Court affirms wide definition of a 'financial institution'

Olympia Securities Commercial Plc (Olympia) was a company specialising in commercial and residential property development. Anglo Irish Bank Corporation Limited (now Irish Bank Resolution Corporation Limited) (IBRC) provided loans to Olympia and also entered into three interest rate swaps with Olympia.  In order to secure this finance, Olympia entered into a facility agreement and an International Swaps and Derivatives Association Master Agreement (ISDA Master Agreement) with IBRC. Olympia also granted a debenture in favour of IBRC.

IBRC suffered severe financial difficulty following the global financial crisis and was ultimately placed into special liquidation by the Minister of Finance for the Republic of Ireland. IBRC, acting through its special liquidators, then agreed to sell a portfolio of assets including the loan to Olympia to LSREF III Wight Limited (LSREF). Under its agreement with LSREF, IBRC assigned its rights under the facility agreement with Olympia to WDW 3 Investments Limited (WDW), as nominee for LSREF. The debenture was also assigned by IBRC to WDW, who held it on trust for itself and a German bank, MHB-Bank AG.  WDW had been incorporated around two weeks prior to the loan sale. It had an issued share capital of £1 and no employees.

Olympia failed to repay its loans when due, thereby suffering an event of default under the facility agreement. As a result, Olympia was placed into administration. Separately, IBRC's liquidators served a notice on Olympia under the ISDA Master Agreement purporting to terminate the swaps. As of the date of the hearing, the administrators had paid all sums due by Olympia under the facility agreement to WDW. The only sums remaining to be distributed were the early termination amounts payable by Olympia following termination of the swaps. Arazim (Gibraltar) Limited (Arazim), the ultimate parent of Olympia and an unsecured creditor, disputed WDW's assertion that this amount was properly due by Olympia and payable to WDW.

As a result, the administrators decided to seek directions from the court under paragraph 63 of Schedule B1 of the Insolvency Act 1986 on three issues:

1. the validity of the assignment of the facility agreement from Olympia to WDW;
2. the validity of the termination of the swaps; and
3. whether the early termination amounts payable by Olympia following termination of the swaps was secured by the debenture which had been assigned to WDW.

The first issue for the court to determine was whether WDW could be regarded as a "financial institution". The facility agreement which had been entered into between Olympia and IBRC and assigned to WDW restricted assignments by IBRC as lender to "any one or more banks or financial institutions". The relevant test was set out by the Court of Appeal in the case of Argo Fund Limited v Essar Steel Limited [2006] EWCA Civ 241. The test provides that for an entity to be regarded as a "financial institution" it must be “…a legally recognised form or being, which carries on its business in accordance with the laws of its place of creation and whose business concerns commercial finance", and whether or not its business included the lending of money on the primary or secondary lending market.

Arazim argued that WDW was, at the date it acquired the loans, a non-trading SPV with an issued share capital of £1, and as such could not be regarded as a "financial institution". Judge Pelling QC, sitting as a judge of the High Court, rejected this argument. Firstly, restricting the definition of a "financial institution" to include entities having a certain size of share capital would be entirely arbitrary, because there was not necessarily any connection between the capitalisation of a company or other incorporated entity and its trading volumes or commercial reputation. Secondly, it is not necessary to consider whether an entity had been trading prior to the relevant transaction in assessing whether or not it was a "financial institution". Taking such an approach would mean that a newly formed corporate entity wholly owned by a multi-national heavily capitalised commercial bank would not be a financial institution before it entered into a nominal £100 transaction, but would became one thereafter. A restriction on this basis would be entirely artificial and therefore incorrect. The correct approach is to assess whether the entity:

1. has been formed for the purpose of carrying on a business that concerns “commercial finance”;
2. is of a legally recognised form or being; and
3. carries on its business in accordance with the laws of its place of creation.

This ruling therefore affirms the definition of a "financial institution" set out by the Court of Appeal in the Argo case.  In his judgment, Judge Pelling QC stressed that the definition is wide enough to encompass a party buying and selling debt in the secondary debt market as well as corporate entities incorporated by such institutions to carry into effect their commercial activity. Therefore, WDW was a financial institution.

The second and third issues to be decided by the court were matters of contractual interpretation. In both instances, the judge favoured WDW's interpretation, ruling that:

• the terms of the ISDA Master Agreement entitled IBRC to terminate its swaps with Olympia following Olympia's default under the facility agreement, although IBRC was itself in continuing default; and
• the amounts payable by Olympia following early termination of the swaps were secured by the debenture notwithstanding the assignment of the debenture by IBRC to WDW.

This judgment should be welcome news for organisations trading in the secondary debt market, which can be comfortable that entities established by them for the sole purpose of acquiring and holding loans and security will be regarded as "financial institutions". Borrowers wishing to avoid their lenders assigning their debt interests to such organisations should seek to negotiate narrower transferability provisions in facility agreements.

Stephen Barclay is a restructuring expert at Pinsent Masons, the law firm behind Out-Law.com