Court of Appeal considers proper approach to determining obligations under sub-participations

In Yieldpoint Stable Value Fund, LP v Kimura Commodity Trade Finance Fund Limited[1], the Court of Appeal has given a judgment on the interpretation of documentation for sub-participations that is of significance for the secondary market for debt trading. In confirming the approach to construing master trading agreements generally, the judgment is also of broader relevance for other financial products documented under master agreements.

The High Court held at first instance[2] that including a maturity date in a sub-participation earlier than the end date of the underlying loan fundamentally undermined the purported sub-participation.

The Court of Appeal overturned the High Court’s decision, providing assurance that, where parties to a sub-participation contract using standard documentation, the conventional terms of that contract should apply.

The nature of a sub-participation

Although a sub-participation is a relatively common financial transaction, it has no strict legal meaningas a matter of English law. A sub-participation (more commonly called a participation in the US market) typically involves a lender passing on all or part of the economic benefits and risks under a loan (or, far less commonly, bonds) to a participant. 

A sub-participation can be: 

• funded – here the participant funds the lender for the amounts that the lender has paid (or will pay) to the borrower, and the lender must pay the participant any amounts that the lender receives from the borrower under the loan; or
• a risk participation – here the participant does not pay upfront, but instead must reimburse the lender for any amounts that the borrower fails to pay under the loan.

The original lender remains the lender of record under a typical English law sub-participated loan. This avoids difficulties that can arise when attempting to transfer a loan, although it is commonly a feature of sub-participations under English law that the participant has to accept the credit risk of the lender, as the lender must pay on the payments made by the borrower.

The sub-participation between Kimura and Yieldpoint

In December 2019, Kimura Commodity Trade Finance Fund Limited (Kimura) lent $22.5m to Minera Tre Valles SPA (Minera) as a multi-year loan. Under the loan, Minera was to pay interest at the rate of LIBOR plus 8%, plus further amounts if the price of copper exceeded a specified level. Following an extension to the term of the loan, as of March 2021 the loan was due to be repaid by Minera in December 2024.

On 30 March 2021, Yieldpoint Stable Value Fund, LP (Yieldpoint) paid $5m to Kimura to acquire a sub-participation in the loan. Under the sub-participation, Kimura agreed to pass to Yieldpoint the amounts received in respect of 22.22% of Kimura’s interest in the loan (the Participated Proportion). (The figure of 22.22% corresponded to Yieldpoint’s $5m investment as a proportion of the $22.5m loan principal.)

Kimura and Yieldpoint used the “Master Participation Agreement for Trade Transactions” published by BAFT (Bankers Association for Finance and Trade) as a master agreement to govern the sub-participation (the Master Agreement), choosing the law of England and Wales as the governing law[3]. They agreed the specific terms of the sub-participation in a further document, the Participation Agreement (PA). The standard form of the Master Agreement provides that a PA overrides the Master Agreement if there is a conflict between the two.

Most significantly, Kimura and Yieldpoint agreed in the PA that the sub-participation would last for one year, until 31 March 2022. This was the date on which Minera was to make its first repayment of an 8.33% of the principal amount of the loan (with the balance of the loan principal remaining outstanding at that time). Yieldpoint could successively extend the sub-participation for another year by giving Kimura not less than 45 days’ notice. 

Kimura agreed to pay Yieldpoint the interest paid by Minera on the Participated Proportion of the loan, less a spread of 0.5% retained by Kimura. This effectively set the expected rate to be received by Yieldpoint in respect of the Participated Proportion of the loan at LIBOR plus 7.5%, together with any copper price-linked payments made by Minera.

Minera continued to make payments on the loan until December 2021. However, by November 2021 Minera’s financial difficulties were so significant that Kimura agreed to postpone the repayment of principal that was due to be made in March 2022.

Minera ceased operations in January 2022.

