capital. It included the following statement at paragraph 4.3.8.:
The FSA will use the responses received to inform work on the definition of capital in the BCBS and in the EU. Engagement with market participants and other stakeholders will continue to support policy development and negotiations. .
Any new definitions of capital will be based on international agreement and The Turner Review makes it clear that the FSA will work to ensure the timing of the introduction of a new long-term capital regime will take into account the health of the macro economy and the recovery of banking profitability.
In the nearer term the FSA will focus attention on the ongoing discussions in BCBS on the definition of capital and the EU in relation to the CRD amendments on hybrid capital instruments. The FSA intends to consult on these amendments later in 2009. The amendments are required to be transposed into Member States' national law by 31 October 2010 and will be implemented from 31 December 2010.
For the reasons set out in the DP (paragraph 3.3 onwards), the FSA does not agree with the responses that suggest that non-Tier 1 capital instruments provide the same degree of loss absorbency as common equity and reserves. During the crisis, mechanisms such as the capability to cancel and defer coupons were not used on a timely basis. Liability management transactions are dependent on external factors such as market prices and take-up by investors and are not sufficiently certain to act as an acceptable loss absorbing mechanism. Further, firms may not be able to derive the Core Tier 1 benefit when needed if falls in secondary market prices do not occur at an early stage. The FSA's view is that hybrid capital instruments must be capable of supporting Core Tier 1 by means of a conversion or write-down mechanism at an appropriate trigger. Instruments with these characteristics could be seen as a form of contingent Core Tier 1 capital.
The FSA notes industry support for the potential role for contingent capital that is capable of supporting core capital at an early enough trigger. Further work is required in this area which will be taken forward in discussions in international fora."
i) The exchange offer and rights issue (together, "the Proposals") had been structured in consultation with the FSA, and that LBG was therefore confident that the Proposals would generate sufficient capital to ensure that LBG no longer required the asset protection that it would have obtained through participation in GAPS, "even if the severe scenario envisaged by the FSA Stress Test were to occur".
ii) The rights issue would raise a total of £13.5 billion of immediately available and non-amortising CT1 capital in order to absorb potential losses across all of LBG's assets. The CT1 capital which would be created on conversion of the ECNs (if and when they were to convert) would also be available to absorb potential losses across all of LBG's assets.
iii) The ECNs had been designed to provide capital to the Group without being dilutive to shareholders at the time of their issue. In effect they were a new form of capital intended to increase LBG's "contingent" CT1 capital. The ECNs would qualify at the time of their issue as lower tier 2 capital and would automatically convert into ordinary shares, and therefore CT1 capital, if LBG's published consolidated CT1 capital ratio fell to less than 5%, thereby increasing LBG's CT1 capital at such time. In the event of such a conversion, up to £7.5 billion of CT1 capital would be generated. This provided protection against unexpected deterioration in the UK economy and the effect that such deterioration would have on LBG's capital ratios. Conversion of the ECNs, and the resulting dilution of Ordinary Shareholders, would only occur if LBG's results (in particular impairments) were significantly worse than the Board of Directors currently expected.
iv) The ECNs would also count as CT1 capital in the context of the FSA's stress testing framework when the CT1 ratio fell below 5% in the stressed projection. In other words, if LBG's CT1 ratio was projected to fall below 5% in the stressed scenario, the ECNs would at that point be treated in the stress test as having converted into ordinary shares, increasing LBG's CT1 capital.
v) The following extracts from the Chairman's letter are material:
"Improved capital efficiency and lower shareholder dilution: The ECNs to be issued pursuant to the Exchange Offers have been designed to provide capital to the Group without being dilutive to shareholders at the time of their issue. The ECNs will qualify at the time of their issue as lower tier 2 capital and automatically convert into Ordinary Shares if the Group's published consolidated core tier 1 capital ratio falls to less than 5 per cent., thereby increasing the Group's core tier 1 capital at such time. In the event of a conversion pursuant to this feature, up to £7.5 billion of core tier 1 capital would be generated. This provides protection against unexpected deterioration in the UK economy and the effect that such deterioration would have on the Group's capital ratios. Conversion of the ECNs, and the resulting dilution of Ordinary Shareholders, would only occur if the Group's results (in particular impairments) were significantly worse than the Board currently expects ..
Improved capital structure: The Proposals are designed to increase both the Group's current and contingent core tier 1 capital.
The ECNs represent a new form of capital which will allow greater efficiency in the Group's capital structure. Each series of ECNs will have terms eligible to qualify as lower tier 2 capital for the Group upon their issue and will automatically convert into Ordinary Shares if the Group's published consolidated core tier 1 ratio falls below 5 per cent. For information on the Group's target consolidated core tier 1 capital ratio, see paragraph 13 below. The conversion price for such conversion will be based on the greater of (i) the volume weighted average trading price of the Ordinary Shares for the five trading days ending on 17 November 2009 and (ii) 90 per cent. of the closing price of an Ordinary Share on the London Stock Exchange on 17 November 2009, as further adjusted for the impact of the Rights Issue. The FSA has determined that the ECNs will be eligible to be classified as lower tier 2 capital in respect of the FSA's current pillar 1 and 2 regime. The ECNs will also count as core tier 1 for the purposes of the FSA Stress Test when the stressed projection shows below 5 per cent. core tier 1, which is the trigger for conversion into Ordinary Shares. Therefore, while the ECNs will not be treated as core tier 1 prior to their conversion into Ordinary Shares, they can count as core tier 1 in the context of the FSA's stress testing framework and will count as core tier 1 for pillar 1 and pillar 2 purposes following conversion. .
Background to GAPS
Given the extremely uncertain outlook for the UK economy at the end of 2008 and into 2009, the Group worked with the FSA to identify and analyse the potential impact of an extended and severe UK recession on the Group's regulatory capital ratios. Due to the significant uncertainty at that time over the length and depth of the recession, the Group was tested against the FSA Stress Test.
The FSA has stated that the assumptions underlying the FSA Stress Test were not intended to be a forecast of what was likely to happen, but were designed to be a severe economic scenario. These assumptions included a peak-to-trough fall in UK GDP of over 6 per cent. with growth not returning until 2011 and only returning to trend-rate growth in 2012. They also included assumptions that unemployment would rise to just over 12 per cent., that the UK would experience a 50 per cent. peak-to-trough fall in house prices and that there would be a 60 per cent. peak-to trough fall in commercial property prices.1
The conclusion from this exercise was that the Group would need additional capital to enable it to absorb the future impairments anticipated in such a severe scenario.
1 Source: FSA statement on its use of stress tests, FSA/PN/ 068/2009.
Background to the Proposals:
The Group accepts and agrees with the merits of severe stress testing of regulatory capital, and the Proposals, together with other management actions which the Board considers to be readily actionable, are specifically designed to provide the capital enhancement that the Board believes is necessary to meet the capital requirements of the FSA Stress Test. The Board believes that, since commencing the negotiation of the terms of GAPS, the UK economy has begun to stabilise and is now expected to return to growth in 2010. Accordingly, the Board believes that the likelihood of the UK economy deteriorating to the levels implied by the FSA Stress Test, the assumptions behind which remain unchanged, is now materially lower than was the case in March 2009."
vi) Paragraph 13 of the Chairman's letter, under the heading "Group capital and liquidity policies", referred to the fact that Part XVI ("Capital Resources") of the Exchange Offer Memorandum incorporated by reference further details of the Group's capital resources and liquidity. Part C of Part XVI stated:
"Information regarding the Group's capital resources and liquidity is contained in Part XV ("Capital Resources-Part C-Capital Resources and Liquidity") on pages 146-152 of the Rights Issue Prospectus, such pages being incorporated by reference into this document."
vii) In the Rights Issue Prospectus, under the heading "Capital Resources and Liquidity", there was the following statement:
"The effective management of capital risk remains central to the Group's strategy. The Group continues to be focused on the maintenance of a strong capital base, to ensure this base expands appropriately and to utilise capital efficiently throughout the Group's activities to both maintain a prudent relationship between the capital base and the underlying risks of the business and also optimise returns to shareholders. In the pursuit of this focused approach to capital risk management, the Group follows the supervisory requirements of the FSA. In 2008, the key focus of capital adequacy shifted to the ratio of core tier 1 capital to risk-weighted assets. In 2009, the emphasis has shifted further, with the FSA now paying significant attention to projections of the core tier 1 capital ratio in a pre-defined stress situation. The FSA has indicated that it expects banking groups to maintain a tier 1 capital ratio of at least 8 per cent. in normal circumstances and a core tier 1 capital ratio of at least 4 per cent. throughout the cycle. At 31 December 2008, the Group had a published core tier 1 capital ratio of 5.6 per cent. and at 30 June 2009 this had risen to 6.3 per cent. The Group has at all times been in compliance with FSA guidance on capital requirements and expects to continue to comply with that guidance in the future. See Risk Factor 1.5 for a discussion of the risks relating to the Group's regulatory capital requirements."
