England and Wales Court of Appeal (Civil Division) Decisions

IN THE COURT OF APPEAL (CIVIL DIVISION)
ON APPEAL FROM THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
THE CHANCELLOR OF THE HIGH COURT
HC-2015-001336

		Royal Courts of Justice Strand, London, WC2A 2LL
		10/12/2015

Lady Justice Gloster:

Introduction

1. This is an appeal by the defendants, LBG Capital No. 1 Plc and LBG Capital No. 2 Plc ("the Issuers"), two special-purpose companies in the Lloyds Banking Group ("LBG"), against an order made by the Chancellor ("the judge") dated 3 June 2015. By that order the judge decided against the Issuers on a point of contractual interpretation heard as an expedited Part 8 claim.
2. The issue, in summary, is whether the Issuers are entitled to redeem, pursuant to their terms, certain contingent convertible securities^[1] known as Enhanced Capital Notes ("ECNs") issued in 2009, in advance of their respective maturity dates. There are some £3.3 billion worth of ECNs outstanding which carry a high coupon (averaging 10.33%)^[2]. Such a redemption can take place if a Capital Disqualification Event ("CDE"), as defined in condition 19 ("Condition 19") of the terms and conditions of the ECNs, has occurred and is continuing.
3. The claimant, BNY Mellon Corporate Trustee Services Ltd ("the Trustee"), claims as trustee of a trust deed dated 1 December 2009 ("the Trust Deed")^[3], which constituted a programme for the issue from time to time of the ECNs. The terms and conditions to which the ECNs are subject are set out in Part A of schedule 4 to the Trust Deed. The Trustee issued the Part 8 proceedings on 31 March 2015, seeking a declaration as to whether a CDE had occurred. The Issuers contend that a CDE has occurred and that they are accordingly entitled to redeem the ECNs. The Trustee (on behalf of the ECN noteholders) contends that no such CDE has occurred.
4. In his judgment^[4] the judge held that no CDE had occurred. That was because, on his view, on the true construction of the ECNs, they had not ceased "to be taken into account for the purposes of any stress test" applied by the Prudential Regulatory Authority ("PRA") "in respect of" the ratio between LBG's top-grade loss absorbing capital and its risk-weighted assets. Accordingly, in the judge's view, the Issuers were not entitled to redeem the ECNs following a stress test conducted by the PRA in December 2014 and must continue to pay the interest due under them. The judge gave permission to the Issuers to appeal against his order.
5. The appeal was heard on an expedited basis on 26 and 27 August 2015. On the appeal, Mr Robert Miles QC and Mr Gregory Denton-Cox appeared on behalf of the Issuers and Mr Robin Dicker QC and Mr Stephen Robins appeared on behalf of the Trustee.

Pre-contractual background

6. Following the financial crisis in 2008, banks and other financial institutions were required by regulators to increase their capital.
7. At the time when the ECNs were issued, LBG was subject to the capital adequacy requirements in the Second Basel Accord ("Basel II"), implemented through Directive 2006/48/EC, known as the Capital Requirements Directive ("CRD I")^[5]. This was interpreted by LBG's then prudential regulator, the Financial Services Authority ("the FSA"), in the manner set out in the General Prudential Sourcebook ("GENPRU") published by the FSA, which, together with stress testing carried out by the FSA, formed the basis of the FSA's capital adequacy regime.
8. Under Basel II, the capital of financial institutions was arranged in tiers. The highest tier was known as core tier 1 ("CT1"). This was calculated by adding the fully paid-up ordinary shares and retained earnings (and other similar items) before deducting certain more vulnerable categories of asset on the balance sheet. For example, to calculate CT1 capital, it was necessary to deduct any goodwill included in the balance sheet^[6]. A bank's CT1 capital was part of its CT1 ratio, being the bank's CT1 capital divided by the value of its risk-weighted assets. The second tier of capital was divided into "upper tier 2 capital" and "lower tier 2 capital". The distinction is not relevant for present purposes but at the time lower tier 2 capital included non-perpetual capital such as dated subordinated debt. So far as UK institutions were concerned, the FSA would define CT1 capital from time to time in its published statements.
9. Risk-weighted assets are calculated by adjusting each asset class for risk in order to determine a bank's exposure to potential losses in times of economic stress. Regulators then use the risk weighted total to calculate how much loss-absorbing capital a bank needs to sustain it through difficult markets. The risk weighting varies according to each asset's potential for default and what the likely losses would be in case of default. For example, a secured loan is regarded as less risky than one that is unsecured. Thus a high CT1 ratio indicates that the bank could sustain a high level of losses without encountering financial difficulties, and a low CT1 ratio the opposite.
10. Stress testing was and is a significant element of the process of determining the minimum capital resources or capital required to be maintained by banks. Various scenarios, and economic assumptions, designed to simulate adverse economic conditions, are applied. The profit and losses and balance sheet of an institution, including its capital and risk-weighted assets, are modelled against the assumptions in those scenarios and the bank is required to show that it would have an adequate ratio of capital (of a specified kind) to such modelled assets. The results of stress testing show the impact of the stress scenarios on an institution's core capital ratio, CT1 ratio and/or its total capital ratio; banks are required to hold "sufficient" levels of each.
11. Prior to the issue of the ECNs, the FSA, as part of its developing supervisory regime following the financial crisis, had been conducting ad hoc stress tests of the capital of banks and building societies, including LBG, to identify their vulnerabilities in a future severe downturn. It was common ground before the judge that the FSA anticipated that the application of stress tests would continue to evolve, and that the precise parameters would continue to change. It was also common ground that the regulators had said that the capital framework for financial institutions would be subject to major reforms and that the expectation was that the framework would be tightened and that regulatory capital requirements would become stricter.
12. On 14 November 2008, the FSA issued its "Statement on Capital Approach Utilised in UK Bank Recapitalisation Package". The statement included a requirement that banks maintained a ratio of CT1 capital to risk-weighted assets of at least 4% after applying an FSA prescribed stress scenario which anticipated significant future losses ("the Capital Framework"). This requirement was intended to ensure that "the amount of capital for each institution would sustain confidence in that institution", and 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". In particular the statement included the following passage:

"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."

13. The stress testing process was therefore seeking to ensure that banks could remain as a going concern even in the prescribed stress scenario. The Capital Framework, and in particular the 4% ratio of CT1 capital to risk weighted assets in stressed scenarios, was confirmed in the FSA's "Statement on Regulatory Approach to Bank Capital" issued on 19 January 2009.
14. A good description of the function of stress tests as carried out by the FSA at the time, and the potential for future evolution, was contained in the FSA's statement on its use of stress tests dated 28 May 2009. This was the most recent statement by the FSA in relation to stress tests published prior to the issue of the ECNs:

"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 19^th 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^[7].]

15. Further changes subjecting financial institutions to more stringent regulatory capital requirements occurred or were announced during 2009. Thus, for example:

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.^[8] 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.:

"FSA response

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."