On 10 February 2022, Yieldpoint notified Kimura that it would not be extending the sub-participation (and so the sub-participation would end on 31 March 2022, as originally scheduled).

Minera defaulted on the payment of interest due on 31 March 2022, the last day of the sub-participation.

In February 2023, Minera was formally declared insolvent. 

Yieldpoint issued court proceedings in July 2022. Yieldpoint claimed that on a proper interpretation of the contract the $5m advanced to Kimura was a loan by Yieldpoint to Kimura that Kimura as borrower must now repay in full.

How will the courts interpret a contract?

The approach the courts will take to interpreting (in legal terms, “construing”) a contract has now been effectively codified in a series of three cases (Arnold v Britton [2013] EWCA Civ 902; Rainy Sky SA v Kookmin Bank [2011] UKSC 50; Wood v Capita Insurance Services Ltd [2017] UKSC 24).

If the wording of a contract is clear and unambiguous, the court will assume that it reflects the parties’ intentions and apply that wording literally. This is the case even if the wording produces an uncommercial or unlikely result, provided the result is not completely absurd. In this case, the court has no power to enquire into the meaning behind the contract words.

If a contract contains unclear or ambiguous wording, the court will embark on the process of interpreting it. It will attempt to identify what the parties intended by the wording in question.

In doing so, the court will apply an objective test. It will consider the ordinary meaning of the words in the contract to establish what a reasonable person with all the relevant background available to the parties would have understood by them.

To achieve this, the court will consider different, “rival” interpretations of the language used (the iterative process), testing them against the language elsewhere in the contract (textual analysis) and the factual circumstances surrounding the making of the contract (contextual analysis).

The court will consider the commercial consequences of each rival interpretation and ultimately adopt the interpretation that most closely accords with what the evidence suggests was the parties’ intentions. Often, this will align with the interpretation that makes most sense commercially, but the court will not discount the possibility that parties intended to conclude an uncommercial bargain.

The High Court judgment

In a ruling in May 2023, the High Court interpreted the transaction documents as creating a sub-participation of the income earned on the loan, but not of the risk of repayment of the principal. In coming to this view, the High Court observed the following.

• The transaction was described as being for a fixed term. Yieldpoint had told Kimura that Yieldpoint had an obligation to repay its own investors after a year. Moreover, a representative of Kimura had stated on a call that, unless Yieldpoint elected to continue participating, Kimura would pay Yieldpoint back on 31 March 2022.
• The Master Agreement did not contain provisions for a sub-participation being of an earlier maturity date than the loan being sub-participated. The one-year maturity was “alien” to a sub-participation of a longer-dated loan, and was instead appropriate for a debt owed by Kimura unlinked to repayment of the Minera loan. Implicit in the High Court’s reasoning is that a sub-participation should pass all credit risk associated with the loan, rather than just the credit risk for a time period of the loan’s existence.
• Kimura argued that the amount Kimura should have been due to repay Yieldpoint on the one-year maturity of the sub-participation was the fair market value (FMV) of the Participated Proportion. However, the High Court observed that:
• the transaction documents did not set out any formula or other method for calculating FMV;
• to imply a FMV feature into the contract would be inconsistent with its express wording; and
• doing so would mean that Yieldpoint was exposed to the default risk of the loan for longer than the single-year fixed term of the sub-participation.

In the High Court’s view, these presented insurmountable obstacles to the concept that Yieldpoint had entered into a sub-participation of Minera’s credit risk on the principal of the loan.

Rather, the High Court determined that Kimura had entered into its own fixed-term loan with Yieldpoint under which Kimura, as borrower, was obliged to pay the income earned on the Participated Proportion of the loan to Minera. The only matter that was sub-participated was the income earned on the loan to Minera, and the only risk passed from Kimura to Yieldpoint was the risk that Minera did not pay this income.

As a consequence, Kimura was obliged to pay back Yieldpoint’s $5m principal amount. 

The Court of Appeal judgment

Kimura appealed to the Court of Appeal.

