Interpreting Ambiguities In Loan Documents - Part I

Saturday, May 1, 2004 - 01:00

Part II of this article appears in the June 2004 issue of The Metropolitan Corporate Counsel.You and your borrower signed the loan documents two months ago. The borrower now tells you that it intends to consummate a transaction you just can't imagine you agreed to let it do. As you listen to the borrower explain the proposed transaction, you ask yourself, "Isn't there something in my 200-plus-page credit agreement that prohibits the borrower from doing that?" After searching all afternoon, you find the one provision that appears to be relevant to the issue, but it goes on for a page and a half and, if the truth be known, you don't really understand what it means. Poised at the abyss of legal ambiguity, you naturally call your lawyer (who, for a king's ransom the borrower won't let you forget, drafted the credit agreement) to ask whether the borrower may consummate the proposed transaction.

Ever wonder what the lawyer actually does to answer your question? This two-part article provides you with the same secret decoder rings used by the best lawyers to interpret contracts.1 With the decoder ring, you can start understanding contract interpretation.

In Part I we will look at some basic rules of contract interpretation and apply them to a question that often arises under loan documents. Then in Part II we will apply the rules to more common questions.
Basic Rules Of Contract Interpretation

Let's start with some, but certainly not all, of the basic rules of contract interpretation.

•Goal of contract interpretation. The objective of interpreting a contract is to effectuate the intent of the contracting parties.2

•Determine the intent of the parties from the four corners of the contract. In general, determine the meaning of the contract from the contract itself (the so-called four-corners rule) rather than by looking to evidence outside of the contract,3 which might include term sheets, information memos, and drafts of the loan documents. A court will generally consider the entire contract to determine the intent of the parties.4 In some cases, however, extrinsic evidence may be used to determine whether a phrase in a contract is ambiguous.5

• Extrinsic evidence can be used to interpret ambiguities. "Only where the language of a contract is ambiguous, uncertain, or susceptible of more than one construction may a court interfere to reach a proper construction by construing uncertainties and considering extrinsic evidence."6

• Interpretation can't override the express language of the contract. Because "the court's role is limited to interpreting and enforcing the agreed terms of the contract, a court cannot make a new contract for the parties under the guise of interpreting the writing, or change the words of a written contract so as to make it express the real intention of the parties if to do so would contradict the clearly expressed language of the contract."7 In some cases, however, the courts appear to do the opposite. On one occasion, the Court of Appeals (New York's highest court) stated, "[A]nd even though literal construction might sustain an opposite interpretation, if it defeats and contravenes the purpose of the agreement it is not to be so construed."8 The case involved a sale of bikes by a seller/middleman. The buyer was supposed to deliver a letter of credit to the manufacturer of the bikes and pay a commission to the seller. The contract contained a provision (not a condition) that said the contract was void if the buyer didn't deliver the letter of credit. The contract also contained a common provision stating that, if the buyer signed and returned the contract to the seller (who had prepared it and sent it to the buyer), the contract would be binding. The buyer returned the contract to the seller, thereby making it binding, but the buyer failed to deliver the letter of credit to the manufacturer. The buyer asserted the contract was void (which is exactly what the contract said should happen in that circumstance), but the court held the buyer liable. The court said the parties intended for there to be a binding contract and couldn't have intended the buyer to have a right to get out of the contract due to its own conduct. If you think the court reached the right decision, consider the possibility that the buyer's intent at the time of signing the contract was to have an escape clause built into the contract because of its concern that it wouldn't be able to obtain a letter of credit. The buyer's concern is not unusual. Acquisition agreements often contain a financing condition. In any event, the words of the contract are clear (the contract is void if the buyer doesn't deliver a letter of credit), yet the court held the buyer liable anyway.

•Every contract implies an obligation of good faith in its performance.9 This does not mean that the obligations of a contract are automatically modified by giving effect to this rule but simply that the obligations contained in a contract must be performed in good faith.

•Terms are given their plain meaning. If terms used in a contract are not given technical definitions within the four corners of the contract, the common meanings of those terms as used in ordinary English shall govern the application of the contract.

•Trade terms may be given meanings different from their plain meaning. Notwithstanding the foregoing rule, parties using technical words or trade terms in a contract probably intended to give them the same meaning they are given in the relevant trade.10

•Statutory definitions may be used by courts to interpret contractual terms. In some cases, a statute may, indirectly, compel the particular construction of a word used in a contract. Sometimes a statute will define words used in statutes generally, such as the New York General Construction Law, which provides meanings of certain terms whenever used in a statute. Courts occasionally use these meanings to interpret words in a contract as well. For example, in addition to containing rules relating to extension of time when performance of an act is due on a Saturday, Sunday, or public holiday (Section 25-a), the New York General Construction Law also contains the obviously useful rule that the term "lunatic" does not include someone suffering from idiocy or mental retardation (Section 28).11 Also of note, Section 1-204 of the New York Uniform Commercial Code (UCC) defines the term "seasonably;" a court might import this definition into its interpretation of such term when used in a security agreement subject to the provisions of the UCC.