16. In March 2009 the FSA stress-tested LBG against a benchmark of a ratio of CT1 capital to risk weighted assets of 4%. LBG was found by the FSA to have a shortfall against that benchmark of £24 billion to £29 billion of CT1 capital. LBG was required by the FSA to take action to correct the position by increasing its core capital ratio. LBG initially intended to participate in the Government's Asset Protection Scheme ("GAPS"), and announced its intention to do so, but subsequently decided that it would be preferable to improve its own capital position without participating in GAPS. In part this was because of the substantial participation fee, in excess of £15 billion, which LBG would have been required to pay to participate in GAPS. To avoid paying this LBG was required to demonstrate to the FSA that it had a further £21 billion CT1 capital.
17. Consequently, in late 2009 LBG embarked on a programme of raising further CT1 capital through the private capital markets by: (1) raising further equity of £13.5 billion by way of a rights issue; and (2) carrying out exchange offers, under which holders of certain existing securities issued by LBG, which did not qualify as CT1 capital ("the Existing Securities"), were invited to exchange those securities for ECNs. The Existing Securities included various notes and securities paying fixed rates (being various rates of up to 15% per annum) in perpetuity.
18. The rationale for, and terms of, the ECNs were set out in a formal invitation by the Issuers ("the Exchange Offer Memorandum")^[9] dated 3 November 2009 to the holders of the Existing Securities to invite them to exchange their Existing Securities for ECNs. The Exchange Offer Memorandum included a letter from Sir Winfried Bischoff, Chairman of LBG ("the Chairman's letter"). The judge viewed the Chairman's letter as an important part of the factual matrix. In summary the letter explained that:

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."

19. The Exchange Offer Memorandum set out^[10] an overview of the proposed terms of the ECNs as well as the full terms and conditions of the ECNs^[11] which were in substantially the same terms as they subsequently appeared in Part A of Schedule 4 to the Trust Deed. These included the terms relating to the Issuers' right to redeem the ECNs as well as the definition of a CDE. I set out the relevant terms and conditions below.
20. In relation to risk factors, the Exchange Offer Memorandum identified inter alia the following factors in relation to the possibility of redemption of the ECNs:

"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."

21. The purpose of the Proposals was also explained by Sir Winfried Bischoff and other directors at a presentation and Q&A session on 3 November 2009. Thus Sir Winfried said that the Proposals represented "a transformational event for our organisation" which "creates a strong platform that ensures the Group is able to meet the FSA's stress test"; and Tim Tookey (LBG's Group Finance Director) said that "the proposals will create a significant capital buffer from new contingent core tier 1 capital and will establish a high quality capital base that meets the FSA's severe stress test requirements..."

The issue of the ECNs and their current profile

22. Following the offers made in the Exchange Offer Memorandum, £8.3 billion of ECNs were issued in December 2009 in accordance with the terms and conditions set out in Schedule 4 to the Trust Deed, and a Deed Poll executed by LBG^[12]. £5 billion of those ECNs have recently been exchanged for other instruments, and approximately £3.3 billion across 33 series remain in issue in their original form. The outstanding ECNs have various maturity dates from 2019 to 2032 when the Issuers are required to repay the capital amounts of the ECNs. Until then, or earlier redemption where permitted, interest is payable on the ECNs at an average rate across the outstanding ECNs of around 10.33%. The ECNs are held by a large number of retail investors as well as by institutional investors. As already explained, at the time of their issue the ECNs qualified 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 per cent., thereby increasing LBG's CT1 capital at such time.

The terms and conditions of the ECNs

23. The relevant terms and conditions of the ECNs, which are set out in Part A of Schedule 4 to the Trust Deed (which by clause 1.5 of the Trust Deed was stated to be part of the Trust Deed and to have effect accordingly), are the following:

"7. Conversion

(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.

……

19. Definitions

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".

24. The definition in the Deed Poll of the FSA (which was also applicable for the purposes of the terms and conditions) was:

"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

25. It was common ground before the judge that, at the time when the ECNs were issued, it was already anticipated that there would be further changes to the regulatory regime which would make the capital requirements more robust and would involve amending or superseding the definition of CT1 capital^[13]. The subsequent history of regulatory changes post-dating the issue of the ECNs and the actions taken by LBG to improve its capital position as a result, are relevant to a determination as to whether a CDE had occurred. It was common ground that post-December events and statements (such as, for example, those made by LBG in the ATI exchange offer memorandum quoted below) were not permissible aids to the interpretation of the terms of the ECNs.
26. In 2010 and 2011, two further EU capital requirement directives, known as "CRD II" and "CRD III" respectively, came into force. However they did not alter the concept of core regulatory capital such as to affect the status of the ECNs in the stress tests conducted prior to 2014.
27. The key regulatory changes for the purposes of this appeal related to the implementation of the Third Basel Accord ("Basel III") by the EU Fourth Capital Requirements Directive ("CRD IV")^[14] and the Capital Requirements Regulation ("the CRR")^[15] (together referred to in the judgment and this judgment as "the CRD IV package"). The CRD IV package:

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.

28. In particular the CRR expressly provided that convertible capital instruments such as the ECNs would only qualify as AT1 Capital, if the trigger for conversion was set at a CET1 ratio of 5.125% or higher, which was above the corresponding minimum CET1 permitted ratio of 4%/4.5%.
29. CET1 capital is more restrictive than CT1 capital. The new regime changed the manner in which financial institutions' capital was calculated. Thus under CET1, as opposed to under CT1, more categories of assets in the balance sheet must be deducted, in addition to goodwill. Thus, for example, the following fall to be deducted for the purposes of CET1 capital:

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.

30. The result of the requirement to deduct such items meant that, in some cases, a bank's CT1 capital (and CT1 ratio) would be different from its CET1 capital (and CET1 ratio). For example, a bank which had substantial deferred tax assets and/or a large holding in another financial institution would find that its CET1 capital was substantially lower than its CT1 capital, whereas a bank which owned no assets in the newly deductible classes would find that its CET1 capital and its CT1 capital were broadly the same.
31. In 2013, the PRA, as successor to the FSA, required LBG to raise a substantial amount of further capital, in order to meet (and exceed) the new minimum capital requirements. This was preceded by various regulatory statements from the regulators.
32. On 27 March 2013 the interim Financial Policy Committee of the Bank of England ("the FPC")^[16] issued a news release recommending amongst other things that:

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.

33. On 20 June 2013, the FPC issued a further news release, setting out the results of a 'capital shortfall exercise' carried out by the PRA with regard to major UK banks including LBG. That showed that the PRA had announced that various banks, including LBG, fell short of the 7% adjusted CET1 ratio standard, and that it was requiring LBG to raise a further £7 billion of capital (in addition to £1.6 billion that would be raised by capital actions already planned by LBG) by the end of 2013. In its material parts the document read:

"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.

34. In August 2013, the PRA published Consultation Paper 5/13, entitled 'Strengthening capital standards: implementing CRD IV". Draft Supervisory Statement 7/13, which formed an appendix to that paper, dealt with the eligibility of 'Co-Cos' and other convertible capital instruments to count as core capital for the purposes of regulatory stress testing. The PRA described those instruments which it intended to consider as eligible as AT1 securities with 'ATI triggers'. Given that, as already stated, the CRR provided that convertible ATI capital instruments should have a minimum conversion trigger set at a ratio of CET1 capital to risk weighted assets of 5.125%, the PRA's draft statement stated that:

"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."