The Court of Appeal allowed the appeal, overturning the High Court’s decision. In doing so, it made the following observations.

• In concluding that the sub-participation was an independent loan, the High Court had put undue weight on evidence of doubtful admissibility (in particular, that Kimura had stated that, if Yieldpoint did not renew after a year, Yieldpoint would be repaid in full). Even if that evidence had been admissible, the discussions added nothing to the documentation. Any discussions had to be considered against the backdrop of the transaction documents, particularly an express warning in those documents that Yieldpoint's capital was at risk.
• The High Court had approached matters the wrong way around, by finding a problem and then determining whether this could be surmounted. The correct approach was to read the contractual provisions together first to reach a coherent interpretation that conformed with commercial sense. Only if that was not possible should the High Court have determined which provisions should be given priority and which should be given a modified reading or overridden altogether. Adopting the proper approach to interpretation, the Court of Appeal said it was difficult to see how the documents could be read as other than a conventional sub-participation with a right of redemption.
• It was not true that the Master Agreement did not contemplate the sub-participation ending before the underlying loan. There were two circumstances in which it could do so, undermining the High Court’s conclusion that the maturity date of the sub-participation brought about a complete change in the nature of the transaction.
• On the High Court’s interpretation, Kimura would have agreed to transfer to Yieldpoint almost all return on the Participated Proportion of the loan while Kimura retained the capital risk. The High Court had wrongly discounted the fact that this interpretation was highly uncommercial. Although in general the adequacy of consideration and the parties’ commercial motives should not be considered by the court, they are relevant when considering competing interpretations. The Court of Appeal stated that it was a strong factor to be considered that Yieldpoint's interpretation undermines the commercial sense of the structure set out in the Master Agreement.
• It was not necessary for the purposes of deciding the case to identify what was to occur if the sub-participation maturity date occurred when there was no default under the loan. However, the Court of Appeal found the more sensible interpretation to be that Yieldpoint would be paid the par amount of its principal.  

Conclusion 

The Court of Appeal’s decision restores the position that most commercial parties may expect, but the fact that the matter required litigation and was decided differently at first instance underscores the need for commercial documents to address clearly each significant potential outcome.

This is particularly so for transactions with a binary payoff, such as those dealing with credit risk. Depending on whether a relevant event has occurred, or a risk has been properly passed, there can be a significant transfer in wealth from one party to another, making the terms especially contentious.

There is wisdom in Phillips LJ’s observation that “[p]arties discussing a trade often focus on what will occur if all goes to plan, without addressing what they no doubt consider to be the unlikely situation of default or non-performance, leaving that to the written terms”. The role of legal counsel is to ensure that all realistic eventualities are addressed in the transaction documentation, including those that commercial parties may not be quick to expressly address.

The judgment is also a prompt to reflect generally on interactions between connected documents (where, as here, a master agreement and all trades concluded under it are to form a single agreement) or between connected contracts (where, for example, a suite of finance documents is intended to comprise separate but linked contracts). Documentation structures that provide that a transaction confirmation or other subordinate document overrides a master agreement or other superior document are common in financial transactions. But, as the Court of Appeal highlighted, it can require a nuanced exercise in contractual interpretation to determine whether terms in a “subordinate” document conflict with those in a “superior” document and so should be overridden or modified.

With thanks to the contributions of Christine Long, Dominic Sedghi and Madeleine Brown.

[1] Yieldpoint Stable Value Fund, LP v Kimura Commodity Trade Finance Fund Ltd [2024] EWCA Civ 639 (18 June 2024) 

[2] Yieldpoint Stable Value Fund, LP v Kimura Commodity Trade Finance Fund Ltd [2023] EWHC 1212 (Comm) (22 May 2023) 

[3] This document is not used as frequently in the London market as the documents published by the Loan Market Association (LMA), while in the United States the Loan Syndications & Trading Association (LSTA) has equivalent documents published under New York law.