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Correcting drafting errors – what is the best approach and what evidence is admissible?

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Butland Russell
Russell Butland

Counsel

London

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17 May 2016

​The High Court held that a mistaken reference in an interest rate swap confirmation to the 1992 ISDA Master Agreement instead of the 2002 ISDA Master Agreement could not be corrected by interpretation. However on the facts the mistaken reference could be corrected by rectification. LSREF III Wight Ltd v Millvalley Ltd [2016] EWHC 466 (Comm) highlights that interpretation is unlikely to cure a drafting error unless there is some ambiguity or linguistic mistake which makes the drafting commercially absurd.  Rectification may however work where interpretation does not, and has the added benefit of allowing evidence of the subjective intentions of the parties and their negotiations to be admitted. 

The dispute arose out of loans and related hedging arrangements between a bank lender and three affiliated special purpose vehicle (SPV) borrowers. Over the course of six years, the loans and hedges were restructured. An issue arose in relation to one restructured hedge with one SPV as to whether it was governed by the printed form of the 1992 ISDA Master Agreement (without a Schedule), which had been incorporated into the Confirmation of the restructured hedge, or whether it was governed by the 2002 ISDA Master Agreement that was then in place between the bank and that SPV at the time of entry into the restructured hedge. This mattered because the 2002 ISDA Master Agreement included an Additional Termination Event that was subsequently triggered by repayment of the loan made to another SPV. No such Additional Termination Event applied under the printed form of the 1992 ISDA Master Agreement. The judge accepted that it was a clear administrative error that the Confirmation documenting the restructured hedge mistakenly omitted reference to the existing 2002 Master Agreement and instead used standard language incorporating the printed form of the 1992 ISDA Master Agreement (without a Schedule).  The error could not be cured as a matter of construction, but rectification was available in these circumstances.

Facts

Millvalley Limited (Millvalley), a SPV of the property developer William McCabe, acquired an interest in a Glasgow department store. In 2006 Millvalley entered into an interest rate swap with Anglo Irish Bank Corporation (the Anglo Irish) to hedge its interest rate exposure on the loan that funded that acquisition (the Original Swap). The Original Swap was confirmed in a long-form swap Confirmation that included market standard language requiring the parties to negotiate in good faith the execution of a 1992 ISDA Master Agreement “with such modifications as you and we shall in good faith agree” and, pending such execution, incorporating the printed form of the 1992 ISDA Master Agreement (without a Schedule). No Master Agreement was in fact executed at that time.

Anglo Irish was nationalised in 2009 and in 2011 merged with another troubled Irish entity to form the Irish Bank Resolution Corporation (the IBRC).

In mid-2011 an extension of loans by the IBRC to two of Mr McCabe's other SPVs (the Loans) was agreed, on the basis that Millvalley sold the store and repaid its loan. However the Original Swap remained in place and was used as a hedge for the Loans. As part of this process Millvalley and the IBRC entered into a 2002 ISDA Master Agreement dated 13 December 2011 (the Millvalley 2002 Master Agreement) to document the existing hedging arrangements. In the Schedule to the Millvalley 2002 Master Agreement, the parties agreed various Additional Termination Events triggered by the repayment, prepayment or cancellation, in whole or in part, of the Loans.

In late 2012 the Loans were further restructured, and the Original Swap restructured so that its term and notional amount matched that of the restructured Loans (the Restructured Swap). On 19 December 2012 Millvalley and the IBRC executed a long-form Confirmation of the Restructured Swap, that did not refer to the Millvalley 2002 Master Agreement but instead included the same market standard language that had been in the Confirmation of the Original Swap requiring the parties to negotiate in good faith to execute a 1992 ISDA Master Agreement and pending such execution incorporating the printed form of the 1992 ISDA Master Agreement (without a Schedule).

In June 2014 one of the Loans was repaid, triggering an Additional Termination Event under the 2002 ISDA Master Agreement. The IBRC issued a notice designating an Early Termination Date under Section 6(b) and sought payment of an Early Termination Amount of GBP 4,282,518.90 plus interest.

Millvalley refused to pay the Early Termination Amount, arguing that the Restructured Swap was governed by the 1992 ISDA Master Agreement, which did not contain the relevant Additional Termination Event. The 2002 ISDA Master Agreement was not referred to in the Confirmation of the Restructured Swap and therefore did not apply.

The IBRC assigned its claim for the Early Termination Amount to LSREF III Wight Limited (Wight).

Correcting the mistake by interpretation?

It was common ground between the parties that there had been no contemporaneous discussions in late 2012 as to which ISDA Master Agreement applied to the Restructured Swap, and Cooke J accepted evidence from Wight that the reason the Restructured Swap referred to the 1992 ISDA Master Agreement was simply because the 2002 ISDA Master Agreement between the parties had not been correctly entered into the IBRC’s operating systems, and so the system that automatically generated the swap Confirmation for the Restructured Swap did not generate the correct form of Confirmation.