35. In October 2013, the Bank of England issued a discussion paper, "A framework for stress testing the UK banking system". The FPC had recommended in March 2013 that the PRA develop proposals for regular stress testing of the UK banking system, to assess capital adequacy. The Bank of England paper set out the main features of the proposed stress testing framework. It described the stress testing process as follows:

"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."

36. In November 2013, the PRA announced in its Supervisory Statement SS3/13 that, from 1 January 2014, it would no longer monitor the capital of banks by reference to the 1 May 2009 definition of CT1 capital.
37. In December 2013 the PRA published its "Supervisory Statement SS7/13 CRD IV and capital". As foreshadowed in the earlier Consultation Paper 5/13, the PRA required AT1 instruments to contain a conversion trigger of at least 5.125 % CET1, but allowed firms to select a higher trigger.
38. It was against this regulatory background that, by 31 December 2013, LBG had substantially strengthened its capital position. According to its Chief Executive's statement which accompanied LBG's 2013 annual accounts:

"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.

39. As a further measure of capital improvement, LBG formulated a further exchange offer (capped at £5bn) whereby holders of the ECNs (i.e. lower core tier 2 capital) were invited to exchange them for new securities which were to qualify as ATI capital within the meaning of the CRD IV Package ("the AT1 Securities"). The Exchange Offer Memorandum for this offer ("the 2014 AT1 Memorandum") made it clear that (a) for the new securities to qualify as AT1 Securities under the CRD IV Package they needed to trigger when LBG's CET1 capital ratio fell to 5.125%; and (b) the PRA had confirmed in late 2013 that such a conversion trigger might not prevent the failure of a firm and that it expected UK firms to meet a 7% CET1 capital ratio. As a consequence, the conversion trigger for the proposed AT1 Securities was therefore set at a 7% CET1 capital ratio.
40. The 2014 AT1 Memorandum also stated under the heading "Purpose of the Exchange Offers:"

"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."

41. The exchange took place over the various series of ECNs in March and April 2014. Approximately £5bn worth of ECNs were exchanged for ATI Securities, with approximately £3.3bn of ECNs remaining outstanding following the exchange exercise.
42. In April 2014, the Bank of England stated in its document "Stress testing the UK banking system: Key elements of the 2014 stress test" that the previous CT1 capital ratio requirement of 4% in the event of the FSA's stressed scenario would be replaced with what was often referred to as "a hurdle rate" of a ratio of CET1 to risk-weighted assets of 4.5%. The document made clear that the PRA's evaluation of the capital adequacy of an individual institution was not dependent upon a simple 'pass/fail' exercise in relation to the stress test. It stated:

"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.

43. Consistent with the statements made in relation to the stress testing regime, as summarised above, in the stress test carried out by the PRA in December 2014 ("the December 2014 Stress Test"), the PRA tested whether UK financial institutions' CET1 ratio (to risk weighted assets) would remain above a minimum 4.5% CET1 ratio threshold in the stressed projections, using figures based on the respective financial positions of the banks as shown in their balance sheets as at 31 December 2013. The Bank of England published the results of the 2014 stress test in a document entitled "Stress testing the UK banking system: 2014 results". As the judge summarised^[17], the results of the stress test so far as LBG was concerned were as follows:

"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^[18], 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.

44. In its document, the Bank of England made clear that there was a distinction between the results of the stress test itself and any consequential action which regulators might take by way of regulatory action in response. Thus the document stated:

"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."

45. Indeed, it was common ground before the judge, and before this court, that the ECNs were not taken into account by the PRA in the December 2014 stress test because LBG remained above the minimum capital threshold in that stress test – in that its CET1 ratio did not fall below 4.5% - by reason of the strength of its capital position without any need to take into account the ECNs, the conversion trigger point for which was well below the new CET1 capital pass ratio.
46. Following the December 2014 Stress Test, the PRA nonetheless judged that LBG's capital position required to be strengthened but noted changes and improvements made since the 2013 year-end including the exchange in April 2014 of £5.3 billion of ECNs for "the high-trigger AT1 Securities". The PRA did not refer to the continued existence of the remaining ECNs as being a factor in the decision not to require the submission of a revised plan.
47. On 16 December 2014 LBG announced that the ECNs had not been taken into account in the December 2014 stress test and that accordingly a CDE had occurred. It stated that it intended to approach the PRA to seek the appropriate permission to redeem 23 series of outstanding ECNs.
48. The PRA's consent to the proposed redemption of the ECNs was necessary because: (1) condition 8(b) of the ECNs requires one month's notice to the PRA, and non-objection from the PRA; and (2) Articles 77 and 78 of the CRR require the prior permission of the PRA for the redemption of any Tier 2 instruments prior to their contractual maturity. Permission was received from the PRA on 31 March 2015. It was common ground that this was based on LBG's capital position rather than any determination by the PRA as to whether a CDE had in fact taken place. LBG agreed to defer redemption in the light of the Trustee's intention to issue the present proceedings, the Trustee having been directed in writing by the requisite proportion of one series of noteholders to issue a claim seeking a declaration that the Issuers were not entitled to redeem the ECNs.
49. There was subsequently further correspondence between inter alios holders of ECNs ("the ECN Holders"), the PRA and Allen & Overy, solicitors for the Trustee.
50. In response to enquiries from the ECN Holders, the PRA stated in a letter dated 17 March 2015 as follows:

"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.

Other observations

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."

51. On 17 April 2015 Allen & Overy, solicitors acting on behalf of the Trustee, wrote in response to this letter as follows:

"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."

52. The PRA responded in a letter dated 23 April as follows::

"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

53. In summary, before the judge, the Issuers submitted that a CDE had occurred, for two reasons:

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

54. In summary, the Trustee submitted:

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.

The judgment

55. The judge rejected the Trustee's preliminary argument that the December 2014 stress test was not a relevant one for the purposes of the CDE definition. He held that the Trustee's reading was the "literally correct reading"^[19] but that the provision should not be interpreted literally. That was either because "it produces such an extraordinary result that it cannot have been intended"^[20] or because there "has been an obvious mistake in the drafting of the definition of a CDE in condition 19"^[21].
56. However he went on to reject both LBG's arguments in support of the proposition that a CDE had occurred. He held that the expression "shall cease to be taken into account" in the definition of CDE "connotes a disallowance in principle of the ECNs on stress testing with continuing effect in the foreseeable future"^[22], such that the ECNs were precluded from counting as CT1 capital for the purposes of the stress test when the stressed projection showed a CT1 ratio below 5%^[23]. He concluded that there had been no such change because, if the stress test had showed that the capital position had reached the trigger point for the conversion of the ECNs, the ordinary shares created would still rank as CT1 capital^[24].
57. He thus concluded that the regulator had not disallowed the ECNs in principle. He said:

"[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"^[25];

and that:

"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." ^[26]

58. The judge placed considerable reliance on the use of the word "Disqualification" in the expression "Capital Disqualification Event" as supporting his interpretation. He said:

"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."

