October 2019

Who is the noteholder? Confusion between the law and practice

The documents constituting a note issue will usually limits the ultimate investor’s ability to sue anyone in provide that a requisite percentage by value of the intermediated securities chain beyond their noteholders can vote on resolutions or direct the immediate intermediary (the so-called “no look trustee to take action under the trust deed. through principle”). Therefore, all participants in a note issue will be concerned to identify the person with the standing to Why is there confusion? cast the votes and to give instructions. If instructions Bonds can be issued in registered or bearer form. are taken from the wrong person, there is a risk that However, most bonds traded in the international any resolution passed or direction given, and debt capital markets are, conceptually, bearer subsequent actions taken in reliance on it, will be instruments in denominations of $US50,000 to invalid. $100,000, title to which passes on delivery. It is easy to lose sight of this fundamental legal truth An investor would (quite rightly) see this as a simple because documentation has, over time, matter. Common sense dictates that when an adapted and evolved to take account of the practical investor purchases debt securities in the debt capital trading and procedures of markets, the investor – being the person with the systems. economic interest and bearing the investment risk – should always be the person whose voice counts Nowadays bonds are almost never issued to when considering any proposals relating to, or investors as “definitive” notes. Definitive notes are actions to be taken in connection with, those notes. physical pieces of printed paper with coupons attached for the payment of interest. However, the question of who is a noteholder can Transfers of definitive notes are effected by the become a far more confused issue than logic would seller handing over the relevant pieces of paper to dictate. Much of this confusion is caused by the the buyer against payment. various attempts in bond documentation to reconcile the practical operation of the clearing systems with Instead, a permanent “global note” (a single the “pure” legal characteristics of a listed bond. As document representing the entire bond issue with we discuss in this article, this can present particular the terms and conditions of the bonds attached) will problems for a note trustee. be issued, which is deposited with a financial institution (the “common depositary” for the clearing It therefore seems to be good news that the Law systems) for safekeeping during the lifetime of the Commission, in August, published a call for evidence bond issue. Trading in bonds occurs through the seeking consultees’ views about, and experiences of, crediting and debiting of securities and cash the current intermediated securities system. One of accounts held with clearing systems (being the projected outputs from the call to evidence is and Clearstream in the eurobond market) and stated to be a scoping study which, among other investors in bonds often hold their investment things, will apparently provide an accessible through complex chains of contractual relationships statement of the current law, including a clear with custodians (“intermediaries”), culminating with explanation of how shares and bonds are “owned” an “accountholder” – a financial institution which and held. The call to evidence seeks views on a holds a securities and cash account with the clearing range of issues relevant to intermediated securities, system. including whether and to what extent the current law

SUCCESSOR NOTE TRUSTEE ROLES

The diagram below shows an intermediated chain.

Common Depositary for the Clearing Systems (holder of the temporary/permanent global note)

Clearing Systems (Euroclear or Clearstream, Luxemborg)

Each clearing system has a number of Account Holders who have accounts with that clearing system

Account Holder (typically a bank or brokerage house)

Each Account Holder holds bonds either for his own account or for his client (who may be the Investor or an Intermediary)

Intermediary(ies) (typically a bank or brokerage house that does not have an account with a clearing system)

There may be one or more Intermediaries between an Account Holder and the Investor

Investor

SUCCESSOR NOTE TRUSTEE ROLES

However, even where a permanent global note in respect of an alleged breach of the misleading represents the note issue, the terms and conditions statements term. of the global note will provide that if a clearing system closes for business for a period of time The Secure Capital note issue involved a fiscal (usually 14 days), or ceases business, the Issuer will agency structure, rather than involving a note be obliged to ensure the delivery of an equal trustee holding the benefit of the issuer covenants aggregate principal amount of definitive notes in on trust and through whom enforcement action exchange for the global note. would usually be taken.