Wight argued that, as a matter of construction of its terms in the relevant commercial context, the Restructured Swap was governed by the Millvalley 2002 Master Agreement, on the basis that something had plainly gone wrong with the language of the swap Confirmation, and a reasonable person having all the relevant background would have understood the parties to be referring to the Millvalley 2002 Master Agreement.

Cooke J rejected this argument. Applying Lord Hodge's summary of the case law on remedying mistakes by construction in Arnold v Britton [2015] AC 1619, he held that the reference could not be corrected by construction as there was no ambiguity in the language and a linguistic mistake could only be corrected by construction where, without the correction, the linguistic mistake would be such a "commercial nonsense as to make it absurd for the parties to refer to it". Cooke J held that, while it was clear on the evidence that the reference to the 1992 ISDA Master Agreement was a mistake, the Confirmation itself did not drive the court to the conclusion that that reference was a commercial nonsense or absurd. The terms of the Restructured Swap could operate perfectly sensibly by reference to the 1992 ISDA Master Agreement.

Correcting the mistake by rectification?

Wight also argued that, if the proper construction of the Restructured Swap is that it is governed by the 1992 ISDA Master Agreement, then it should be rectified so as to refer to the Millvalley 2002 Master Agreement.

Cooke J found that as a matter of construction the Millvalley 2002 Master Agreement governed the Original Swap from 13 December 2011. In other words, it was the ISDA Master Agreement contemplated by the language requiring the parties to negotiate in good faith to put in place an ISDA Master Agreement. The fact that it was based on the standard form 2002 ISDA Master Agreement rather than the standard form 1992 ISDA Master Agreement did not affect this conclusion, the choice of form falling within the scope of the words “with such modifications as you and we shall in good faith agree”. Cooke J further held, on the evidence of the exchanges between the parties during the 2011 and 2012 restructurings, that there was a common understanding that was objectively communicated between the IBRC and Millvalley that the Millvalley 2002 Master Agreement would also apply to the Restructured Swap. Therefore the mistaken reference to the 1992 ISDA Master Agreement in the Confirmation of the Restructured Swap was capable of rectification as, on the facts, the four requirements for rectification set out in Daventry District Council v Daventry & District Housing [2012] 1 WLR 1333 were met. There was an objective common continuing intention that the Restructured Swap should be governed by the Millvalley 2002 ISDA Master Agreement, that continued at the time of the execution of the Restructured Swap, there was an outward expression of accord as to that intention, and it was only by mistake that the Confirmation of the Restructured Swap did not reflect that intention.

Comment: This case is a good lesson on the importance of seeking the right remedy. In particular it demonstrates that, although the four Daventry requirements for rectification are often not easy to satisfy, where a linguistic mistake falls shy of commercial absurdity a rectification argument may succeed where a construction argument would otherwise fail, especially in light of the reversion to a more literal approach to the construction of contracts in Arnold v Brittan.

In particular a rectification argument can be a useful tool to put before the court contemporary evidence as to the parties' negotiations and subjective intentions, which would otherwise be inadmissible in a pure contractual interpretation case. Often, as in this case, such evidence makes plain the parties' real understanding of their agreement, and exposes the artifice of one side's legal position. In this case Cooke J posed himself the same essential question on construction and rectification – what would the reasonable objective observer, possessed of all the relevant background, conclude as to the intention of the parties – but, because of the additional background information available to that observer for the rectification question, arrived at a different conclusion.    

While he did not need to decide the point, Cooke J noted that a number of recent High Court decisions have doubted whether an outward expression of accord should be a strict legal requirement for a rectification claim (rather than simply an evidential factor), reflecting academic criticism of Daventry. Daventry remains good authority that it is a strict legal requirement, but the issue is ripe for further judicial consideration. 

Finally the court also emphasised that standard form contracts, such as the ISDA Master Agreement, are less susceptible to purposive linguistic interpretations by reference to background circumstances and factual matrix, due to the heightened importance of consistency and predictability of the meaning of terms in such contracts, given their widespread use and therefore the potential impact of a judicial interpretation of any provision of the standard form on other transactions governed by the same standard terms. 

Two minor points worth noting in passing. First, the Millvalley 2002 Master Agreement included a form of “sweep-in” clause in Part 5(a) of the Schedule, although as a matter of interpretation the clause did not encompass the Restructured Swap for reasons explained by Cooke J in his judgment. Secondly, Cooke J specifically considered Section 11 in awarding costs on an indemnity basis in favour of Wight and rejecting an argument by Millvalley that the Section 11 indemnity somehow fell outside the limited permission to transfer an Early Termination Amount under Section 7 of the ISDA Master Agreement.

Further information
 
This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  For more information please contact Sarah Garvey sarah.garvey@allenovery.com, or tel +44 20 3088 3710.