59. In the circumstances the judge did not consider it necessary to consider the factual argument advanced in the Trustee's reply submissions that, on the evidence, the conversion of the ECNs would not have been triggered, even if the additional £8.6 billion had not been raised in response to the PRA's requirements in 2013.

The submissions of the parties before this court

The Issuers' submissions

60. In relation to the preliminary issue (which formed the subject of the Respondent's notice), namely as to whether the December 2014 stress test was a relevant test at all for the purposes of the definition of a CDE, Mr Miles QC, on behalf of the Issuers, supported the conclusion of the judge for the reasons which he gave. Mr Miles submitted that, as the judge had correctly held, there had been an obvious infelicity in the drafting of the definition of a CDE, but the correct interpretation had to be one in which the reference to a stress test was to one applied by the regulator in respect of the ratio of top grade loss-absorbing capital (as defined from time to time by the regulator for the purpose of stress testing) to risk weighted assets.
61. He further submitted that the extreme literalism pressed by the Trustee on this part of the case could equally well be turned against it. If the Trustee's argument - that there were no longer any stress tests by the regulator in respect of the Consolidated Core Tier 1 Ratio - were correct, then, taking a purely literal approach, the ECNs had "cease[d] to be taken into account for the purposes of any stress test applied by the FSA in respect of the Consolidated Core Tier 1 Ratio". That was because there were no longer any such stress tests in relation to the "Consolidated Core Tier 1 Ratio" at all. The Issuers did not contend that that was the right answer; but, taking the logic of the Trustee's argument to its logical conclusion, this demonstrated the dangers of interpreting a contract without regard to its purpose and common sense.
62. Mr Miles defined the principal issue of construction on the Issuers' appeal as 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. Mr Miles submitted that, on the contrary, a CDE could occur in circumstances where, as a result of changes in the regulatory capital requirements, the ECNs no longer served to assist LBG to remain above the minimum ratio requirements in the stress test.
63. Mr Miles' first submission in relation to this issue was that, when the ECNs were issued, with a contractual trigger point for conversion above the then minimum regulatory ratio, they indeed provided LBG with a buffer for stress testing purposes, and therefore enhanced its capital for those purposes. The setting of the Conversion Trigger above the regulatory requirement was an absolutely key part of the contractual structure of the notes. The regulatory context at the time that the notes were issued was that the published guidance made it clear that banks were required not to fall below the 4% CT1 capital ratio minimum standards at any stage in the five-year period covered by the stress scenario. Thus there was a significant relationship between the contractual 5% Conversion Trigger point in the ECNs and the then regulatory requirement that a bank's CT1 capital should have a ratio of 4% to risk weighted assets. That was not a point that had featured in the judge's reasoning. He submitted that the ECNs ceased to assist for the purposes of the stress test, when the relationship between the contractual Conversion Trigger point and the regulatory minimum was reversed as a result of changes to the regulatory requirements as a result of CRD IV - in other words the increase in the relevant stress test hurdle.
64. Accordingly, he submitted that, on the evidence and in the language of the clause, a CDE had occurred because the ECNs had ceased to be taken into account for the purposes of the December 2014 stress test in respect of the relevant ratio. Moreover, absent further regulatory change relaxing the stringent regulatory requirements of CRD IV, the ECNs would not be taken into account for the purposes of any future stress test.
65. Mr Miles' second and alternative argument, in relation both to the principal construction issue and the issue whether a CDE had occurred, was that, because of the improvements in LBG's capital position during 2013, as a result of a change in Regulatory Capital Requirements (as defined), it was able to pass the December 2014 Stress Test without any need to consider the ECNs. In summary, he submitted as follows:

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.

66. Mr Miles submitted that LBG's second argument was also supported by commercial sense. It was because the PRA had changed its requirements and obliged LBG to bolster its capital base for actual capital that LBG was able to pass the December 2014 Stress Test without consideration of the ECNs. The judge's suggestion that the clause could not be satisfied by LBG simply "happening" to improve its capital position ignored the requirement of the clause that the relevant events have occurred "as a result of changes to the Regulatory Capital Requirements". It also ignored the evidence that the bolstering of capital was the direct result of the enhanced capital requirements introduced in 2013 and was not a voluntary decision of LBG.

The Trustee's submissions

67. In relation to the preliminary issue, namely whether the December 2014 stress test was a relevant stress test for the purpose of the CDE definition, Mr Dicker QC on behalf of the Trustee submitted that the judge was wrong to reject the Trustee's argument that, on the construction of the relevant provision, the December 2014 stress test was not a stress test "applied…in respect of the Consolidated Core Tier 1 Ratio" as specified in the definition of a CDE, but rather was a test applied in respect of a CET1 ratio. Having accepted as "literally correct" the Trustee's case, Mr Dicker submitted that the judge was wrong to go on to conclude that the provision should not be interpreted literally because "it produces such an extraordinary result that it cannot have been intended" and because there "has been an obvious mistake in the drafting of a CDE in condition 19". ^[27]
68. In support of this contention, Mr Dicker submitted that, when it was said that a contract contained a mistake which should be corrected as a matter of construction, the court could intervene only if it was clear: (i) that a mistake had been made; and (ii) what correction ought to be made: Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38; [2009] 1 AC 1101 at [22]. In that context, the mistake and correction must also be clear from the circumstances known to all parties: it could not be right, when interpreting a contractual provision, to take account of a fact or circumstance known to only one of the parties: Arnold v Britton [2015] UKSC 36, at [21]. This might be of particular significance where the offer was made to individuals rather than sophisticated commercial counterparties, because (a) the circumstances known to both parties would be fewer; and (b) it was less likely that both parties would be able to identify a mistake. The wording of the instrument, rather than the background or matrix of fact, was likely to be paramount.
69. Mr Dicker further submitted that the judge was wrong to conclude that these requirements had been fulfilled. A reasonable holder of Existing Securities would have understood the contract to have its literal meaning, and would not have concluded there had been a mistake by LBG and the Issuers:

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 [2011] EWCA Civ 707 at [42].

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.

70. In relation to the main issue of construction, Mr Dicker sought to support the decision of the judge for the reasons which the latter gave. Mr Dicker submitted that it was important to construe the conditions in the notes in the context of the factual background, which was primarily the Exchange Offer Memorandum. The ECNs continued to do exactly what LBG had told the investors they were to do at the time of the issue of the notes. The description of the notes in the Exchange Offer Memorandum reflected the first and second limbs of the definition of a CDE. It was significant that the Exchange Offer Memorandum did not mention three points which were critical to the Issuers' proposed construction:

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.

71. Mr Dicker submitted that it was essentially up to LBG to ensure that the noteholders were adequately informed of the relevant risks and the circumstances in which a CDE would occur. In fact all they were told was that the ECNs would convert into ordinary shares if CT1 capital fell below 5% and that ECNs would be taken into account as CT1 for the purposes of the FSA's stress test if the stressed projection showed LBG's CT1 ratio falling below 5%. There was nothing in the references to risk factors or the redemption risk that explained what the Issuers now say is the correct construction of the definition of a CDE. That was surprising because, on the basis of what LBG knew and intended, at the time, the prospect of a CDE was a highly significant, if not likely, occurrence. That was because:

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.

