In Re Arboretum Devon (RLH) Ltd [2021] EWHC 1047 (Ch), the High Court concluded that a market standard clause within an intercreditor agreement (ICA) (restraining challenge to the validity or enforceability of any security) prevented a junior lender from undermining an agreed priority waterfall.

The junior lender had contended that the priority waterfall was ineffective as the senior debt was not in fact secured pursuant to the “Finance Document” (such that the ICA did not attach to the debt as a matter of fact) where the borrower’s obligations to repay the senior debt arose not in accordance with the terms of the Finance Document itself but by reason of a separate unsecured, secondary restitutionary claim.

The court (obiter) construed (broadly market) definitions of “Finance Document” and “Secured Liabilities” in the senior security document and adopted broad based interpretations in each case to the benefit of the secured senior lender. (The restitutionary claim was said to arise “pursuant to” the “Finance Document”, was hence secured, and as such attracted the protection of the ICA). 

Nonetheless, the reading of the phrase “pursuant to [the] Finance Documents” was somewhat surprising, likely out of line with unjust enrichment theory, and notably pro-draftsman.

The junior lender’s case was nonetheless restrained by the ICA – which market form language was held to broadly restrict challenges to the security’s value and practical efficacy, and not merely challenges concerning matters of formal validity (such as execution) alone. Importantly, the judge further confirmed that even if he had concluded that the restitutionary claim was not a Secured Liability under the debenture, the ICA would nonetheless have blocked the junior lender’s challenge because the junior lender acknowledged the senior secured lender’s debt as secured. This in turn raises numerous interesting practical questions, considered within.

Finally, contractual estoppel came into play (obiter): the recorded recitals to the ICA (acknowledging that the senior debt was effectively secured) were incompatible with the nature of the junior lender’s challenge, and the estoppel arose to prevent such claims being made.

Lendy (the peer to peer lending platform) loaned funds to the borrower, secured in favour of a security trustee (Saving Stream Security Holding Ltd) (Security Agent). Further secured lending was obtained from Shoby. Shoby and the Security Agent entered into the ICA where it was agreed that the secured lending in favour of the Security Agent would rank in priority up to a certain amount. The borrower entered into administration, and its business and assets were sold. Under the ICA, this sum was to pass in priority to the Security Agent, and hence to Lendy and its exposed investors.

Shoby challenged the distribution to the Security Agent on a preliminary basis: that certain warranties and representations made by Lendy under the relevant finance documentation were unfounded at the time of the lending, and as such it was claimed (via an under-developed argument for unjust enrichment) that the “basis” of the loan “failed” at the outset, such that any money flowing from Lendy to the borrower was not in fact loaned under the contractual finance documents. Instead, it was said that any obligation to repay lies in restitution (the author suggests that this must be a claim in unjust enrichment – albeit a notably under-articulated one) or what Shoby called an “implied loan” (which must also, the author submits, in turn be just another under¬developed claim in unjust enrichment). The judges’ commentary on point bears repeating – as it neatly addresses certain of the serious hurdles such a claim would face at the outset:

“Insofar as it alleges a breach of warranty or misrepresentation, that would not be sufficient to make the loan contracts void ab initio, and Mr Tabari accepts that (a) Shoby has no standing to take any action on behalf of Arboretum to avoid those contracts if they are presently only voidable and (b) neither Arboretum nor its administrators have sought to do so. He submits that Shoby does not have to show that the contracts are void, only that nothing was lent under them. Pressed as to what the alleged ‘failure of basis’ means in law, he struggled to articulate it.”

Assuming however that such a claim would nevertheless survive those difficulties (and would generate grounds for restitution of the unjust enrichment), the judge addressed two distinct questions:

• whether a claim for restitution (of unjust enrichment) was secured in favour of the Security Agent; and
• whether Shoby’s challenge to the effectiveness of the security was restrained by the ICA.

The relevant terms of the Security Agent’s debenture were as follows:

• "Secured Liabilities” means “all present and future monies obligations and liabilities of the Borrower to the Beneficiaries whether actual or contingent and whether owed jointly or severally, as principal or surety or in any other capacity together with all interest (including without limitation default interest) accruing in respect of those monies obligations or liabilities pursuant to any Finance Document.” (authors’ emphasis)
• “Finance Documents” means “the Loan Agreement, the Security Documents and all other agreements entered into between [Lendy] (directly or as agent) or [the Security Agent] ... and [the borrower].”
• “Loan” means the principal amount outstanding under the Loan Agreement and “Loan Agreement” means “the loan agreement entered into on or around the date of this debenture between [the borrower] and [Lendy] as agent for the Lenders.”

Shoby’s argument was helpfully summarised as follows:

“the debenture secures ‘Secured Liabilities’ as defined, which must be liabilities arising ‘pursuant to a Finance Document’. If whatever obligations are owed to the Lenders arise by way of restitutionary obligation or pursuant to an implied contract of loan, rather than the loan documented in the Loan agreements, those obligations do not arise pursuant to a Finance Document and so are not Secured Liabilities as defined.”

The premise being that claims “pursuant to” a Finance Document are limited to claims to enforce the terms of that document as a contract. The judge posited two potential meanings of the phrase “obligations ... pursuant to any Finance Document”:

• obligations arising under the law of contract from the terms of any Finance Document; or
• obligations arising from the “transactions provided for” in any Finance Document.

