Contractual interpretation – objective commercial purpose prevails over insolvency concerns

BACKGROUND

Between 2006 and 2008, NatWest (previously ABN Amro) entered into seven Deeds of Indemnity (the "Deeds") with CMIS (previously a subsidiary of General Motors) to manage financial risks associated with the securitisation of residential mortgages.

Under the Deeds, CMIS covenanted to pay NatWest any "EMAC Indemnifiable Amounts" due under the agreement on an "on demand" basis, in its capacity as the "primary obligor". CMIS paid the amounts to NatWest for about a decade.

From January 2017, CMIS refused to pay such amounts to NatWest, contending that it was not liable under the proper construction of the Deeds.

CMIS argued that the Deeds were construed as contracts of guarantee (a secondary obligation conditional upon payment default by the principal debtor), rather than contracts of indemnity (a primary obligation to pay for a cost or reimburse a loss).

RELEVANT LEGAL PRINCIPLES IN CONTRACT INTERPRETATION

In interpreting the Deeds and other securitisation documents together, Mr Nigel Cooper KC (sitting as a High Court Judge), referred to the common law principle of contractual interpretation: the exercise is a unitary one in which the Court must consider the following factors[1]:

1. the objective meaning of the language in the contracts;
2. the relevant commercial context / surrounding circumstances; and
3. the commercial consequences of rival constructions.

If there are two possible constructions, the Court is entitled to prefer the construction that is consistent with business common sense and to reject the other, or to prefer the construction that produces the more commercial result.

COURT'S DECISION

• Language used in the contract

The judge held that while neither the title nor language of the Deeds was necessarily conclusive as to the nature of the parties' agreement, the choice of title and or language does carry significant weight in determining the nature of the contract.

In this case, the Deeds are entitled "Deeds of Indemnity", and the verb "indemnify" appears twice in the recital. The words "guarantee" or "guarantor" do not appear anywhere.

Furthermore, the judge observed that each sub-clause in the covenants is in "on demand" terms and gives rise to obligations of indemnity. This was further reinforced by CMIS's acceptance of a role as "primary obligor", which is consistent with the primary obligation found in an indemnity.

• Business common sense and parties' commercial intentions

The judge highlighted that the Deeds were advised on and drafted by very skilled lawyers who were very experienced in securitisation structures of the type in issue. Those advisers would have been well aware of the difference between contracts of guarantee and contracts of indemnity, as well as the potential impact of language.

The bespoke nature of the Deeds reflects the parties' commercial intentions to ensure that if CMIS failed to pay the "EMAC Indemnifiable Amounts" to NatWest, then NatWest was entitled to recover those sums from CMIS.

The judge's view was that "it cannot be said that the possibility that CMIS owes NatWest such a significant sum is such a commercially absurd result that … this is not what the parties intended".

The judge concluded that if the Deeds were intended to have the limited effect suggested by CMIS, then they would have been drafted in substantially different form.

• Objective assessment where there is lack of witness evidence

The judge acknowledged, however, that the difficulty in this case was the lack of contemporaneous evidence.

As CMIS said, "[t]he deed was signed by executives at General Motors and ABN Amro, both of which notoriously collapsed during the crisis. The protagonists have now moved on …" and "no one has been able to adduce any meaningful evidence".

In such circumstances, he concluded that the more reliable guide would be to analyse objectively the language of the Deeds, including their recitals, to understand the proper construction of the Deeds.  It would be contrary to the spirit of the agreement to speculate about what the true commercial purpose of the parties would have been.

• Risk of insolvency is not a material factor

CMIS argued that the scale of payment demanded by NatWest was so significant that it may lead to CMIS becoming insolvent so that the outcome could result in CMIS not being able to carry out its obligations as Issuer Administrator and its obligations as original lender to the mortgagors.  CMIS contended that the parties to the Deeds could not have intended CMIS to become insolvent during the life of the transactions.

The judge rejected this argument, stating that "there is no evidence that the risk of such significant exposures was in the mind of either party at the time the Deeds were concluded".

In fact, he observed that the risk that CMIS could become insolvent was a risk that the Noteholders were exposed to generally and it was expressly contemplated by some of the securitisation documentation.

In summing up, the judge said, in relying on the approach taken in Wood v Capita[2] and Arnold v Britton[3], it is possible that one side may have agreed to something which with hindsight did not serve its interest.

PRACTICAL CONSIDERATIONS FOR CLIENTS

Contractual interpretation is a key battleground in commercial contracts. 

When drafting a contract, it is important to consider the objective assessment of each provision, its intended consequences, and the overall commercial purpose of the agreement.

The judgment serves as a good reminder that in construing a contract, the Court will consider the objective language used by the parties in the contract and what is consistent with business common sense.  The Court will not speculate or retrospectively re-construct the commercial intentions of the parties.

Therefore, when negotiating a contract, it is imperative that the parties have in mind the overall aim of the deal and ensure that any language used stands up to scrutiny as time passes.