"2.1 Differences between the Existing Securities and the New Securities
The form and terms and conditions of the Existing Securities are substantially different from those of the New Securities. Holders should carefully consider the differences (which include, inter alia, in some cases the payment dates, the maturity dates, the ranking, obligations with respect to interest payments, the redemption prices in the event of tax or capital disqualification redemption triggers, the identity of the obligor and the form in which the New Securities are issued and, in the case of all ECNs, the inclusion of an automatic conversion feature into Ordinary Shares in certain prescribed circumstances).
5.10 Redemption risk
The ECNs may, subject as provided in the ECN Conditions and subject to the prior consent of the FSA, be redeemed prior to their stated Maturity Date in the circumstances described below.
Upon the occurrence of a Tax Event or a Capital Disqualification Event (each as defined and more fully described in Part A of Appendix 6 ("Terms and Conditions of the ECNs - Redemption and Purchase"), the ECNs may, subject to the Conditions, be redeemed by the relevant ECN Issuer at any time (in the case of a Fixed Rate ECN) or on any Interest Payment Date (in the case of a Floating Rate ECN) prior to the Maturity Date specified in the relevant Pricing Schedule, in each case at their principal amount (or, in relation to a Capital Disqualification Event only, at such other amount as may be specified in the relevant Pricing Schedule), together with accrued but unpaid interest.
5.11 ECN Security holders have no right to call for redemption. The relevant ECN Issuer is under no obligation to redeem the ECNs at any time prior to the stated Maturity Date and the ECN Security holders shall have no right to call for their redemption at any time."
The issue of the ECNs and their current profile
The terms and conditions of the ECNs
(a) Conversion upon Conversion Trigger
(i) If the Conversion Trigger occurs at any time, each ECN shall, subject to and as provided in this Condition 7(a) and in the Deed Poll, be converted on the Conversion Date into new and/or existing (as determined by LBG) Ordinary Shares credited as fully paid in the manner and in the circumstances described below and in the Deed Poll.
The ECNs are not convertible at the option of ECN Holders at any time.
The "Conversion Trigger" shall occur if at any time, as disclosed in the latest published annual or semi-annual consolidated financial statements of LBG or as otherwise publicly disclosed by LBG at any time, LBG's Consolidated Core Tier 1 Ratio is less than 5 per cent. As used in these Conditions, "Consolidated Core Tier 1 Ratio" means the ratio of the Core Tier 1 Capital of LBG to the risk weighted assets of LBG, in each case, calculated on a consolidated basis.
As soon as reasonably practicable following the occurrence of the Conversion Trigger, the Issuer shall give notice thereof to holders of the ECNs (the "Conversion Trigger Notice") in accordance with Condition 17. The Conversion Trigger Notice shall specify the Consolidated Core Tier 1 Ratio, the prevailing Conversion Price and the Conversion Date, which shall be not earlier than 20 London business days nor later than 30 London business days following the giving of the Conversion Trigger Notice.
(ii) If the Conversion Trigger occurs, the ECNs will be converted in whole and not in part as provided below and in the Deed Poll.
(iii) Prior to giving the Conversion Trigger Notice, the Issuer shall deliver to the Trustee a certificate signed by two Authorised Signatories of LBG stating that the Conversion Trigger has occurred and the Trustee shall accept such certificate without any further enquiry as sufficient evidence of such matters, and such certificate will be conclusive and binding on the Trustee and the ECN Holders.
(b) Payment of Conversion Settlement Sum
(i) Upon Conversion, the Issuer shall redeem the ECNs at a price (the "Conversion Settlement Sum") equal to their principal amount. ECN Holders shall be deemed irrevocably to have directed and authorised the Issuer to pay the Conversion Settlement Sum to LBG as consideration for LBG's agreement to Issue Ordinary Shares pursuant to the Deed Poll and the obligations of the Issuer and [the]*/[each]** Guarantor to pay principal on the relevant ECNs to holders of the ECNs shall be discharged by the Issuer's obligation to pay the Conversion Settlement Sum to LBG.
(ii) In order to obtain delivery of Ordinary Shares on a Conversion, ECN Holders will be required to comply with the provisions of the Deed Poll which require, amongst other things, the delivery of a Conversion Notice and the relevant ECNs or the Certificate representing the same (in the case of Registered ECNs) on or before the Notice Cut-off Date. If ECN Holders fail to make such delivery on or before the Notice Cut-off Date or otherwise the relevant Conversion Notice shall have been determined to be null and void pursuant to the Deed Poll, the Deed Poll contains provisions relating to the sale of the relevant Ordinary Shares and the payment of the net proceeds of such sale (the "Ordinary Share Sale Proceeds") to such ECN Holders.
8, Redemption and Purchase
(a) Final Redemption
Unless previously converted, redeemed or purchased and cancelled as provided in these Conditions, each ECN shall be redeemed on the Maturity Date at the Final Redemption Amount specified in, or determined in the manner specified in, the relevant Final Terms.
(b) Conditions to Redemption and Purchase
Any redemption or purchase of the ECNs in accordance with Condition 8(c), (d), (e) or (g) is subject to
(i) LBG giving at least one month's prior written notice to, and receiving no objection from or, in the case of any redemption of the ECNs prior to the fifth anniversary of the Issue Date, receiving the consent of, the FSA (or such other period of notice as the FSA may from time to time require or accept and in any event, provided that any such notice is required to be given) and (ii) LBG (both at the time of, and immediately following, the redemption or purchase) being in compliance with the Regulatory Capital Requirements applicable to it from time to time (and a certificate from any two Authorised Signatories of LBG confirming such compliance shall be conclusive evidence of such compliance).
Prior to the publication of any notice of redemption pursuant to Condition 8 (d) or (e), the Issuer shall deliver to the Trustee a certificate signed by two Authorised Signatories of the Issuer stating that the relevant requirement or circumstance giving rise to the right to redeem is satisfied and the reasons therefor and the Trustee shall accept such certificate without any further inquiry as sufficient evidence of the satisfaction of the relevant conditions precedent, and such certificate shall be conclusive and binding on the Trustee and the ECN Holders.
(e) Redemption for regulatory Purposes
If immediately prior to the giving of the notice referred to below, a Capital Disqualification Event has occurred and is continuing, then the Issuer may, subject to Condition 8(b) and having given not less than 10 or more than 21 days' to the ECN Holders in accordance with Condition 17, the Trustee, the Issuing, Paying and Conversion Agent and the Registrar (which notice shall, subject as provided in Condition 8(f), be irrevocable), redeem in accordance with these Conditions at any time (in the case of a Fixed Rate ECN or in the Fixed Interest Rate Period in the case of a Fixed/Floating Rate ECN) or on any Interest Payment Date (in the case of a Floating Rate ECN or in the Floating Interest Rate Period in the case of a Fixed/Floating Rate ECN) all, but not some only, of the ECNs at their Capital Disqualification Event Redemption Price, together with any accrued but unpaid interest to but excluding the relevant redemption date. Upon the expiry of such notice, the Issuer shall redeem the ECNs as aforesaid.