72. As to the construction of the relevant wording in the definition of CDE, Mr Dicker's primary submission was to endorse the approach adopted by the judge. He submitted that the key to what was meant by "taken into account" in the second limb of the definition were the words used to entitle the definition of a CDE, namely "Capital Disqualification Event." Those words were apt to encapsulate the concept of disqualification which the draftsman was seeking to cover in that provision. Indeed, there was a broad similarity between the first and second limbs of the definition. Both were essentially concerned with a situation in which the regulator made a pronouncement:

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.

73. In this context, Mr Dicker gave examples of the types of concerns which might lead the regulator to "disqualify" the ECNs as contingent CT1 capital on the grounds that the contingencies surrounding conversion were too uncertain or insufficiently transparent to justify inclusion of the ECNs as contingent CT1 capital for the purposes of the stress test: (a) the fact that the Conversion Trigger depended on the semi-annual publication by LBG of its CT1 ratio, and that LBG's decision to publish that ratio might lead to a delay before the CT1 ratio was published; (b) the potential delay before the calculations could be completed resulting from sudden economic turmoil; (c) the uncertainty as to whether, as a matter of fact, the relevant CT1 ratio was less than 5%. Mr Dicker gave as another example of possible disqualification a situation in which the regulator had expressly said that it was not going to take the ECNs into account because the stress test hurdle which the regulator had now set was higher than the contractual Conversion Trigger; the scenario might lead to LBG being told not to include the ECNs in the modelling for the purposes of the stress test.
74. Mr Dicker further submitted that, even if, as a matter of construction, the occurrence of a CDE was not limited to the happening of what might be characterised as a disqualifying event, nonetheless in all the circumstances the ECNs continued to be taken into account for the purposes of the December 2014 stress test and would (in the absence of a future disqualifying event) continue so to be taken into account in the future. His submissions under this head (although they also related to his submissions on the main issue of construction) may be summarised as follows:

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.

75. In relation to the second way in which the Issuers put their case on construction, and in relation to whether a CDE had occurred (namely that, because the PRA required LBG to increase its CET1 capital, as a result of the changes to "Regulatory Capital Requirements", LBG was in a strong position going into the 2014 stress test, and therefore the Conversion Trigger did not occur in that stress test), Mr Dicker first submitted that this argument was wrong as a matter of construction, for the reasons identified by the judge^[28].
76. Secondly, Mr Dicker submitted that the Issuers' contention was wrong on the facts. The Issuers' own evidence (as summarised in the Respondent's Notice) showed that the Conversion Trigger would not have occurred in the 2014 stress test, even if the PRA had not imposed a new capital requirement on LBG in 2013. This was an issue which it was not necessary for the judge to consider given his conclusion on the point of construction.
77. The Trustee did not accept the Issuers' contention that, in 2013, the PRA required LBG to raise additional CET1 capital which improved its CET1 ratio by 2.4%. The assertion was not clearly supported by the documents: it seemed that LBG had already decided to raise a substantial amount of this capital and that the PRA's guidance was merely consistent with actions which LBG had already decided to take. However, even if one were to assume in the Issuers' favour that their contention is correct, it would not make any difference. Without the increase of 2.4%, LBG would still have achieved a stressed CET1 ratio of 2.6% (or 2.9% after strategic management actions) in the 2014 stress test, comfortably above the Conversion Trigger equivalent to 1% CET1. Accordingly, even if their contention about the cause of the increase of LBG's capital were correct, the Issuers could not say that the PRA's requirement caused the Conversion Trigger not to occur. On their evidence the Conversion Trigger would not have occurred in any event.
78. Accordingly Mr Dicker submitted that the appeal should be dismissed.

Discussion and determination

79. In the circumstances described above, the following issues arise for determination on the appeal and the respondent's notice:

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

iv) Whether:

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

80. There was no dispute as to the applicable principles of law in relation to the construction of the Trust Deed and the ECNs. They are usefully summarised in paragraphs 14 to 22 of the speech of Lord Neuberger in Arnold v Britton [2015] UKSC 36 and, in relation to provisions that are said to contain a mistake, in paragraphs 22 to 25 of Lord Hoffmann's speech in Chartbrook Ltd v Persimmon Homes Ltd, supra. As Lord Hoffmann said in paragraph 25:

"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."

81. In my judgment, and contrary to Mr Dicker's submissions, it is clear in the present case that something has gone wrong with the language and it is also clear what a reasonable person would have understood the parties to have meant.
82. The problem arose as follows. For the purposes of the definition of the Conversion Trigger, which occurred when at any time LBG's "Consolidated Core Tier 1 Ratio is less than 5%", the concept of "Core Tier 1 Capital" (upon which the definition of Consolidated Core Tier 1 Ratio was based) had to be fixed by reference to a certain and constant definition. The reason Core Tier 1 Capital had to be fixed by reference to a specific definition, that was not going to change, was to ensure that conversion of the ECNs would not automatically occur in the event of a unilateral change by the regulator to the definition of CT1 capital. This was explained by Mr Richard Shrimpton, the Group Capital Markets Issuance Director of LBG, in his witness statement as follows:

"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."

83. The establishment of a certain and constant trigger point for automatic conversion of the ECNs was achieved as a matter of drafting by incorporating a fixed definition of "Core Tier 1 Capital" (in Condition 19) into the term "Consolidated Core Tier 1 Ratio" (in Condition 7(a)). That was fine so far as establishing a certain Conversion Trigger was concerned. The exercise of working out whether a Conversion Trigger has occurred by reference to a fixed and historic definition of "Core Tier 1 Capital" can still notionally be carried out irrespective of whether there has been a subsequent change by the regulator to the definition of CT1 capital.
84. However, when the draftsman came to define the trigger for redemption, i.e. a CDE, he also, at the very end of the definition of CDE, deployed the defined term "Consolidated Core Tier 1 Ratio", which in turn was defined by reference to the expression "Core Tier 1 Capital" – a concept fixed, as I have said, by reference to the FSA's definition as at 1 May 2009. If the language is construed literally, as the Trustee submits it should be, this would have the result that: (a) a CDE can only occur where a stress test is carried out in relation to LBG's consolidated CT1 ratio using the fixed definition of "core tier 1 capital" as promulgated by the FSA as at 1 May 2009; and (b) because the December stress test did not use this historic definition, a CDE cannot have occurred. For all practical purposes the Trustee's construction also leads to the result that, following the PRA's adoption of the concept of CET1 capital post Basel IV, there could never be a CDE in the future, because the regulator no longer uses the concept of CT1 capital or the CT1 ratio in carrying out stress tests. It was common ground that CT1 capital, as in effect and applied as at 1 May 1 2009, is now a historical concept, that it has been superseded, as was expected, by the CET1 capital concept.
85. Why is it obviously wrong drafting for the definition of a CDE to be based on the definition of "Consolidated Core Tier 1 Ratio" and consequentially upon the embedded definition of "Core Tier 1 Capital"; and therefore for a fixed, immutable concept of core tier 1 capital "as defined by the FSA as in effect and applied as at 1 May 2009" to be used for ascertaining whether a CDE has occurred? My reasons for agreeing with the judge's conclusion on this point largely reflect Mr Miles' submissions and are as follows:

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.^[29]

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.