The court preferred the second interpretation, applying the principles of contractual interpretation, on the basis that the definition of “Secured Liabilities” was intended to be broad, and that there was little reason to consider that the multiple types of Secured Liabilities referred to therein (monies, obligations or liabilities) must all be contractual in nature. The court’s reasoning (that it would be a “nonsense” to suggest that any objective observer would have understood the parties to be limiting the types of liabilities secured in this way – given the economic substance of the obligation to repay was the same under contract and restitution) can be found in paras 30 and 31: 

“While it is obviously the case that each Loan agreement ... is intended to create a contract and give rise to contractual obligations, at a more general level it describes a transaction that the parties have agreed to enter into, by which substantial amounts of money are to be paid over, on behalf of the Lenders, to Arboretum. The monies that were in fact paid over were no doubt so paid with the intention on both sides of pursuing the transaction described in that document. If the fact of payment gives rise to obligations to repay (as Shoby’s proposed pleading accepts it does) then those obligations, whatever their legal characterisation, are it seems to me properly considered as obligations arising ‘pursuant to’ that transaction. It may thus equally be said that the obligations arise ‘pursuant to’ the Finance Document, in that it was that document that provided for the transaction to be entered into, and which the parties to it considered they were following.”

The court’s reasoning remains open to criticism, given that it relies upon:

• Ignoring a linguistic (definitional) mistake in a formal finance document: The author would highlight that the norms of contractual interpretation do not, after the case of Investors Compensation Scheme v West Bromwich Building Society [1998] 1 WLR 896 (HL), readily allow specific definitional frameworks (especially ones such as this – so widely relied upon in the loan market) to be so easily bypassed, especially given they were professionally drafted, and further the ease of including a restitution catch-all in the definition of Secured Liabilities for example. The court has re-written the loan market’s definition of Secured Liabilities, replacing the (previously well understood) loan market term of “Finance Document” with the more amorphous and lower case term of “transaction”, and ignoring what might have been more readily viewed as a mistake of drafting (failing to secure restitutionary obligations). We await the broader consequences of this re-imagination of the loan market form.
• Treating a remedy in restitution for unjust enrichment as one arising “in accordance with” the transaction: In the case of a failed loan contract, unjust enrichment lawyers would conceptually describe such an event as a “failure of basis/condition”: the parties have a common understanding, objectively assessed, that the borrower’s enrichment is conditional on the happening of an event (the proper performance of the loan contract) – and that event does not occur, or “fails”. Where such an event occurs, query whether it is then logically coherent to say that an obligation to effect restitution arises “pursuant to” the “transaction” (in the sense of it being defined as meaning “in accordance with”). The obligation to repay might be better described as arising as a consequence of the failure of that very transaction, as opposed to arising “in accordance with it”. Nonetheless, the ruling contains drafting lessons for advisors to senior lenders: ensure the security suite expressly secures restitutionary obligations however arising.

Clause 2.9 of the ICA provided that:

“Neither Lender shall challenge or question ... the validity or enforceability of any Security constituted by a Security Document ...”

Shoby presented a nuanced legal argument to the effect that: questions of “validity” per se are limited to matters such as “whether formalities of execution and registration had been complied with, whether the Security Documents refer accurately to any associated legal charges, whether one debt or security ranks above another and what assets the security attaches to”. As such, it was argued that security may in principle be valid security, “in the sense that all necessary formalities have been complied with and a security interest in property has been created, and yet in the event secure nothing because no liabilities of the sort it is expressed to secure have arisen”. Those latter points, it was said, go rather to the practical efficacy, and value of the security – which security could be said to be valid and registered, but, practically, hollow. Had the parties wished to restrain such challenges, Shoby suggested drafting should have been so included.

The court held that the circumstances at hand, and the drafting of the ICA as a whole, made this narrower interpretation not viable – it was much more than a challenge on quantum. The judge concluded that every indication in the recitals, and framework of the ICA as a whole, was that both parties had entered separate loan agreements with the borrower, that these loans had been secured effectively, acknowledged by each party (as giving rise to Senior Debt in the case of Lendy’s exposure), and that the issue in hand was the relative priority of that secured lending. This conclusion was buttressed by numerous specific provisions of the ICA (eg the clauses specifying that the senior debt and not just the senior security ranked in priority to the junior debt and the further clause providing that the Lenders’ priority shall stand regardless of any invalidity, illegality, or unenforceability, such that all enforcement proceeds should be applied first towards the senior debt). To permit such a challenge would, in the author’s view, and in the absence of clear language permitting it, have improperly stultified the ICA’s broader framework – it would have undermined the premise of the ICA and the mutually acknowledged reason for its existence.

This section of the judgment too raises drafting lessons for senior lender advisors: clarify that the relevant clause of the intercreditor restrains challenges to effectiveness and value in addition to challenges to validity and form.

Importantly, the judge also confirmed that even if he had concluded that the restitutionary claim was not a Secured Liability under the debenture, he would nonetheless have blocked Shoby’s challenge pursuant to cl 2.9 of the ICA: “if Shoby has agreed not to challenge the validity of the security as security for obligations it acknowledged to exist, it cannot matter what the nature of those obligations is, or the nature of the challenge that is raised”.

This in turn raises the possible difficult case for the junior lender: if a borrower (or, for example, an insolvency office holder) could successfully argue (the author contends this remains possible for the reasons below) that the restitutionary obligation in unjust enrichment does arise “pursuant to”/in accordance with the “Finance Documents” – this means the security would fall away vis a vis the borrower and senior secured lender, but not as between the junior and secured lender. This could result in a situation where the junior lender’s security is valid, the senior security is ineffective, the recoveries in the insolvency are paid out to the junior (and only) secured lender, but the junior lender is nonetheless caught by the mandatory turnover provisions in the ICA – resulting in the senior secured lender paradoxically maintaining its effective senior secured status.

Finally, the doctrine of contractual estoppel would have prevented Shoby from effectively arguing its case: the recorded recitals to the ICA (stating that the senior debt was secured) were incompatible with the nature of the junior lender’s challenge, and the estoppel arose to prevent the claims being made.