(f) Conversion Trigger
The Issuer may not give a notice of redemption of the ECNs pursuant to this Condition 8 if a Conversion Trigger Notice shall have been given. If a Conversion Trigger Notice shall be given after a notice of redemption shall have been given by the Issuer but before the relevant redemption date, such notice of redemption shall automatically be revoked and be null and void and the relevant redemption shall not be made.
(i) Trustee Not Obliged to Monitor
The Trustee shall not be under any duty to monitor whether any event or circumstance has happened or exists within this Condition 8 and will not be responsible to ECN Holders for any loss arising from any failure by it to do so. Unless and until the Trustee has actual knowledge of the occurrence of any event or circumstance within this Condition 8, it shall be entitled to assume that no such event or circumstance exists.
a "Capital Disqualification Event' is deemed to have occurred (1) if at any time LBG or, where LTSB is a or the Guarantor, LTSB is required under Regulatory Capital Requirements to have regulatory capital, the ECNs would no longer be eligible to qualify in whole or in part (save where such non-qualification is only as a result of any applicable limitation on the amount of such capital) for inclusion in the Lower Tier 2 Capital of LBG or, as the case may be, LTSB on a consolidated basis; or (2) if as a result of any changes to the Regulatory Capital Requirements or any change in the interpretation or application thereof by the FSA, the ECNs shall cease to be taken into account in whole or in part (save where this is only as a result of any applicable limitation on the amount that may be so taken into account) for the purposes of any "stress test" applied by the FSA in respect of the Consolidated Core Tier 1 Ratio;
"Core Tier 1 Capital" means core tier one capital as defined by the FSA as in effect and applied (as supplemented by any published statement or guidance given by the FSA) as at 1 May 2009;
"Lower Tier 2 Capital" has the meaning given to it by the FSA from time to time.
"Regulatory Capital Requirements" means any applicable requirement specified by the FSA in relation to minimum margin of solvency or minimum capital resources or capital;
"Tier 1 Capital" has the meaning given to it by the FSA from time to time" and
"Upper Tier 2 Capital" has the meaning given to it by the FSA from time to time".
"the Financial Services Authority or such other governmental authority in the United Kingdom .. having primary supervisory authority with respect to LBG and the LBG Group."
Regulatory changes after the issue of the ECNs, the impact of such changes on LBG and the consequential changes in its capital position
i) introduced the concept of Common Equity Tier 1 capital ("CET1 capital"), which replaced CT1 capital; and
ii) increased the minimum core capital ratio (including in a stressed scenario) at a European level from a CT1 capital ratio of 2% under CRD III to a CET1 capital ratio of 4%, as from 1 January 2014, increasing to 4.5% as from 1 January 2015; and
iii) introduced the concept of "Additional Tier 1 capital" ("AT1 Capital") which included capital instruments such as contingently convertible loan stock such as the ECNs, provided they satisfied certain conditions.
i) deferred tax assets: i.e. losses in previous years which can be offset against future profits to reduce tax liabilities; they are included as assets in a balance sheet, but must be deducted for the purposes of calculating CET1 capital because their value is contingent on (uncertain) future profits;
ii) significant investments in financial institutions: these must be deducted (in part) because, in a financial crisis, their value may be impaired.
a) the PRA should assess current capital adequacy using the Basel III definition of equity capital but after: (i) making deductions from currently-stated capital to reflect an assessment of expected future losses and a realistic assessment of future costs of conduct redress; and (ii) adjusting for a more prudent calculation of risk weights;
b) the PRA should take steps to ensure that, by the end of 2013, major UK banks and building societies held CET1 capital resources (based on the Basel III definition, adjusted in accordance with (a) above) equivalent to at least 7% of their risk-weighted assets (being an equivalent of an unadjusted CET1 capital ratio of 10% in the context of LBG's balance sheet at the relevant time); and
c) The PRA should ensure that major UK banks and building societies meet these requirements by issuing new capital or restructuring balance sheets in a way that did not hinder lending, with any newly-issued capital, including contingent capital (such as the ECNs) needing to be clearly capable of absorbing losses in a going concern to enable firms to continue lending.
"The PRA has judged that, after these adjustments have been made, each firm should target a risk-weighted capital ratio based on the Basel III definition of at least 7%.
The PRA's assessment is that, at the end of 2012, five of the eight banks (Barclays, Co-operative Bank, LBG, Nationwide and RBS) fell short of this standard. They had an aggregate capital shortfall relative to this standard of £27.1bn. When the FPC made its announcement in March this shortfall was provisionally estimated to be around £25bn. At that time, five firms had in place plans to take actions that generated the equivalent of approximately £12.5bn of capital during 2013. The final figure for these actions is £13.7bn. A number of these intended actions will require regulatory approval before being implemented. As such, they cannot be assumed to have contributed to meeting the requirement until approval is given. In the event that they are either not carried out or fail to be approved, other actions will be required of those firms in order to reach the specified standard.
After these planned actions, the PRA assesses that four of the five firms will have a shortfall against the 7% standard. (Nationwide's shortfall was already accounted for in its planned 2013 actions.) These firms have been required to submit plans for additional actions. All of the firms have been informed of their requirements and have produced for the PRA plans to meet them. It is for the firms themselves to announce the actions they plan to take. In aggregate, the additional actions, which include disposals and restructurings, will generate the equivalent of an additional £13.4bn of capital. The PRA believes that these plans can be put into effect. The vast majority of actions are due to be completed by end-2013, but the PRA has allowed some limited flexibility for a small part of these actions to be delivered during the first half of 2014. . The PRA will hold firms to these plans, and will require additional actions to be taken if capital to cover the full shortfalls is at risk of not being delivered by any firm."
The document then set out a table in relation to the 8 banks. This showed that LBG had a CET1 ratio of 8.2 and that the FPC "recommended" certain adjustments to the amount of its capital and the amount of its risk weighted assets. The table also showed that LBG was itself planning to take additional actions to improve its capital position in the sum of £1.6 billion, and was additionally required to take further action to improve its capital position by the sum of £7 billion, in order to meet the required target of a risk-weighted capital ratio of at least 7% based on the Basel III definition. The analysis was not based on any stress testing model, but rather on actual figures in the context of LBG's balance sheet at the relevant time.
"The aim of the trigger and conversion is to contribute to the firm's recovery following a significant stress. Therefore, if UK firms, especially those whose failure may have systemic consequences for the United Kingdom, issue ATI instruments, the PRA expects them to set ATI triggers at a level that is unambiguously consistent with being able to recover from a stress without entering into resolution. This may be at a level higher than 5.125% CET1. The PRA also expects the conversion or write-down to be for the full amount of the instrument and to be permanent."
"Bank staff, under guidance from the FPC and the PRA Board, will synthesise the outputs of these models to form a single, overall view about the performance of the system and individual banks in each scenario, interpreting these results, and reaching a judgement around capital adequacy, will require a view on the level of capital that regulators want banks to maintain in the face of such losses. This is ultimately a policy decision by the FPC and the PRA Board, according to their respective responsibilities. At the very least, banks would need to maintain sufficient capital to be able to absorb losses in the stress scenario and not fall below internationally agreed minimum standards."