86. It follows that I consider the Trustee's proposed construction (viz. it was the parties' intention that the redemption right triggered by the second limb of the definition of a CDE should last only for so long as the regulator did not revise its definition of core capital) as unrealistic. An interpretation which sought to limit the relevant stress tests to those using the May 2009 definition of CT1 capital and the related "Consolidated Core Tier 1 Ratio" is inconsistent with the point and purpose of Condition 8(e), which is to give an option where, owing to regulatory changes (including to the definition of tier 1 capital), the ECNs no longer are taken into account for the purposes of any stress test in relation to the relevant ratio. The Trustee's suggestion that the purpose of the provision was to enable redemption only if the ECNs were "disqualified" for another reason in a stress test carried out before the expected change in the definition of CT1 capital is unduly and illogically limited. There would not appear to be any commercial justification for creating an option which lasts only as long as the regulator happens to employ the same definition of CT1 capital, but which then lapses. Accordingly, in my judgment, the use of the term "Consolidated Core Tier 1 Ratio" with its embedded defined term "Core Tier 1 Capital" for the purposes of the definition of a CDE was wholly inapt.
87. Nor am I persuaded by Mr Dicker's arguments to the effect that the error would not have been obvious to a reasonable addressee of the Exchange Offer Memorandum, who, he submitted, would have justifiably assumed that the language meant what it said. He pointed to the fact that many of them were retail investors who would assume that the terms and conditions had been drafted by sophisticated lawyers who would have been meticulous in their use of language. In my judgment the fact that the investors included retail investors is irrelevant to assessing what the "reasonable addressee" would have thought. The ECNs were highly sophisticated and complex financial instruments. The Exchange Offer Memorandum made it clear that the decision to invest should only be taken after informed and detailed consideration of the risks surrounding the investment. For example, it stated:

"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."

88. In those circumstances the reasonable addressee has to be taken as someone having an informed understanding, whether on his own or with the assistance of a financial adviser, of the working of the relevant markets, the regulatory background, the use of stress tests in the regulator's testing of the adequacy of a bank's capital resources and the function which the ECNs were intended to fulfil. In my judgment such a person would, for the reasons I have given, have realised that an obvious mistake had been made in using the embedded definition of "Core Tier 1 Capital" in the definition of a CDE.
89. Moreover, the fact that this was a substantial transaction with the involvement of lawyers did not mean that any infelicity in the drafting was "extremely unlikely", as Mr Dicker suggested. As Lord Collins recognised in In Re Sigma Finance Corporation [2009] UKSC 2, at para 37, in complex documents of this kind,

"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 [2008] EWCA Civ 1303.)

90. Likewise, in my judgment, there is no difficulty in ascertaining what the correction by way of interpretation should have been to the erroneous drafting, albeit that there might be slightly different views as to the precise wording of any potential replacement text. I agree with the judge that the correct interpretation is one which construes the last two lines of the definition of a CDE as a reference to any stress test applied by the FSA in respect of the ratio between LBG's consolidated core tier one capital or its then regulatory equivalent (under whatever definition of CT1 capital or its equivalent as was then applying) and its consolidated risk weighted assets; or, as the judge put it: "a stress test applied by the regulator in respect of the ratio of top grade loss-absorbing capital (as defined from time to time by the regulator for the purpose of stress testing) to risk-weighted assets".^[30] It is irrelevant how as a matter of drafting that result might have been achieved. It could have been done simply by the addition of a different - and dynamic (in the sense of being the definition applied by the regulator from time to time) - definition of core tier one capital and consolidated core tier 1 ratio for the purposes of the CDE definition.
91. Nor was I impressed by Mr Dicker's argument that there was a fundamental inconsistency in LBG's argument because LBG did not contend that its proposed revised definition of "Core Tier 1 Capital" for the purposes of the definition of a CDE should likewise be applied to the Conversion Trigger. As I have already explained, the fixing of the Consolidated Core Tier 1 Ratio to the 1 May 2009 definition of CT1 capital for the purposes of the Conversion Trigger was deliberate and had commercial logic. However, the incorporation, through a series of defined terms, of the 1 May 2009 definition of CT1 capital into the concept of stress testing in the CDE definition cannot have been intended and leads to a commercially absurd result.
92. In the circumstances it is not necessary to address Mr Miles' alternative argument that the logical conclusion of the Trustee's literal approach to the construction of the CDE definition is that, since there are no longer any stress tests carried out by the regulator in relation to Core Tier 1 Capital, as defined as at 1 May 2009, the ECNs have "cease[d] to be taken into account for the purposes of any stress test applied by the FSA in respect of the Consolidated Core Tier 1 Ratio". If it had been necessary, I would have been minded to accept the submission.
93. Accordingly I would dismiss the Trustee's cross-appeal in relation to this point. In the light of my conclusion in relation to this preliminary point I shall refer hereafter to "the relevant ratio" rather than to "the Consolidated Core Tier 1 Ratio" where appropriate when referring to the definition of a CDE.

