Pari passu clauses: English law after NML v Argentina

2 Capital Markets Law Journal, Vol. 9, No. 1 Pari passu clauses: English law after NML v Argentina Lachlan Burn* Key points Recent litigation in the USA has raised doubts about the meaning of the pari passu provision typically included in sovereign bonds. As many sovereign bonds are subject to English law, it is sensible to ask whether English courts might take the same approach as those in the USA. This article considers how English law approaches the interpretation of contracts and, in particular, the willingness of the courts to look at background information known to the parties at the time of the contract to determine what their intentions might have been; and to use that information to unravel ambiguities or even to rescue the parties from mistakes in their use of language that may be linguistically correct but does not reflect their intentions. In the context of the pari passu provision, the article concludes that the parties to a sovereign bond could not have intended the provision to require proportionate payment of all creditors and that, therefore, the English courts would take a different view from that currently taken by those of the USA. 1. Introduction The long-running litigation in the USA involving the meaning of a pari passu provision in the Republic of Argentina s bonds has resulted in interpretations that many find surprising. The bonds in question were governed by New York law. But, as sovereign bonds are also issued under English law and many contain similar provisions, it is worth considering how an English court might approach the subject. The starting point is to look at the rules of interpretation that would be applied by an English court. These have changed considerably over the years, moving (broadly speaking) from a strict dictionary and syntactical interpretation of the words used in the contract alone, to a more flexible approach aimed at understanding what the parties to the contract must have intended, recognizing that human beings sometimes misuse words and fail to express themselves precisely. Having established these rules, the next stage is to apply them to the facts. As will be seen, this process involves looking not just at the words in isolation, but at whether a reasonable person would, knowing the consequences of an interpretation, have intended that interpretation. 2. English law relating to interpretation of contracts The traditional approach of English law to the interpretation of contracts was to seek for the ordinary meaning of the words used, without looking outside the contract to find the *Lachlan Burn, Linklaters, London. This article is based on the text of a presentation given by the author at the recent conference on pari passu clauses in sovereign bonds held by the Institute for Law and Finance, Goethe-Universität, Frankfurt am Main. ß The Author(s) (2014). Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com doi:10.1093/cmlj/kmt029 Accepted 28 November 2013

Lachlan Burn Pari passu clauses 3 intention of the parties. Put simply, contractual parties were presumed to have articulated their intentions clearly within the contract itself and there was therefore no need to look further. And, in addition, there may have been a policy behind the rule, to do with the avoidance of lengthy debate as to the intentions of the parties and resulting protracted legal proceedings. This approach has, however, changed significantly in recent decades. In a 1971 case, 1 Lord Wilberforce stated that a contract should not be interpreted in isolation from what he called the matrix of facts in which it was set. It is necessary to enquire, he said, beyond the language and see what the circumstances were with reference to which the words were used, and the object, appearing from those circumstances, which the person using them had in view. This contextual approach to the interpretation of contracts has been taken further in recent years in a series of cases in the highest court in England (which was then the House of Lords). In a 1997 case 2 Lord Steyn said:...there has been a shift from strict construction of commercial instruments to what is sometimes called purposive construction of such documents...it is better to speak of a shift towards commercial interpretation...in determining the meaning of the language of a commercial contract...the law therefore generally favours a commercially sensible construction. In the same case, Lord Hoffmann said that it was important to distinguish between the meaning of words and what the user of the words would have understood them to mean. The dictionary and grammar books are an important element in interpreting the meaning of words. But another part of the material used to understand that meaning is our knowledge of the background against which the utterance was made. This helps not just to resolve ambiguity in the words of the contract but also to understand the intended meaning where the wrong words have been used. Lord Hoffmann then goes on to say:...commercial contracts are construed in the light of all the background which could reasonably have been expected to have been available to the parties in order to ascertain what would objectively have been understood to be their intention. These concepts were brought together by Lord Hoffmann in 1998, 3 in what is generally considered to be the authoritative statement of modern English law on the subject of contractual interpretation. He set out five principles. The following are relevant in this context: (1) Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract. (2)...[The background] includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man... 1 Prenn v Simmonds [1971] 1 WLR 1381. 2 Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd [1997] AC 749. 3 Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896.