The "internationally agreed minimum standards" referred to the requirement under CRD IV for a minimum CET1 capital ratio (including in a stress scenario) of 4%, as from 1 January 2014, increasing to 4.5% as from 1 January 2015. The discussion paper also made clear that:
"Crucially, the results of the stress tests are not expected to be mechanically linked to policy responses. This is not intended to be a simple "pass-fail" regime. Rather, it aims to deliver a more graduated policy framework, where the magnitude of remedial actions taken would be a function of policymakers' judgment around the adequacy of banks' capital plans. For example, if the stress tests revealed that individual banks or the system as a whole fell below internationally agreed minima in the stress scenarios, this could point to material inadequacies in their capitalisation. In turn, this would likely result in the PRA requiring material remedial actions to strengthen capital levels. Required remedial actions would likely be smaller if stress tests revealed that banks remained above internationally agreed minima, but still below the appropriate level of post-stress capital determined by the FPC and the PRA Board. Banks could also be required to take remedial actions in light of identified inadequacies in their stress testing and capital management capabilities, even if the PRA Board judged that they were adequately capitalised to withstand the range of scenarios explored as part of the stress test."
The document went on to explain the framework for assessing capital adequacy and in particular the requirement for a bank to maintain a minimum level of capital required by internationally agreed standards. It stated:
"Framework for assessing capital adequacy
The process outlined above will result in a central view of the size of stressed Losses in a given scenario and, hence, remaining capital resources. Interpreting these results, and reaching a judgment around bank capital adequacy, requires a view on the level of capital that regulators want banks to maintain in the stress scenario. This is often referred to as the 'hurdle rate'.
Ultimately, this is a policy decision by the FPC and the PRA Board. But there are a number of considerations the FPC and the PRA Board might take into account in considering the level of capital banks should maintain in a stress.
A key consideration will be the minimum level of capital required by internationally agreed standards. Banks need to maintain sufficient capital resources to be able to absorb losses in the stress scenario and remain above these minimum requirements. Minimum capital standards have been set internationally by the Basel Committee on Banking Supervision and transposed into European Legislation under the Capital Requirements Regulation and Directive (CRD IV). For example, under the PRA's proposed implementation of CRD IV, the minimum Pillar 1 common equity Tier 1 capital requirement will be set at 4.5% from 1 January 2015 onwards.
But requiring banks to remain above internationally agreed minima in a stress may be insufficient to mitigate risks to financial stability. There are other factors that the FPC and the PRA Board will consider when setting the hurdle rate."
"This uplift was driven by capital generation in the core business, as well as management actions including the reshaping of our core business portfolio, the substantial reduction of non-core assets in a capital accretive manner and the payment of dividends of £2.2 billion to the Group by the Insurance business. We reduced non-core assets by £34.9 billion, while at the same time releasing approximately £2.6 billion of capital."
There is a factual dispute between the Trustee and the Issuers on the evidence as to whether the improvement in LBG's capital position was brought about as a result of a change in Regulatory Capital Requirements as defined in the terms and conditions.
"The terms and conditions of the ECNs include a Regulatory Call Right (as defined herein) should, amongst other things, the ECNs cease to be taken into account for the purposes of any "stress test" applied by the PRA (successor to the FSA) in respect of core capital. Whilst still uncertain, management of LBG believes recent developments resulting in higher capital requirements for banks, including a changed definition of core capital, make it likely that the ECNs will not provide going concern benefit under future stress tests.
These recent developments include:
- a requirement in the CRR that with effect from 1 January 2014 convertible Additional Tier 1 ("AT1') capital instruments should have a conversion trigger set at no less than 5.125 per cent. CET1 Ratio. ("CET1 Ratio" means the ratio of a firm's common equity Tier 1 capital to risk-weighted assets, and calculated in accordance with the end-point requirements of CRD IV.)
- Statements by the PRA in late 2013 that a conversion trigger of 5.125 per cent. CET1 Ratio may not convert in time to prevent the failure of a firm and that it expects major UK firms to meet a 7 per cent. CET1 Ratio determined in accordance with the end-point requirements of CRD IV;
- a statement by the EBA in January 2014 that tier 2 instruments must have a conversion trigger above 5.5 per cent. CET1 Ratio to be recognised in its forthcoming stress tests; and
- an announcement by the PRA that, following a consultation commenced in October 2013, it expects to revise stress testing methodology and pass marks in 2014.
As a result of differences in definition, the Group's CET1 Ratio is substantially lower than the core tier 1 ratio on which the conversion trigger of the ECNs is based. As at 31 December 2013, the difference was 4.0 per cent. Applying the same difference to the 5.0 per cent. core tier ratio used as the ECN conversion trigger gives a 1.0 per cent. CET1 Ratio determined in accordance with end-point requirements of CRD IV, well below the CRR minimum requirements."
"If a firm's capital ratio was projected to fall below the 4.5% CET1 ratio in the stress, there is a strong presumption that the PRA would require the firm to take action to strengthen its capital position over a period of time to be agreed between the firm and the PRA If a firm's capital position was projected to remain above the 4.5% CET1 ratio in the stress, the PRA may still require it to take action to strengthen its capital position".
The document also stated that firms should model the impact of any triggers of contingent capital instruments. Thus in 2014, the only published "hurdle rate" which enabled an institution to "pass" the stress test was the ratio of 4.5% CET1 capital to risk-weighted assets.
"18 So far as concerned LBG, its actual CET1 ratio as at the end of 2013 was 10.1%, and its minimum "stressed" ratio in the stress test was 5% before the impact of strategic management actions, or 5.3% after the impact of such actions. The ECNs were not taken into account by the PRA in the December 2014 stress test."
Indeed it was clear from the table at page 7 of this document that, as Mr Dicker accepted, the ECNs had not been included so far as LBG was concerned in the modelling for its stress scenario. That was because the combination of a "hurdle rate" of 4.5% CET1 capital to risk-weighted assets and LBG's financial position was that its capital position was not reduced sufficiently to trigger the Conversion Trigger.
"The FPC and PRA Board actions taken in response to the stress test
The stress-test results were used by the PRA Board and the FPC as part of their evaluation of the capital adequacy of individual institutions and the resilience of the system as a whole. The overall 'hurdle rate' framework had been agreed by the FPC and the PRA Board earlier in the year. This is not a mechanistic 'pass-fail' test and there is, therefore, no automatic link between stress-test results and capital actions required. Although the exercise only assessed the impact of a single stress scenario, it allowed policymakers to form judgements on the resilience of the UK banking system to a severe macroeconomic downturn, which could be a feature of different possible stressed states.
From an individual-institution perspective, the PRA Board judged that this stress test did not reveal capital inadequacies for five out of the eight participating banks, given their balance sheets at end-2013 (Barclays, HSBC, Nationwide, Santander UK and Standard Chartered). The PRA Board did not require these banks to submit revised capital plans."
In relation to LBG, the PRA took the view that, although LBG had passed the stress test, nonetheless further improvements to its capital position were required. The document stated:
"Lloyds Banking Group;
Lloyds Banking Group's projected CET1 capital ratio remains above the 4.5% CET1 threshold in the stress scenario. The PRA Board has, however, judged that, as at December 2013, the bank's capital position needed to be strengthened further. The PRA Board noted that, since end-2013, Lloyds Banking Group has delivered positive financial results and is continuing to take steps to strengthen and de-risk the balance sheet, ahead of baseline projections. In April 2014, the bank also exchanged certain Tier 2 capital instruments into £5.3 billion of high-trigger ATI securities. In light of the measures that Lloyds Banking Group already has in train to augment capital, the PRA Board did not require the bank to submit a revised capital plan."
"LBG Enhanced Capital Notes (ECNs) and stress testing
Further to your interest in the LBG ECNs, I am sharing with you information that is being provided in response to enquiries from other investors about the LBG ECNs and stress testing, to ensure that all interested parties have received the same information
2014 stress test
The Bank of England's 2014 stress test involved an assessment of how LBG would perform against current regulatory capital requirements and expectations through a hypothetical stress scenario.