The main construction issue

94. Contrary to the judge's conclusion, I accept Mr Miles' first argument that, as a result of a change in the Regulatory Capital Requirements (i.e. both the change in the definition of what comprises top grade loss-absorbing capital and the change in the ratio of such capital to risk-weighted assets), with the consequence that the contractual Conversion Trigger for the ECNs is now far below the minimum CET1 ratio threshold in respect of which the stress testing is now carried out, so that the Conversion Trigger will never be reached before the minimum stress test threshold is crossed, the ECNs have ceased, at least for the foreseeable future, as a matter of the language and purpose of the redemption provisions, be "to be taken into account... for the purposes of any "stress test" applied by the FSA in respect of the [relevant ratio]". That is because they have ceased to be able to assist LBG to pass the stipulated threshold capital ratio in the stress testing environment. Even though, at least theoretically, the position could change on a future change of Regulatory Capital Requirements which relaxed the stringency of the capital adequacy requirements and the relevant ratio (an unlikely event in the wake of CRD IV), the fact is that the ECNs could not have been, and were not, taken into account for the purposes of the December 2014 stress test in respect of the relevant ratio, because the Conversion Trigger could not have been reached in the stress scenario. My reasons for this conclusion as to the construction issue are as follows.
95. The critical words in the second limb of the definition of a CDE are "the ECNs shall cease to be taken in to account in whole or in part ….. for the purposes of any "stress test" applied by the FSA in respect of the [relevant ratio]." To my mind the natural meaning of those words is that, once the ECNs cease to be capable of contributing to LBG's ability to meet the relevant ratio in the stress test in question (i.e. "any" stress test), they cease to be taken into account for the purposes of the clause and a CDE has occurred. In my view, as I explain below, Mr Dicker's arguments do not give sufficient weight to the words "in respect of the [relevant ratio]".
96. This interpretation is supported by the relevant factual matrix which I have summarised above. Thus for example, the FSA's "Statement on Capital Approach Utilised in UK Bank Recapitalisation Package" dated 14 November 2008^[31], as confirmed in the FSA's subsequent "Statement on Regulatory Approach to Bank Capital" issued on 19 January 2009, made it clear that the FSA used, as an integral part of its stress testing process, a simple common benchmark of ratios of capital to risk-weighted assets, applicable to all institutions, albeit with weightings tailored to the specific institutions; the statements explained that the framework ratio of CT1 capital to risk-weighted assets was at least 4% after the stressed scenario and that banks were expected to meet at least that minimum requirement; and it made clear that the threshold ratio was central both as a regulatory tool (a good first indicator as to whether a bank is properly capitalised to be resilient in stress conditions) and as a transparent benchmark to inform the market.
97. The FSA's statement on its use of stress tests dated 28 May 2009^[32] again underlined the requirement that, in the stress testing process, a bank should be able to demonstrate that it complied with the minimum requirement of maintaining CT1 capital of at least 4% of risk-weighted assets and emphasised the use of the 4% ratio as a hurdle which had to be met by banks, failing which they could expect regulatory intervention. The statement likewise emphasised that the stress tests were used "to identify if at any time in the next 5 years there is a danger that under the stress scenario the level of capital will fall below the 4% Core Tier 1 minimum."
98. Similarly, the FSA's feedback Statement 09/3 "A regulatory response to the global banking crisis", published in September 2009, as quoted above, made it quite clear that its view was that "hybrid capital instruments" had to be "capable of supporting Core Tier 1 by means of a conversion or write-down mechanism at an appropriate trigger" and that it was working on appropriate mechanisms to ensure this in the international regulatory environment.
99. There can be little doubt that, as a result of these published statements, a reasonable person in the position of the ECN Holders and the Issuers must have appreciated the critical importance to a bank of clearing the hurdle of the standard CT1 capital ratio of 4% in order to satisfy its regulators (and indeed convey to the market the adequacy of its capital position).
100. That was reinforced by the particular context in which the Exchange Offer Memorandum was circulated: LBG had failed the March 2009 stress test because it had failed to clear the CT1 ratio hurdle throughout the stress test period and was therefore compelled to take action to satisfy the regulators, either by paying to enter the GAPS or by increasing its capital resources so as to show that it could clear the CT1 ratio hurdle throughout the 2009 stress test period (and for any other stress test conducted by the FSA). Thus the parties knew that clearing the CT1 ratio hurdle in a stress test was critically important if the bank was to avoid having to take costly forms of action to satisfy regulators (and also to maintain its credibility in the market - banks which routinely failed the 4% criterion in the stress tests would suffer commercially). I thus accept Mr Miles' argument that, in all the circumstances, the express reference to the CT1 ratio in Condition 19 in the context of the known stress testing environment (with its primary emphasis on the CT1 ratio as the main matter being tested and the immediate history of a failure by LBG to meet the 4% ratio in the 2009 test) would indicate to a reasonable reader that the relationship between the 5% figure in the Trust Deed and the well-published, lesser, 4% figure used by the regulator was deliberate and was commercially important. Moreover, it is also pertinent that, as I have already set out above^[33], the Chairman's letter referred in two places to the fact that further details about LBG's "target consolidated core tier 1 capital ratio" and capital resources were incorporated by reference in Part XVI of the Exchange Offer Memorandum; Part XVI incorporated by reference the information relating to LBG's Capital Resources and Liquidity contained in the Rights Issue Prospectus and the Rights Issue Prospectus itself; and the last document expressly referred to the FSA's indication that it expected banks to maintain a CT1 capital ratio of at least 4% in the stress scenario. The reasonable reader of the Exchange Offer Memorandum, who necessarily would be adequately informed about the regulatory environment, can have been in no doubt of the intended function of the ECNs to enable LBG to meet the capital ratio threshold in the stress scenario.
101. It follows that I do not accept Mr Dicker's arguments to the effect that a reasonable addressee of the Exchange Offer Memorandum would not have appreciated (a) that the required function of the ECNs was to enable or assist LBG to meet the 4% CTI ratio threshold in the stress test; or (b) the relationship between any stress test threshold and the contractual Conversion Trigger of 5%. In my judgment the Exchange Offer Memorandum adequately set out and explained, by reference to the express terms of the CDE, the circumstances in which redemption of the ECNs would occur.
102. I turn to deal with the primary way in which Mr Dicker put his case, namely that the only kind of event which could cause a CDE to occur under the second limb would be a statement or declaration from the regulator to the effect that ECNs could not in principle ever be taken into account as contingent CT1 capital or its equivalent from time to time. Although such an event would almost inevitably have the consequence that the ECNs would "cease 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 [relevant ratio]", the wording of the second limb cannot be construed in my judgment as limiting the occurrence of a CDE to what might be characterised as a regulatory disqualification of ECNs as contingent CT1 capital. Mr Dicker's construction in my view wrongly - and contrary to their natural meaning - construes the relevant words as equivalent to the very different wording in the first limb of the clause "the ECNs would no longer be eligible to qualify." There is a very real difference between the first limb test of "ceasing to be eligible" and the second limb test of "ceasing 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 [relevant ratio]". Mr Miles' construction on the other hand gives appropriate weight to the difference in language use in the two limbs of the clause.
103. For similar reasons, based on the difference in the language used in the respective limbs, I do not think that the title of the definition "Capital Disqualification Event" can be taken to predicate that the occurrence of a CDE under the second limb is restricted to the ECNs being expressly disqualified in some way. In my judgment, what matters on the wording of the second limb is whether or not the ECNs had ceased to be capable of being taken into account for the purposes of the stress test in relation to the relevant ratio. And the key question for the purposes of modelling the stress test is whether the contractual Conversion Trigger point is reached prior to LBG meeting the relevant stress test hurdle ratio (i.e. from 1 January 2014 a ratio of CET1 to risk-weighted assets of 4%, and as from 1 January 2015 a ratio of 4.5%). Mr Dicker's submission leads to an excessively narrow and uncommercial construction of the definition of a CDE.
104. Mr Dicker's examples of the type of regulatory pronouncement at which he said that the second limb of Condition 19 was aimed were unconvincing. As Mr Miles pointed out, it was highly unlikely that the PRA would ever say that ordinary shares (which the ECNs would become, if the Conversion Trigger was reached), as opposed to preference shares, would not count in the relevant ratio. Likewise I did not find Mr Dicker's submission, by reference to the new CRD IV definition of an AT1 instrument (which requires the conversion trigger point for AT1 capital instruments to be 5.125% of CET1 - i.e. above the 2014 4% or 2015 4.5% CET1 threshold ratio), in any way supportive of his argument. He submitted that the PRA could have made an express statement to similar effect – i.e. that no contingently convertible notes such as the ECNs would be taken into account in the stress test, unless they had a contractual conversion trigger set at no less than 5.125% of CET1; in that event he accepted that a CDE would have occurred; but, he said, where no such statement had been made by the PRA, a CDE had not occurred. In my judgment this argument does not assist the Trustee's case - on the contrary it supports the Issuers' case. The reality is that the practical effect of what the PRA has done by adopting its new ratio by reference to CET1^[34], above the contractual Conversion Trigger point for the ECNs, is exactly the same as such an express statement: it excludes the ECNs from meeting the definition of CET1 at a level which would enable them to be counted as relevant CET1 capital before the ratio threshold is breached in the course of a stress test. If, according to Mr Dicker's argument, the second limb of the definition of a CDE covers the first situation where an express statement is made by the PRA, I find it difficult to see why it does not equally cover the second situation, simply because the PRA did not expressly state the necessary implications of the new CET1 capital ratio test which it had adopted.
105. Nor do I accept Mr Dicker's submissions to the effect that it would be surprising, given what was known at the date of the issue of the ECNs about the likely future strengthening of regulatory requirements, that, simply because of a change in what the regulator was prepared to treat as the highest tier of capital and what happened to be the particular profile of LBG's "dynamic" capital assets at any given time, a CDE would occur merely because the combination of those two factors meant that the ECNs no longer helped LBG to pass the stress test. It could not, Mr Dicker submitted, have been intended that the ECN Holders would bear the risk of what in reality was the contingency of the future composition of LBG's capital assets at the time when the anticipated regulatory changes were brought into force.
106. I disagree. When the ECNs were issued, they were known to count towards CT1 capital for the purposes of the FSA's stress test (and had been specifically devised to do that as the Chairman pointed out in his letter). But by reason of the change in the ratio used as the threshold test by the PRA, it was immediately obvious that as a matter of principle the ECNs ceased to qualify as CT1/CET1 capital for that purpose; and that consequence occurred irrespective of how the application of the CET1 capital definition might, given the particular LBG capital asset profile, vary from the application of the previous CT1 definition. Even if some elements of capital discounted for the purposes of the CET1 requirements - in particular tax losses - might change over time, it was still obvious that the shift to the CET1 ratio stress test in 2014 meant that the ECNs could not, in principle, be brought into play to assist LBG to show that, throughout the 5 year stress test cycle, it remained above, and hence did not breach, the relevant CET1 stress test ratio. The change in the definition of CET1 capital and the change in the CET1 ratio were changes of principle in relation to the capital regulatory requirements; they had an immediate and obvious effect of disabling LBG from ever reaching the relevant ECN contractual Conversion Trigger point in the course of the stress test modelling to be able to rely at all on the ECNs to save it from breaching the stress test ratio. In effect, by reason of the regulatory change to the CET1 ratio threshold, the ECNs were comprehensively prevented from being brought into account in order to satisfy the CET1 ratio part of the stress test. In my judgment that was precisely the risk which the ECN Holders had assumed on the correct interpretation of the ECNs. It was indeed a "Capital Disqualification Event". It was not, as Mr Dicker sought to suggest, merely a fortunate change in the composition and profile of LBG's capital assets.