Crucially, therefore, the fact that a note is at its core The documentation stated that it was only the a definitive instrument (rather than a book entry in a “holder” of the notes who had locus to sue the issuer clearing system) will enable the investor to claim for breaches of covenant. The Court of Appeal payment from the issuer – even where there is a concluded that the “holder” of the Notes for this complete failure of the current market through which purpose was the common depositary as holder of the it can be traded. permanent global note. The effect of the judgment was to remove from the investors contractual The definition of noteholder in bond recourse against the issuer, as the common documentation depositary will never take action on their behalf. The uneasy relationship between the practical way in However, if the definition of Noteholder had been which bonds are held in intermediated chains and extended to encompass those with beneficial the fact that they are, at their heart, definitive interests in the Notes, would an investor be in a instruments has led to inconsistency over the way in stronger position? Not according to Business which “Noteholder” is defined in bond Mortgage 6 v Greencoat & others, a case documentation. involving the latest attempt by an SPV associated with Rizwan Hussain to wrest control of a Historically, trust deeds would define the noteholder securitisation structure1 . In this case, the judge as “the bearer of a Note” – reflecting the fact that recently stated, on an obiter (i.e. non-binding) basis, notes are, conceptually, definitive bearer that the “holder of the beneficial interests” in the instruments. Trust Deeds issued by a number of law relevant notes, for the purposes of the definition of firms with considerable expertise in the capital instrumentholder, meant only those persons in markets arena still use this drafting. whose name the notes are held in the records of the clearing systems (i.e. the account holders at Tweaks and enhancements to the operative Euroclear and Clearstream). provisions of trust deeds sometimes attempt to reflect clearing systems procedures and the way in This decision is in line with the so-called “no look which the notes are held in intermediated securities through principle” which limits an ultimate investor’s chains. ability to sue anyone in an intermediated securities chain beyond their immediate intermediary. In Re It is also now common to see trust deeds in which Lehman Brothers International (Europe) (in the definition of Noteholder has been extended. For administration) the court categorised the legal example, the definition can be construed to include, nature of an intermediated securities chain as a for certain purposes, “a holder of beneficial interests series of trusts and sub-trusts. in the Notes”. However, while investors might assume they would be covered by a Noteholder The Law Commission’s call to evidence on definition which includes within its scope the holder intermediated securities flags that the no look of “beneficial interests” in the notes, recent case law through principle has been described as suggests that this is not the case. “controversial” - noting that Richard Salter QC points out that the ultimate investors are the ones who Case law on noteholders and the holders have paid for the securities and taken the economic of beneficial interests in notes

In 2017 in Secure Capital SA v Credit Suisse AG the

Court of Appeal looked at whether an investor with 1 Please also see our article “Stepping in or over-stepping” an interest in notes issued in bearer form and held relating to issues arising from the attempts of Mr Hussain and through the Clearstream system had a direct claim his SPV, Clifden, to take control of the Fairhold securitisation for breach of contract against the issuer of the notes structure.

SUCCESSOR NOTE TRUSTEE ROLES

risk, yet they get “the downside of the advantages This is likely to mean seeking proof of holding and that this principle confers on others”.2 We have authority from each intermediary at each level of the sympathy with this concern given that a bond is, at intermediary chain, until it is possible to identify the its legal core, a definitive bearer instrument and the ultimate investor of the notes attributable to the trading and settlement mechanics are procedural relevant direction. matters which can be dispensed with where necessary. Conclusion Hopefully note trustees will actively engage with the The position of a note trustee Law Commission’s call to evidence process to explain The stark way in which the courts have applied the the particular challenges that they encounter. no look through analysis presents a note trustee with particular challenges. For a note trustee (whose Whether or not change will follow as a result of the fiduciary duties are owed to the noteholders as a resulting scoping study will remain to be seen. At class) matters are rarely as simple as looking to the this stage the Law Commission has not been asked holding of the clearing system accountholder, but not to produce a full report with detailed beyond. A trustee will see itself as owing its duties to recommendations for reform. The purpose of the those with any ultimate right to call for definitive scoping study is stated to be to inform public debate, notes, rather than to the financial institutions develop a broad understanding of potential options fulfilling mechanistic roles in an intermediary chain. for reform and develop a consensus about issues to be addressed in the future. Processes and procedures have developed to enable the ultimate investor in notes held through the In the meantime, note trustees and their lawyers will clearing systems to cast votes on extraordinary need to continue to navigate the issues prudently. resolutions at noteholders’ meetings. The Law Commission’s call to evidence raises the fact that Key contacts these processes do not always work well, in part due to the sheer length of certain intermediary chains. Charlotte Drake Senior associate, corporate trusts However, in general there should (in theory at least) and restructuring be a well-trodden route, supported by mechanisms T: +44 20 7809 2583 set out in the meetings schedule of the trust deed, E: [email protected] which ensure that it is the ultimate investor (or its authorised agent) who will ultimately dictate how votes will be cast. However, the position can be Jayesh Patel rather different where the note trustee receives, for Partner, corporate trusts and example, directions to accelerate following an event restructuring of . Many trust deeds provide that if an event T: +44 20 7809 2238 of default occurs the trustee may, and, if so E: [email protected] requested in writing by holders of at least one quarter of the aggregate principal amount of the outstanding Notes, shall, accelerate the bonds (subject to the trustee’s right to be indemnified to its satisfaction).

The trustee will therefore always need to satisfy itself that any person or persons from whom it receives a direction to accelerate represents at least the requisite percentage of holders entitled to serve such a notice. We would argue that best practice continues to be for the trustee to look beyond the clearing system accountholder to satisfy itself that the clearing system accountholder is acting in accordance with the wishes of the ultimate investor.

2 Paragraph 2.35 of the Law Commission’s call to evidence on intermediated securities, citing R Salter, Intermediation and Beyond (2019) p 139.

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