In April 2014 we provided guidance on the stress test for participating firms. This set out, amongst other things that firms should model the impact of the stress including any triggers of contingent capital instruments. We also confirmed that a key threshold for the test was set at 4.5% of risk-weighted assets (RWAs), to be met with Common Equity Tier 1 (CET1) capital using a CRD IV end-point definition of CET1 resources in line with the UK implementation of CRD IV.
As stated in the guidance, there was a strong presumption that if a firm's CETl ratio fell below 4.5% of RWAs in the stress the PRA would require the firm to take action to strengthen its capital position.
LBG remained above the 4.5% CET1 threshold in the stress testing exercise and also remained above the ECN conversion trigger level. The changes to LBG's financial position in the stress scenario were not projected to trigger the conversion of the ECNs. Therefore, the ECNs counted towards LBG's projected total capital ratio (which includes Tier 2 capital) in the stress, but did not count towards LBG's projected CET1 capital ratio in the stress.
LBG did not include any increase in the accounting value of the embedded derivative constituted by the conversion clause in the ECNs in its CET1 capital ratio as modelled through the stress and we did not adjust this approach.
For the above reasons, the question of whether the ECN's would have converted before the 4.5% CET1 threshold did not arise in the 2014 stress test. However, we note that as a result of the differences between the definitions of CT1 and CET1 capital, it is likely the ECNs would only reach the contractual conversion trigger at a point materially below 4.5% CET1."
"We act for BNY Mellon Corporate Trustee Services Limited (the Trustee), which is the trustee for the holders of the ECNs issued by entities in the Lloyds Banking Group (LBG) in 2009.
We refer to the ECNs and to your open letter dated 17 March 2015 in relation to the ECNs and the stress test carried out in relation to LBG in 2014.
You stated in your letter:
"LBG remained above the 4.5% CETl threshold in the stress testing exercise and also remained above the ECN conversion trigger level. The changes to LBG's financial position in the stress scenario were not projected to trigger the conversion of the ECNs. Therefore, the ECNs counted towards LBG's projected total capital ratio (which includes Tier 2 capital) in the stress, but did not count towards LBG's projected CETl capital ratio in the stress.
LBG did not include any increase in the accounting value of the embedded derivative constituted by the conversion clause in the ECN's in its CETl capital ratio as modelled through the stress and we did not adjust this approach"
We understand from this that the reason the ECNs were not counted towards LBG's projected CETl capital ratio in the stress scenario was that, in simple terms, LBG's capital position was sufficiently robust so as not to result in the conversion of the ECNs into shares. We do not understand this to mean that if they were to convert in the stress scenario, the resulting additional CETl capital constituted by the shares would not be taken into account.
You went on to state that:
"For the above reasons, the question of whether the ECN's would have converted before the 4.5% CETl threshold did not arise in the 2014 stress test. However, we note that as a result of the differences between the definitions of CTl and CETl capital, it is likely the ECN's would only reach the contractual conversion trigger at a point materially below 4.5% CETl."
It is unclear to us from this passage whether you are: (a) commenting as to the likelihood of the ECNs counting towards projected CETl capital in a future stress test; or (b) suggesting that they are now disqualified from counting towards projected CETl capital, so that even if they were to convert in the stress scenario, the resulting additional CETl capital constituted by the shares would not be taken into account.
If the latter, we would be grateful if you could explain whether this is a result of a change in law, regulation or policy since the ECNs were issued in 2009 and, if so, the nature of that change."
"Enhanced Capital Notes and stress testing
Your letter of 17 April asked for clarification of my open letter of 17 March. I am publishing your letter and this response to ensure that interested parties have the same information available to them.
The first passage you cite from my letter was part of a response to a question about the treatment of the ECN's in the 2014 stress test. It was not intended as a comment on how the ECN's might have been treated in different circumstances. As noted in that letter, LBG was projected to remain above the 4.5% CET1 ratio threshold in the 2014 stress test.
The second passage you cite dealt with the hypothetical situation of a stress test in which the firm was projected to cross the 4.5% CET1 ratio threshold.
The setting of that threshold for presumed action was a supervisory judgement in the design of the 2014 stress test. That judgement was reached against the wider regulatory background. This included the binding requirement, introduced by the Capital Requirements Regulation, that banks should at all times meet a CET1 ratio of 4% from 1 January 2014 and 4.5% from 1 January 2015.
The PRA's actual response if a firm were projected to cross that threshold in a stress test would depend on a supervisory judgement that would be taken by reference to the relevant circumstances of that firm at that time. The point at which an instrument issued by the firm would convert to CET1 capital, including in particular whether this would be before or after it crossed that threshold, would be a relevant factor in determining the PRA's response."
The Issuers' arguments before the judge
i) The result of the conversion trigger for the ECNs now being far below the minimum CET1 ratio threshold in respect of which the stress testing is now carried out (as a result of a change in the Regulatory Capital Requirements) is that the conversion trigger will never be reached before the minimum stress test ratio is crossed. The ECNs therefore will not, as a matter of the language and purpose of the redemption provisions, be "taken into account... for the purposes of any "stress test" applied by the FSA" within the meaning of the definition of a CDE.
ii) The improvement in LBG's capital position by the end of 2013, such that the new CET1 pass mark was satisfied without needing to look at the ECNs, was as a result of the requirement imposed by the PRA in June 2013 that LBG increase its capital by more than £8bn. This was a change in the Regulatory Capital Requirements (being a "requirement specified by the [PRA] in relation to minimum... capital resources or capital") because it was a change in, and requirement as to, the minimum level of capital that LBG was required by the PRA to hold. Thus the ECNs were not, in fact, taken into account for the purposes of the PRA's most recent stress test.
The Trustee's arguments before the judge
i) A CDE had not occurred because the December 2014 stress test was not a relevant one for the purposes of the stress test "applied by the FSA in respect of the Consolidated Core Tier 1 Ratio" as specified in the definition of a CDE in condition 19 of the Terms and Conditions. That was because "Core Tier 1 capital" was defined in Condition 19 as:
"core tier one capital as defined by the FSA as in effect and applied (as supplemented by any published statement or guidance given by the FSA) as at 1 May 2009."
But, the Trustee submitted, the December 2014 stress test was not a stress test conducted by reference to a CT1 Ratio; on the contrary, it was a test applied in respect of a CET1 ratio.
ii) That, in any event, even if the 2014 December stress test was a relevant one, the ECNs had not "ceased to be taken into account in whole or in part for the purposes of any stress test applied by the FSA in respect of the Consolidated Core Tier 1 Ratio".
iii) That, even if the Issuers were correct to contend that the PRA's requirement for LBG to increase its capital could in theory give rise to a CDE, the Issuers' evidence did not prove that a CDE had in fact occurred on that basis.
"[N]othing has changed to bring about a CDE because, as has always been the case, the ECNs will be treated as converted and ordinary shares will be treated as created in any stress test if, in the hypothetical stress scenario, the risk weighted capital has diminished to the point at which the conversion of the ECNs would be triggered";
"the ECNs will still be relevant, if LBG were to fail the stress test, in ascertaining the extent of any shortfall in capital and the kind and extent of remedial action required." 
"46 . The definition of a CDE is not looking at the happenstance of the particular strength of LBG's capital and the particular composition of its capital at any one particular moment of time in the context of a particular stress test imposed by the regulator at that time. The FSA's statement on stress tests published on 28 May 2009, following earlier statements made on 14 November 2008 and 19 January 2009, makes clear that there were no fixed rules for the formulation of the severe hypothetical scenario for a stress test. The assumptions made by the regulator could and would involve an element of judgement about perceived economic risks and would change and evolve over time.
47. That explains why the expression "shall cease to be taken into account " is not looking at the actual performance of LBG on a particular stress test at any one particular moment of time but rather connotes a disallowance in principle of the ECNs on stress testing with continuing effect in the foreseeable future. The very word "Disqualification" in the expression "Capital Disqualification Event" also supports that connotation."