4 Capital Markets Law Journal, 2014, Vol. 9, No. 1 (4) The meaning which a document...would convey to a reasonable man is not the same thing as the meaning of its words. The meaning of words is a matter of dictionaries and grammars; the meaning of the document is what the parties using those words against the relevant background would reasonably have been understood to mean. The background may not merely enable the reasonable man to choose between the possible meanings of words which are ambiguous but even...to conclude that the parties must, for whatever reason, have used the wrong words or syntax... (5) The rule that words should be given their natural and ordinary meaning reflects the common sense proposition that we do not easily accept that people have made linguistic mistakes, particularly in formal documents. On the other hand, if one would nevertheless conclude from the background that something must have gone wrong with the language, the law does not require judges to attribute to the parties an intention which they plainly could not have had. Finally, in a 2011 decision, 4 the Supreme Court has made it clear that, if there are two possible interpretations of a commercial contract, the court is entitled to prefer the interpretation that is consistent with business common sense, without first having to show that a particular construction would produce an absurd or irrational result. In summary, therefore, under English law the interpretation of a contract is not confined to a dictionary and grammatical construction of the words within the contract alone. It is not only permissible but sometimes essential to look at background information that parties had at the time the contract was entered into to determine what their objectives and intentions were. And, very importantly, where there are several possible interpretations, the one to be preferred is that which is consistent with business common sense. 3. English law in the context of the pari passu provision Before looking at how English law might be applied in a context similar to that of NML v Argentina, I should declare an interest. The UK s Financial Markets Law Committee (the FMLC) published a paper on this subject in 2005. 5 I was not a co-author of the paper, but was a member of the Committee at the time it was published and agree with it. It is, I would suggest, authoritative not because I was a Committee member, but because of the composition of the working group that produced it, which was chaired by a former senior Law Lord. Much of what I will now say is based on its conclusions. The FMLC summarized the two possible interpretations of the pari passu provision in a sovereign bond as follows: The first [interpretation] is a ranking interpretation that argues that the pari passu clause merely affirms that the obligations rank and will rank pari passu with all other unsecured debt as a matter of mandatory law and the second is a payment interpretation that argues that the borrower has undertaken that it will in fact pay its obligations pro rata when it is unable to pay all of them in full. It goes on to say that, until recently, the first interpretation was the only interpretation and the purpose of the clause was believed to be to prevent sovereigns from earmarking revenues or allocating foreign currency reserves to a single creditor or to prevent the sovereign from preferring one set of creditors over another by law. 4 Rainy Sky SA v Kookmin Bank [2011] UKSC 50. 5 Financial Markets Law Committee: Issue 79 Pari Passu Clauses.

Lachlan Burn Pari passu clauses 5 The report then looks at the payment interpretation in the light of English law. As case law permits, the report starts by looking at the background knowledge of the parties at the time of the contract. The essential question to answer is whether, given the practical consequences, the issuer or, indeed, the subscribers of the bonds intended the payment interpretation of the pari passu condition. And the conclusion of the paper is that they could not; and that the correct interpretation of the condition under English law is the ranking interpretation. A brief look at some of these consequences will illustrate the point. First, there is the effect of the payment interpretation on the sovereign s freedom to manage its affairs. If this interpretation were intended by it and the subscribers of the bonds, they would essentially be saying that, when the issuer had insufficient funds to pay everyone, it would be unable to pay anyone in full. So, if it had borrowed money to pay for construction in a foreign shipyard of a naval vessel that was essential to its defence, it would be unable to continue paying for the construction and the ship would not be delivered. Of, if it had borrowed money to pay annual software licence fees, its computer systems, and the government operations dependent on them, would be jeopardized. And so on. If the payment interpretation had been intended by the issuer, then surely it would have limited it in such a way as to avoid these consequences. Indeed, as the continued operation of the government is also in the interests of investors, surely they too would not have intended this interpretation. Creditors of countries that collapse into anarchy because government ceases to function will get even less back than those of a functioning, though impoverished, state. Secondly, any sovereign issuer will be aware that, if it were to call for assistance from entities such as the IMF, any loans made to it would have to be preferred to other creditors. Therefore, if the sovereign intended the pari passu condition in its bonds to have the payment meaning, it would necessarily have to expressly exclude such loans. The fact that it did not must indicate that the payment interpretation was not intended. Thirdly, any issuer of bonds will be well aware that, if it were to get into financial difficulties, it would need to reach an arrangement with as many of its creditors as possible, in order to set its finances in order. Such arrangements will typically involve creditors agreeing to receive less and/or extend maturities. Armed with that knowledge, why would an issuer deliberately make such a composition with creditors more difficult, if not impossible, by agreeing to a pari passu provision that required it to make proportional payments to those who refused the haircut as well as those that did not? Put the other way round, why would any creditor agree to reschedule or reduce its claim, if it could keep its original claim without risk of foregoing payment? Fourthly, there is the problem of what the FMLC report calls lender liability. If the payment interpretation were intended by the parties to the contract, then the lenders would be exposing themselves to the risk that whatever payment they might receive from the issuer would be attacked in their hands by other creditors who have received nothing.