The taken into account issue

107. Mr Dicker's submission under this head was that, even on the assumption that the main construction issue was decided in favour of the Issuers, the ECNs had not as a matter of 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]". That was because, he submitted, a stress test was not a simple "pass or fail test" which looked simply at the question whether or not the bank had failed the specific threshold capital ratio part of the stress test; on the contrary, a stress test had to be regarded as a holistic exercise by the regulator, which examined the resilience of the bank overall in the stress environment and which included the regulatory response; if the stress test was viewed in that broader way, it was clear that the regulator would take into account the ECNs as part of the wider picture, given that, in the event that LBG's financial position deteriorated so that it fell well below the required threshold capital ratio, the contractual Conversion Trigger would be reached, the ECNs would be available as ordinary share capital and might prevent the bank from becoming insolvent.
108. I cannot accept this submission. It is contrary to the actual language of Condition 19 which clearly focuses, not on any broader assessment by the regulator of LBG's capital adequacy or the appropriate regulatory response to its modelled position in the stress scenario, but rather on whether the ECNs have ceased to be taken into account "for the purposes of any "stress test" applied by the FSA in respect of the [relevant ratio]". That in my view necessarily requires a consideration as to whether the ECNs are capable of assisting LBG to meet the required threshold CET1 capital ratio: i.e. 4%. from 1 January 2014 and 4.5% from 1 January 2015.
109. Therefore it necessarily follows, in my judgment, that a CDE occurred following the stress test conducted by the PRA in December 2014 and the Issuers consequently became entitled to redeem the ECNs.

The increase in capital issue

110. I do not accept Mr Miles' submission that, as a matter of construction of the second limb of Condition 19, the mere fact that LBG has been "required" to raise a total of £8.6bn further capital by the end of 2013, as a result of which LBG was in a strong capital position going into the 2014 stress test, and therefore the Conversion Trigger was not as a matter of fact reached in that stress test, meant that a CDE had occurred and the Issuers' rights of redemption had arisen. That submission was tantamount to saying that, because of the happenstance of the improvement of LBG's capital position (albeit as a result of the PRA's requirements), there was no actual need to take the ECNs into account. That in my judgment is a totally different argument from that which I conclude has succeeded: namely that, because of the regulator's change from CT1 to CET1, and the change in the capital ratio, the ECNs no longer remained capable of assisting LBG to pass the relevant threshold capital ratio in the stress test.
111. In the circumstances there is no need to consider Mr Dicker's alternative argument that on the evidence:

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.

Disposition

112. For the above reasons I would allow the appeal and grant a declaration that a CDE has occurred thereby entitling the Issuers to redeem the ECNs in accordance with their terms.

Lord Justice Briggs:

113. I agree that this appeal should be allowed, substantially for the reasons given by Gloster LJ. Since we are differing from the Judge, and out of respect for the powerful submissions of Mr Dicker on what my Lady calls the main construction issue, which I admit provisionally persuaded me at the time, I add a few short observations of my own.
114. Once all the voluminous and technical background detail has been trawled through, as Gloster LJ has done with commanding thoroughness, the question of construction of this one-off provision is really quite short. In order to resist early redemption of the ECNs is it sufficient that they continue to be taken into account for some purpose or purposes in the stress-test now applied by the FSA, which in my view they do, or must they play a part in enabling LBG to pass that test, which they clearly no longer do, because of the change in the Regulatory Capital Requirements which had the effect of elevating the pass ratio to a level above the Conversion Trigger.
115. This is a difficult question on which my mind has vacillated several times since first reading the papers for this appeal. In the end I have become convinced, like my Lady, that it is the ability of the ECNs to assist in passing the stress test that is the governing criterion. If the language of the clause stopped before the words "in respect of the [relevant ratio]", I would have found Mr Dicker's submissions compelling. But, taking the dispositive part of the clause as a whole, the inclusion of those concluding words is just enough in my judgment to import the notion of passing the test as a necessary element in the continuing utility of the ECNs, for them to survive LBG's right of early redemption.
116. I am comforted, even in this technically intricate context, by the perception that it was to assist in passing, rather than merely featuring in, the stress test that the ECNs were issued in the first place, that they have now ceased to play any useful part in doing so, and are on the face of it unlikely to do so again for the foreseeable future.

Lord Justice Sales:

117. I agree that this appeal should be allowed for the reasons given by Gloster LJ.

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.    [Back]

Note 4   [2015] 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]