Now it's time to take two aspirin and test yourself on the application of the rules.
Priority Of Postpetition Interest

Hypothetical 1: Is interest on subordinated debt really junior to debt service on a senior bank loan?

The bank will make a senior loan to a borrower to finance an acquisition but only if the borrower can finance 60 percent of the acquisition price with equity or subordinated debt. The subordination agreement says exactly what you want it to say when discussing the concept of subordination to senior indebtedness:

The payment of principal, interest, fees, expenses, indemnities and all other amounts of any nature whatsoever in respect of the Subordinated Note are subordinated to the indefeasible payment in full in cash of all principal, interest, fees, expenses, indemnities and all other amounts of any nature in respect of the Senior Indebtedness.

Unfortunately, the borrower becomes bankrupt, and $10 million of interest accrues on the senior indebtedness during the bankruptcy proceeding. Ready for the test question? Are payments on the subordinated note junior to the payment of the $10 million of postpetition interest on the senior indebtedness?

Read literally, the answer is clearly "yes," but, the actual answer is "no." Notwithstanding the rules of contract interpretation cited above, some courts have adopted a "Rule of Explicitness."12 Under this rule, unless the subordination provisions specifically refer to postpetition interest, the subordination provisions will be interpreted to exclude postpetition interest from the scope of the definition of senior indebtedness. General references to "interest" in the definition of "senior indebtedness" do not suffice.

So where's the ambiguity that enabled the court to create this result? The key, it turns out, is the phrase "payment in full" in the subordination provision itself. What exactly has to be paid in full? Under certain circumstances, the senior lender may not under the Bankruptcy Code be entitled to assert a claim for postpetition interest even though the senior lender's loan documents, purely as a matter of contract, provide that the interest on the senior indebtedness continues to accrue. If the senior lender receives the interest accrued on the senior indebtedness to the petition (as well as principal), has it been "paid in full" for purposes of the subordination provisions? The court noted that although the paid-in-full language "sounds in absolute terms," it is nonetheless ambiguous in the context of a bankruptcy proceeding. The court stated that "a junior creditor may reasonably expect to recover some repayment from the debtor without being held hostage to an often sizable claim for the senior creditor's post-petition interest."13

That was an easy one. In Part II we will examine more applications of the rules.1 This article does not address the related topic of statutory interpretation. The interpretation of the Uniform Commercial Code (UCC) (particularly Article 5 relating to letters of credit, Article 8 relating to investment property, and Article 9 relating to security interests generally) is of particular interest. The experts frequently disagree on the interpretation of the UCC. Washburn University Law School runs a chat room for questions relating to the UCC airing interpretative questions. See,
2 Hartford Accident & Indem. Co. v. Wesolowski, 33 N.Y.2d 169, 350 N.Y.S.2d 895 (1973).
3 22 N.Y. Jur. Contracts §§ 214-215 (1996).
4 22 N.Y. Jur. Contracts § 251 (1996).
5 Pellot v. Pellot, 759 N.Y.S.2d 494 (A.D., 2nd Dept. May 2003).
6 22 N.Y. Jur. Contracts § 214 (1996).
7 22 N.Y. Jur. Contracts § 217 (1996).
8 Indovision Enterprizes, Inc. v. Cardinal Export Corporation, 354 N.Y.S.2d 113 (App. Div., 1st Dep't. 1974), aff'd 370 N.Y.S.2d 897 (1975).
9 22 N.Y. Jur. Contracts § 230 (1996). Section 1-203 of the New York UCC provides that every contract within its scope imposes an obligation of "good faith in its performance or enforcement."
10 22 N.Y. Jur. Contracts § 242 (1996).
11 While this statute may not be useful in loan agreement interpretation, it may nonetheless be useful to readers' efforts in being precise during loan workout negotiations.
12 In re Southeast Bank Corp., 156 F.3rd at (CA 11 1998), certifying questions to 93 N.Y.2d 178. The applicable contract in this case was governed by New York law and the court certified the question to the New York Court of Appeals.
13 In re Southeast Bank Corp., 156 F.3rd at 1124 (CA 11 1998), certifying questions to 93 N.Y.2d 178.

William E. Hiller is a Partner in the Corporate and Financial Services Department in the New York office of Willkie Farr & Gallagher LLP. Geoffrey R. Peck is an Associate in that same department. This article was originally publsihed in the March 4, 2004 edition of Commercial Lending Review (Vol. 19, No. 2, pp.21-25). Reprinted with permission from Aspen Publishers.

Please email the authors at or with questions about this article.