6 Capital Markets Law Journal, 2014, Vol. 9, No. 1 There are examples of provisions in financing agreements where lenders agree to do exactly this. A typical example is a syndicated loan agreement, under which each lender will agree with the others that if it receives a proportionately higher payment from the borrower than the others, it will share the amount received. But I am not aware of any example of a lender agreeing to share whatever it receives with any other creditor of the borrower. That would be commercial madness. Fifthly, the payment interpretation would make no commercial sense, either for issuer, investors or for the international financial system as a whole. Financial markets depend, among other things, on certainty of payment. Funds move, in an electronic age, in the instant. They are often used in complex chains of inter-linked transactions. The payment on a sovereign bond may instantly provide collateral for another transaction. Payment systems are unconditional and automated. If the bank or clearing system through which the payments on the bond pass are required to hold up payments due to proceedings or even just the threat of proceedings by an alleged unpaid creditor of the issuer, then there is a risk that the system will just seize up. It is unreasonable to argue that either issuer or investor could have intended that result. So, in summary, I have little doubt that an English court, faced with similar facts to those in NML v Argentina, would conclude that the pari passu provision could not have been intended by the issuer or the subscribers of the bonds to be interpreted on the payments basis. What the court would do is to attempt to determine the purpose of the pari passu provision not just from the words on the page but by working out the intention of the parties, based on the background information available to them at the time the contract was made. In the context of a bond, there is one complication in this approach namely that a bond is a unilateral instrument. The only party to it, in a contractual sense, is the issuer. The issuer determines what the provisions of the bond are, in conjunction with those who will sell the issue on its behalf (usually a group of banks). The investors in the bond typically don t participate in the negotiation of its terms. But I think that a court would nonetheless consider not just what the issuer intended when writing the terms of the bond but also what the initial subscribers thought they were buying. Imagine, then, the issuer being confronted with the pari passu provision and being told that it had the payment interpretation. As a consequence, it is told: any rescheduling of debt would be almost impossible, because there would be no reason for bondholders to agree to it; it may be very difficult for it to receive help from entities such as the IMF, because of the priority attached to IMF loans; it would not be able to pay anyone unless it paid everyone so that even payments of licences to use its computer software would be at risk. Only an insane issuer would agree to such a provision. As for the initial subscribers, who are assuming that they are buying a performing asset (and paying on that basis), would they really want a provision in the bonds that exposes them to litigation if they received payments allegedly in breach of the provision? Would

Lachlan Burn Pari passu clauses 7 they want the issuer, if it got into financial difficulties, to be unable to pay even creditors who are essential to enable it to continue to govern itself? Almost certainly not. And would either the issuer or the initial investors really want the international payment mechanisms and clearing systems to be slowed down or even, in some cases, stopped by litigation initiated by hold out creditors? No. Not unless they have the mentality of Dr Strangelove. The conclusion therefore would be that the parties to the bond could not reasonably have intended the payment interpretation. It would have been commercial madness. 4. The meaning of the pari passu provision What then does a pari passu provision mean in the context of a sovereign bond? Perhaps the first thing to say is that it may be wrong to assume that it has any very precise meaning. Some commentators on the Argentinian case seem to have a very high opinion of lawyers and their role in commercial and financial deals. There is an assumption not only that lawyers always ensure that contracts are worded to reflect the precise intention of the parties, without ambiguity or error; but even that lawyers sometimes know better than the parties themselves and, using some sixth sense, are able to anticipate requirements the parties themselves are unaware of and include provisions in the contract on their own authority. Reality is not like that. They say that Homer nodded occasionally and wrote the odd boring or irrelevant paragraph. So do lawyers (with perhaps more than the odd boring passage). Sometimes precedent is used without sufficient thought and, who knows, maybe the explanation for the sovereign pari passu clause in bonds is simply that someone in the dim distant past took up a corporate bond as a basis for drafting a sovereign bond and just didn t think it through. Lawyers try to document the deal that their clients think they have concluded. If the clients are not clear about what they want, then the lawyer may try to sharpen their minds by asking questions and offering different options. But, if the attempt fails, then parts of the contract may be obscure or even, in some cases, meaningless. Sometimes, despite the lawyers best efforts, the instructions from the client are simply to do it the same as last time. And that is what they do. This may be part of the explanation why many sovereign bonds, even after the Argentine litigation set hares running across the field, have kept the pari passu provision unchanged. Maybe issuers and investors simply do not believe that the Argentine litigation will continue in the direction it appears to be heading. Or maybe they believe that, provided they do not use New York law, there is no threat. Having said that, I think that it is wrong to say that the version of the pari passu clause in sovereign bonds must either be interpreted on the payment basis or have no meaning at all. As the FMLC paper rightly says, the crucial word in the provision is rank. Rank is not the same as pay. It has a perfectly good meaning of its own, which has to do with order or queuing. In other words, where there are limited funds to pay, it indicates how