The submissions of the parties before this court
The Issuers' submissions
i) The requirement imposed on LBG by the PRA in 2013 that it should raise a total of £8.6bn further capital by the end of 2013 (about which there was no dispute) was a change in the Regulatory Capital Requirements as defined - i.e. "Any applicable requirements specified by the FSA in relation to the minimum margin of solvency or minimum capital resources or capital".
ii) As a direct consequence of this changed requirement, LBG substantially strengthened its capital position by 31 December 2013.
iii) As a result, LBG exceeded the 4.5% CET1 ratio in the December 2014 Stress Test. Accordingly, the question whether and when the ECNs would convert did not arise and they were not taken into account in the December 2014 Stress Test.
iv) It was therefore as a result of a change in the Regulatory Capital Requirements that LBG's CET1 ratio exceeded the 4.5% threshold in the December 2014 Stress Test, and the ECNs were not taken into account in that Stress Test. Accordingly a CDE had occurred.
The Trustee's submissions
i) First, this was not a case of a bilateral agreement between negotiating counterparties. Rather, the Conditions were included in the Exchange Offer Memorandum addressed to holders of Existing Securities, including some 123,000 retail investors, none of whom could have altered the words of the Exchange Offer Memorandum by negotiation: Bashir v Ali  EWCA Civ 707 at .
ii) Second, the language was clear and precise. For example, the choice to adopt a fixed definition of "core tier one capital as defined by the FSA as in effect as at 1 May 2009" provided a striking contrast with the other meanings of capital, which referred to "the meaning given to it by the FSA from time to time".
iii) Third, a reasonable addressee would have considered it extremely unlikely that the Issuers had made a mistake in defining a CDE, given (for example): the novelty, size and significance of the transaction to LBG; the obvious and lengthy involvement of sophisticated city lawyers; the importance of certainty in relation to the right to redeem both to LBG and to the noteholders; the precision of the drafting; and the contrast between the definition of CT1 capital and the other meanings of capital in the Conditions.
iv) Fourth, the results of a literal interpretation were not commercially absurd. Nor did they evidence a clear mistake.
v) Fifth, even had there been a mistake it was not clear what correction should be made. There were a number of equally plausible ways of changing the language of the clause, with potentially different effects. The judge's concept of the "top grade loss-absorbing capital (as defined from time to time by the regulator for the purpose of stress testing)" is not a clear alternative. There was no reason to expect that reasonable recipients of the exchange offer would each have reached the same conclusion about how the clause should be changed to correct the supposed mistake.
vi) Finally, the Issuers' position was inconsistent:
a) The 1 May 2009 definition of CT1 capital was at the heart of both the Conversion Trigger and the early redemption right based on the occurrence of a CDE; and the Conversion Trigger was part of the CDE definition, as the conversion of the ECNs at a CT1 ratio of 5% is one of the ways in which the ECNs may be taken into account in a stress test.
b) The Issuers contended that their updating construction should be applied to the CDE definition; but they did not wish to apply it to the Conversion Trigger, as to do so would be fatal to their case. It would alter the Conversion Trigger to 5% CET1 above the current hurdle of 4.5% CET1 thereby destroying their main argument on the occurrence of a CDE.
c) But an updating construction could not apply to the CDE definition alone. Rather, the role of the 1 May 2009 definition of CT1 capital in the Conversion Trigger must also be recognised, and the terms and conditions of the ECNs should be considered as a whole. When that approach was adopted, it became clear that it was impossible to change the CDE definition in isolation.
i) First: there was nothing said about any threshold or hurdle for any stress test. The figure of a 4% CT1 ratio was not referred to in the letter or anywhere in the three hundred and thirty-five pages of the memorandum.
ii) Second: the Exchange Offer Memorandum did not suggest that there was any relationship between any stress test threshold and the contractual Conversion Trigger of 5% or that such a relationship was important. For example, it was not said that the Conversion Trigger had been fixed at 5% because that was above the stress test threshold or sufficiently above it.
iii) Third: there was no discussion of the possibility of the regulator increasing capital requirements or changing the stress test threshold and no suggestion that if it were to do so, LBG might be entitled to redeem the ECNs.
i) LBG's understanding was that the regulatory climate was such that regulators would almost inevitably increase the severity of capital requirements and be likely to increase any stress test hurdle; and
ii) LBG itself intended to increase its own capital, whether or not as a result of regulatory requirements or independently. For example the Chairman's letter made clear that the board's target was to increase its CT1 capital ratio to more than 7%.
None of the Issuers' present construction arguments were reflected anywhere in the Exchange Offer Memorandum. A reader of the document could not reasonably have appreciated that there was a risk that, if the regulators sought to increase the stress test hurdle or LBG's capital position improved, the Issuers would be entitled to redeem the ECNs. If that indeed had been the position, and it had been explained in the Exchange Offer Memorandum, it was unlikely that holders of the existing securities would have given up their existing notes with a fixed maturity date in exchange for ECNs which bore the risk of being converted into ordinary shares in the likely and immediate future.
i) so far as limb one was concerned, that he was no longer prepared to include the ECNs as Lower Tier 2 capital, prior to conversion; and
ii) so far as limb two was concerned, that he was no longer prepared to count the ECNs as contingent CT1 capital for the purposes of a stress test; Mr Dicker gave as an illustration the exclusion of certain types of preference shares from CT1 capital; he also pointed to examples where there might be many factors affecting the contingency of the ECNs' conversion, and the regulator might take the view that the uncertainty surrounding those factors justified the disqualification of ECNs as contingent CT1 capital.
i) It could not sensibly have been intended that even a small increase in the level of the hurdle (if it resulted in the hurdle falling above the Conversion Trigger) would result in a CDE. No reasonable holder of ECNs would have contemplated that the Issuers could redeem merely because, for example, the hurdle applied by the regulator in a stress test increased from 4% to fractionally above 5% of the CT1 ratio. That would have fundamentally undermined the noteholders' rights.
ii) The Issuers' submission that the Conversion Trigger had to be above the hurdle rate to ensure that the ECNs assisted LBG in passing the stress test had no justification. The CDE definition did not refer to the concept of the ECNs assisting LBG to 'pass' stress tests nor indeed to the results of stress tests at all. Rather, the definition only required that the ECNs continued to be taken into account for the purposes of stress tests. The ECNs could be taken into account in two ways when they were issued. First, they could be taken into account as Ordinary Shares if they converted in the stress test. Second, as a result of the conversion feature, the regulator could take into account the existence of the contingent capital constituted by the ECNs (even in their unconverted state) in fashioning a response to the outcome of the stress test, even if the ECNs had not been taken into account for the purposes of passing the relevant regulatory hurdle; the existence of the contingent capital constituted by the ECNs in their unconverted form was a factor which the PRA could take into account in assessing the problem and in fashioning a regulatory response as part of the stress test process. The fact that LBG had £3.3 billion of contingent capital in the form of the ECNs to protect against a major disaster was not something the regulator would leave out of account altogether. As the regulatory materials made clear, stress testing was not a mechanistic "pass-fail" test. In that broader sense, the ECNs were still available to be taken into account in the PRA's fashioning of a regulatory response. In other words, submitted Mr Dicker, a stress test in fact encompassed the overall holistic assessment of capital adequacy and resilience by the regulator; that, in the absence of "disqualification", necessarily involved taking into account the impact of the ECNs at some stage.
iii) The Issuers were also wrong to say that inversion of the Conversion Trigger and the hurdle for stress tests currently in use by the PRA had rendered the ECNs useless to LBG in future stress tests. On the contrary, it remained possible that the ECNs would be treated as converting into Ordinary Shares in future stress tests and that the contingent capital constituted by unconverted ECNs would be taken into account in considering, as part of the stress test process, what (if any) capital actions might be required by LBG:
a) That the Conversion Trigger was 3.5% below the stress test hurdle by reference to LBG's accounts for 2013 was the result of the particular composition of LBG's asset base on that date. However the difference between the Conversion Trigger in CT1 terms and the hurdle in CET1 terms was not fixed. Rather, it was dynamic and, to an extent, within LBG's control. For example, as the deferred tax assets were used, the Conversion Trigger of a CT1 ratio of 5% and the hurdle of a CET1 ratio of 4.5% would converge and the amount of Ordinary Shares generated by the conversion of the ECNs might be sufficient to boost LBG's CET1 capital to a level above the hurdle.
b) Even where the Conversion Trigger was below the hurdle, the ECNs were not useless for stress testing purposes. The ECNs would still notionally convert into Ordinary Shares (and be counted as Ordinary Shares) if the Conversion Trigger occurred in the stress test. The limited consequence of the inversion of the Conversion Trigger and the hurdle is that, if LBG were to fall below the hurdle by only a small margin (so as to fall into the gap between the hurdle and the Conversion Trigger), the ECNs would not convert into Ordinary Shares in the stress test. However that limited possibility of non-conversion in certain circumstances did not mean that the ECNs had ceased to be taken into account within the meaning of the CDE definition. Nor did it mean that the ECNs had become useless for stress testing purposes.
c) On the contrary, if LBG were to fall below the hurdle by more than a marginal amount, the Conversion Trigger would be reached and the ECNs would convert into Ordinary Shares which would be taken into account in the stress test. In the 2014 stress test, for instance, the Co-operative Bank plc achieved a CET1 ratio of minus 2.6%. If the ECNs had been issued by the Co-operative Bank, rather than by the Issuers, there could be no doubt that they would have converted into Ordinary Shares which would have been taken into account as CET1 capital. This demonstrated that the Issuers were wrong to assert that the ECNs were now useless for stress testing purposes.
Discussion and determination
i) Whether the December 2014 stress test was a relevant stress test for the purposes of the definition of a CDE ("the preliminary issue");
ii) Whether the judge was correct to "read down" the clause in such a way so as to conclude that a CDE only occurred in circumstances where there was what the judge called a "disallowance in principle" of the use of ECNs in connection with the stress test ("the main construction issue");
iii) Whether, even on the assumption that the main construction issue was decided in favour of the Issuers, the ECNs had in fact "cease[d] to be taken into account in whole or in part .. for the purposes of any "stress test" applied by [the regulator] in respect of the [relevant ratio]" ("the taken into account issue"); and
a) because LBG had increased its CET1 capital, as a result of the changes to "Regulatory Capital Requirements" by the PRA, the fact that (as alleged by the Issuers) LBG was able to pass the December 2014 Stress Test without any need to consider the ECNs, meant that as a matter of construction a CDE had occurred; and
b) as a matter of fact, LBG had increased its CET1 capital, as a result of the changes to "Regulatory Capital Requirements" by the PRA and was accordingly able to pass the December 2014 Stress Test; ("the increase in capital issue").
The preliminary issue
"All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant."
"The establishment of a certain and constant trigger point for automatic conversion of the ECNs
At the time the ECNs were issued, it was anticipated that the definition of core capital might change as regulators, including the FSA, could impose more stringent capital requirements on banks: . Any change by the FSA in the definition of what constituted core tier 1 capital carried with it a risk that LBG's own core tier 1 capital would be reduced, even though there had not been any deterioration in the actual capitalisation of LBG.
In other words, there was a risk that a unilateral change to the meaning of core capital by the FSA (or a successor regulator) might, without anything more, result in LBG's core tier 1 capital falling below 5% of its risk-weighted assets and trigger the automatic conversion of the ECNs, and the dilution of LBG's shareholding.
In order to remove this uncertainty from the perspective of both LBG and the holders of the ECNs, it was agreed between LBG and the FSA that, for the purposes of the automatic conversion trigger set out at Condition 7(a) of the ECNs, the numerator of the relevant ratio would be a fixed definition of core capital, namely the definition of core tier 1 capital in place at the time the ECNs were issued, as contained in Condition 19 of the ECNs at Schedule 4, . The definition in place on 1 May 2009 was contained in the letter of the same date from Paul Sharma of the FSA to Simon Hills of the British Banker's Association."
i) At the time of the issue of the ECNs, it was expected and anticipated that regulatory requirements in relation to the maintenance and adequacy of banks' and other financial institutions' capital would be strengthened and changed; see for example the announcements referred to in paragraph 15 above. Indeed, it was the Trustee's own evidence that the provision was drafted against the backdrop of a specific expectation that regulatory requirements in relation to what could constitute CT1 capital might change. It was also common ground that it was already anticipated when the ECNs were issued that there would be changes to the regulatory regime to make capital requirements more robust which would involve amending or superseding the definition of CT1 capital in the near future.
ii) The words used in the definition of a CDE in respect of both limbs necessarily envisage that the stress testing carried out by the regulator would be a dynamic process and might change. The term "Regulatory Capital Requirements" itself, by use of the word "any" in its definition, envisage an evolving process, and the reference in the second limb to "any changes", likewise clearly anticipate that there may be changes to the applicable concept of CT1 capital and the regulator's requirements in relation to the minimum margin of solvency or the minimum capital or capital resources which LBG must maintain. It likewise must have been obvious that in such circumstances the criteria or parameters of any stress test, including relevant capital ratios, might change from time to time and that, as a result, the ECNs might no longer be taken into account for the purposes of stress testing.
iii) It would thus have been obvious at the time of issue of the ECNs that, if the concept of CT1 capital (or its application) was amended or revised in any way, the regulator would stop using the 1 May 2009 version for the purposes of stress testing and would use the revised version, and any consequentially revised capital ratio, whatever they might be, rather than the now redundant definitions of capital and capital ratio. It cannot sensibly have been the expectation of the parties that the regulator would thereafter continue to apply a stress test in respect of a historic or superseded minimum capital ratio.
iv) The aim and commercial purpose of the option contained in Condition 8(e) is to enable LBG to redeem instruments which no longer serve their function as stress test capital because of changes in the regulatory requirements about capital. It would undermine this aim and purpose if a CDE was limited only to a stress test to be carried out by reference to the fixed May 2009 definition of "Core Tier 1 Capital" and "Consolidated Core Tier 1 Capital Ratio", but not to stress tests applied by the regulator using revised criteria or definitions.
v) It would make no commercial sense, against this background, to limit LBG's ability to redeem the ECNs only to a situation in which they failed to be taken into account in a stress test using the definition which was about to be replaced i.e., to make the ECNs capable of redemption on this ground only during the limited window in which the FSA continued to conduct stress tests based on the 1 May 2009 definition of CT1 capital and a CT1 capital ratio. As Mr Miles pointed out, in this regard:
a) The ECNs were (subject to redemption for a CDE) long dated instruments in some cases up to 23 years (2032). The CDE provisions were intended to give LBG a right of redemption in the event that regulatory changes meant the ECNs were no longer taken into account for the purposes of stress tests. On the Trustee's case, however, as soon as the anticipated change occurred, it would be impossible for a CDE under the second limb to occur.
b) The purpose of the ECNs was to assist LBG in meeting its minimum capital requirements in the context of the regulator's stress testing.
c) The only contractual purpose of the term "Capital Disqualification Event" in the documents was to enable LBG to redeem the ECNs if they ceased to meet that purpose by reason of a change in the Regulatory Capital Requirements (and therefore ceased to provide any benefit to LBG).
d) That purpose would be defeated if the very change to the Regulatory Capital Requirements that was anticipated, namely a change in the definition of what constituted tier 1 capital, would mean that the ECNs could never be redeemed on this basis, as (self-evidently) no stress testing would any longer be carried out in respect of the historic definition.