8 Capital Markets Law Journal, 2014, Vol. 9, No. 1 different creditors are to queue for payment. It does not say that any of those in a particular part of the queue will be paid rateably with others in the same part of the queue. So, when the issuer says that its bonds will rank equally with other unsecured indebtedness, it is promising that it will not take action to prefer any other such unsecured creditors for example, by giving them access to an earmarked fund. As with any promise, this provision can be broken. But the remedy for breach of contract is an action for damages or (perhaps) an injunction if the breach is merely anticipated (although I doubt whether an English court would grant such a remedy against a sovereign). The remedy is NOT to take action against those who may receive payment as a result of the breach (unless, perhaps, they have been active in procuring the breach, which is not the case here). What is the point of such a provision? This is an interesting question and one that prompts another observation. The pari passu provision is presumably included in sovereign bonds because someone thinks that it is important. As whatever protection it provides is for the benefit of the investor, presumably the investor is the person who values it. But I doubt whether, if you asked an investor what the benefit of the provision is, you would get a clear answer. I very much doubt that the subscriber would argue for the payment interpretation. That argument is for the benefit of those who buy distressed debt at heavy discounts when the issuer is in trouble. Investors at the time of issue are buying in the expectation of the debt performing, not in the expectation of using the courts as a lever against the issuer and other investors to extract a profit. But I also doubt whether the more normal initial subscriber would have anything more than a general feeling that the provision gives some sort of protection without being clear what that is. What might that protection be? I don t know. If pressed, I would perhaps say that it has something to do with protection of price in the secondary market. Rather like the negative pledge, the pari passu provision might be intended to prevent the issuer from creating future unsecured debt that has some kind of priority to particular revenues which, having that priority, would trade at a better price (or cause the investor s bonds to trade lower in the market). But that is just a guess. It is that or perhaps nothing much at all. But what the pari passu clause is not is a payment provision that allows distressed debt investors to buy cheap and then use the courts either to extract value at the expense of other investors who have already taken a haircut or to bully the issuer into paying them at par on securities they have bought at 30 per cent of face value as the price of getting them off their back, so that a sensible rescheduling can take place. 5. What next? By nature, I am conservative and don t like unnecessary change. But I am also risk averse especially so when acting on behalf of others. The views I have expressed above

Lachlan Burn Pari passu clauses 9 are firmly held and, I believe, right. There is almost no risk that English courts, faced with similar facts to NML v Argentina, would adopt the payment interpretation. (I say almost because litigation is always uncertain and there is always the risk of a judge who has had a bad breakfast giving the wrong decision). But markets cannot depend on the last appellate court giving the right decision after years of litigation. One can lose a lot of money as a result of litigious persons who try it on, even if after years of litigation judgment is given against them. And, of course, sovereign issuers who are in financial difficulties will be anxious to reschedule their debts speedily, without having either to engage in protracted litigation with minority hold out investors or to buy them out at par. Nor will bodies like the IMF or, indeed, banks or clearing systems through whom payments are channelled want to be exposed to such investors. It therefore seems to me to be very important that one of two things happens. The first involves investors and their advisers working out, in precise terms, what the commercial objective behind this provision is. Armed with that, lawyers can draft something that not only achieves that objective but avoids other, damaging, interpretations. The second is dependent on the failure of the first. If we really cannot identify what this provision is supposed to do, we should remove it. Leaving the provision as it is simply plays into the hands of those whose sole interest is to maximize their profit at the expense of others and who will create the maximum of disruption to achieve their ends.