"5.1 ECNs may not be a suitable investment for all investors
Each potential investor in the ECNs must determine the suitability of that investment in light of its own circumstances. In particular, each potential investor should:
(i) have sufficient knowledge and experience to make a meaningful evaluation of the ECNs, the merits and risks of investing in the ECNs and the information contained or incorporated by reference in this document or any applicable supplement;
(ii) have access to, and knowledge of, appropriate analytical tools to evaluate, in the context of its particular financial situation, an investment in the ECNs and the impact such investment will have on its overall investment portfolio;
(iii) understand thoroughly the terms of the ECNs and be familiar with the behaviour of financial markets in which they participate; and
(iv) be able to evaluate (either alone or with the help of a financial adviser) possible scenarios for economic, interest rate and other factors that may affect its investment and its ability to bear the applicable risks.
The ECNs are complex financial instruments and such instruments may be purchased by potential investors as a way to reduce risk or enhance yield with an understood, measured, appropriate addition of risk to their overall portfolios. A potential investor should not invest in ECNs unless it has the expertise (either alone or with a financial adviser) to evaluate how the ECNs will perform under changing conditions, the resulting effects on the value of the ECNs and the impact this investment will have on the potential investor's overall investment portfolio."
"there are bound to be ambiguities, infelicities and inconsistencies. An over-literal interpretation of one provision without regard to the whole may distort or frustrate the commercial purpose."
(See also paragraph 100 of the judgment of Lord Neuberger in the Court of Appeal  EWCA Civ 1303.)
The main construction issue
The taken into account issue
The increase in capital issue
i) the Issuers have not shown that it was a result of regulatory requirements on the part of the PRA that LBG raised additional CET1 capital in 2013;
ii) that, even if such was the case, the Issuers could not say that the PRA's requirement caused the Conversion Trigger (i.e. a 5% CT1 ratio) not to occur in the 2014 stress test. On the Issuers' evidence the Conversion Trigger would not have been reached in any event.
Lord Justice Briggs:
Lord Justice Sales:
Note 1 Colloquially referred to as CoCos". [Back] Note 2 The coupon payments across all series amount to some £940,000 per day. [Back] Note 3 The Trust Deed was entered into between the Issuers, LBG, Lloyds TSB Bank plc and the Trustee. HREF='#back3'>[Back] Note 4  EWHC 1560 (Ch). [Back] Note 5 As at that date, HM Treasury owned a 43.4 per cent holding in LBG. [Back] Note 6 See GENPRU 2.2.1 55R and 2.2.1 56G.
[Back] Note 7 All bolded text in this judgment is for emphasis and is added. [Back] Note 8 This was to be implemented by 31 December 2010. [Back] Note 9 Among others, approximately 123,000 retail investors were sent Exchange Offer Memorandum. Apparently about 86% of those retail investors accepted the offer. [Back] Note 10 See part VII of the Exchange Offer Memorandum. [Back] Note 11 See Part A of Appendix 6 to the Exchange Offer Memorandum. [Back] Note 12 This deed set out certain of the terms relating to the conversion of the ECNs and in particular the calculation of the conversion price at which the ECNs would be converted into ordinary shares. Its provisions are not material for present purposes. [Back] Note 13 See paragraph 40 of the judgment. [Back] Note 14 2013/36/EU. [Back] Note 15 575/2013. [Back] Note 16 The FPC was established under the Bank of England Act 1998 through amendments made in the Financial Services Act 2012. The legislation establishing the FPC actually came into force on 1 April 2013. The objectives of the FPC are to exercise its functions with a view to contributing to the achievement by the Bank of England of its financial stability objective and, subject to that, supporting the economic policy of the government. The PRA was also established under the Financial Services Act 2012. [Back] Note 17 See paragraph 18 of the judgment. [Back] Note 18 See page 14 of the transcript of the second day of the appeal. [Back] Note 19 See paragraph 38 of the judgment. [Back] Note 20 See paragraph 38 of the judgment. [Back] Note 21 See paragraph 42 of the judgment. [Back] Note 22 See paragraph 47 of the Judgment. [Back] Note 23 See paragraphs 47 and 62 of the judgment. [Back] Note 24 See paragraph 58 of the judgment. [Back] Note 25 See paragraph 58 of the judgment. [Back] Note 26 See paragraph 55 of the judgment. [Back] Note 27 See paragraph 42 of the judgment. [Back] Note 28 See paragraphs 46 to 50 of the judgment. [Back] Note 29 See the judgment paragraph 40.
[Back] Note 30 See paragraph 43 of the judgment. [Back] Note 31 See paragraph 12 above. [Back] Note 32 See paragraph 14 above.
[Back] Note 33 See paragraphs 18 (v), (vi) and (vii) above. [Back] Note 34 I.e. the requirement under CRD IV for a minimum CET1 capital ratio of 4% as from 1 January 2014, and 4.5% from 1 January 2015. [Back]
Note 1 Colloquially referred to as CoCos". [Back]
Note 2 The coupon payments across all series amount to some £940,000 per day. [Back]
Note 3 The Trust Deed was entered into between the Issuers, LBG, Lloyds TSB Bank plc and the Trustee. HREF='#back3'>[Back]
Note 4  EWHC 1560 (Ch). [Back]
Note 5 As at that date, HM Treasury owned a 43.4 per cent holding in LBG. [Back]
Note 6 See GENPRU 2.2.1 55R and 2.2.1 56G. [Back]
Note 7 All bolded text in this judgment is for emphasis and is added. [Back]
Note 8 This was to be implemented by 31 December 2010. [Back]
Note 9 Among others, approximately 123,000 retail investors were sent Exchange Offer Memorandum. Apparently about 86% of those retail investors accepted the offer. [Back]
Note 10 See part VII of the Exchange Offer Memorandum. [Back]
Note 11 See Part A of Appendix 6 to the Exchange Offer Memorandum. [Back]
Note 12 This deed set out certain of the terms relating to the conversion of the ECNs and in particular the calculation of the conversion price at which the ECNs would be converted into ordinary shares. Its provisions are not material for present purposes. [Back]
Note 13 See paragraph 40 of the judgment. [Back]
Note 14 2013/36/EU. [Back]
Note 15 575/2013. [Back]
Note 16 The FPC was established under the Bank of England Act 1998 through amendments made in the Financial Services Act 2012. The legislation establishing the FPC actually came into force on 1 April 2013. The objectives of the FPC are to exercise its functions with a view to contributing to the achievement by the Bank of England of its financial stability objective and, subject to that, supporting the economic policy of the government. The PRA was also established under the Financial Services Act 2012. [Back]
Note 17 See paragraph 18 of the judgment. [Back]
Note 18 See page 14 of the transcript of the second day of the appeal. [Back]
Note 19 See paragraph 38 of the judgment. [Back]
Note 20 See paragraph 38 of the judgment. [Back]
Note 21 See paragraph 42 of the judgment. [Back]
Note 22 See paragraph 47 of the Judgment. [Back]
Note 23 See paragraphs 47 and 62 of the judgment. [Back]
Note 24 See paragraph 58 of the judgment. [Back]
Note 25 See paragraph 58 of the judgment. [Back]
Note 26 See paragraph 55 of the judgment. [Back]
Note 27 See paragraph 42 of the judgment. [Back]
Note 28 See paragraphs 46 to 50 of the judgment. [Back]
Note 29 See the judgment paragraph 40. [Back]
Note 30 See paragraph 43 of the judgment. [Back]
Note 31 See paragraph 12 above. [Back]
Note 32 See paragraph 14 above. [Back]
Note 33 See paragraphs 18 (v), (vi) and (vii) above. [Back]
Note 34 I.e. the requirement under CRD IV for a minimum CET1 capital ratio of 4% as from 1 January 2014, and 4.5% from 1 January 2015. [Back]