Posted on Sep 03, 2015 by | Tags: Tailored Business Loan, TBL, fixed rate loan, breakage charges, unenforceable, challenge, early redemption, termination, internal swap arrangement, economic costs | 0 Comments
Fixed Rate loans excluded from FCA Review Process
Internal review into fixed rate loans
Both Lloyds/Bank of Scotland and Clydesdale Bank had very reluctantly initiated their own Internal Review processes after David Thorburn, at the time CEO of Clydesdale bank plc, admitted to the Treasury Select Committee on 17th June 2014 that fixed rate loans operated in exactly the same way as IRHPs, that the wording on the Bank’s documentation was confusing, and that the documentation of many of the fixed rate loans being sold was wholly deficient in terms of defining breakage costs under these contracts. However, as a voluntary exercise, these internal Review processes are not subject to any external independent objective scrutiny, and provide no possibility of appeal.
Legal challenge to “breakage costs” under fixed rate loans
A real breakthrough for fixed rate loan customers has occurred, however, when borrowers successfully established in the Chancery division of the English High Court that their bank could not enforce “breakage costs” or “termination costs” which it maintained would arise on early redemption of a fixed rate loan.
The bank’s “internal swap arrangement”
The Merchant Place Property Syndicate had taken RBS to court over “termination costs” of around £2.4 million which RBS were attempting to impose on the Syndicate if it were to redeem a loan of £9.2 million. The bank described the costs specifically as an “Interest Rate Swap termination cost” but it became clear that what the bank were actually referring to was what they described as an “internal swap arrangement” between one department of the bank, RBS Corporate Banking, and another, RBS Markets, the interest rates desk responsible for hedging all of the Bank’s interest rate risk. The Markets desk would fund the Internal Swap by entering into an interest rate swap with an external market counterparty.
Borrower to indemnify the bank against any loss in unwinding funding transactions
The loan agreement contained an indemnity whereby the borrower would indemnify the bank for any “loss” which would include “any cost to the Bank incurred in the unwinding of funding transactions”. The key question therefore was how this provision should be interpreted. What would qualify as a relevant “funding transaction”? When considering how contractual provisions should be interpreted and construed, judges will generally look at the “background factual matrix”.. However, the judge held that the internal arrangements of the Bank formed no part of this factual matrix because the borrowers were not, and could not have been aware of the way in which the bank funded or hedged fixed rate loans it made available to its customers.
He also went on to point out that the internal swap was not a contractual arrangement, but simply an arrangement between two departments in the bank. The borrowers, and subsequently their solicitors, had repeatedly asked for the basis for imposing termination costs, and the bank had consistently refused to disclose the basis on which the costs were being applied. The judge held that the bank could not simply decline to explain the legal basis for the calculation. At the hearing before him, he had pushed the bank to identify the relevant funding transaction that resulted in a cost to the bank of unwinding of funding transactions. Eventually, as the judge put it, the bank pinned its colours to the internal swap as being the relevant funding transaction.
Bank told any “internal swap arrangement” is not a “relevant funding transaction”
The judge was very clear: any internal arrangement between two different departments within the bank could not qualify as a relevant funding transaction. The context of the definition of “Loss” clearly envisages a transaction which takes place between two different legal entities, and different departments of the Bank do not qualify as separate entities. These were all internal arrangements within the bank, effected for its own purposes. Even if the internal swap could be regarded as a funding transaction, nevertheless it was a transaction which gave rise to no loss or cost to the bank because it was simply an internal arrangement between departments.
Key issue: the wording of the loan document and associated terms and conditions
The first thing anyone with a fixed rate loan should bear in mind is that the case turned very much on the precise wording of the fixed rate loan contract, which provided that the borrower should pay any cost to the bank incurred in the unwinding of any funding transaction. Anyone seeking to challenge breakage costs on their fixed rate loan should look carefully at the precise terms of their fixed rate loan contract: in particular, what does the contract say about losses and cost to the bank on early redemption?
If you were a Clydesdale Bank customer, you may well have taken out a Tailored Business Loan which was a particular type of fixed rate loan in which the customer was offered a fixed rate, or a partially fixed rate such as a cap and collar. There is no reference to any breakage costs or indemnity against losses in the terms of the TBL contract; instead the TBL says that the loan is subject to the bank’s standard Terms and Conditions. These in turn state that that the bank may pass on to the SME the cost to the bank arising from early redemption. But what are these economic costs?
Early TBL customers were provided with a document explaining Economic Costs as being breakage penalties calculated on the value of the interest which could have been earned on the facility for the remainder of the term if it had not been redeemed early. This type of calculation provides an entirely theoretical “loss” which is simply a hypothetical assessment of what the bank could have earned if the contract had remained in place, and the approach taken in the Merchant Place Syndicate case suggests that these notional breakage costs might well be capable of challenge.
Later TBL customers were told that the costs were “breakage costs” incurred as a result of having entered into “various arrangements with third parties”. These arrangements are not well defined but generally the process is understood to be that the bank will adopt an insurance policy called an Interest Rate Swap Agreement, commonly referred to as an IRSA. It is signed with a counterparty, commonly a larger bank, and the terms are negotiated in the markets on the trading floor. If the SME's loan is large, the IRSA could be negotiated specifically for the loan. If the loan is relatively small, it could be bundled with other loans and an IRSA negotiated in respect of the total. The IRSA contract is legally independent of the SME’s business loan incorporating the fixed rate, but although the business loan and the IRSA contracts are legally separate, they are linked internally by the bank in order to have a permanent record of the link for accounting purposes. The key question is whether the analysis in Merchant Place Syndicate could be applied to arguments about TBL breakage costs.
With potential breakage penalties currently running at between 20% and 40%, the time is ripe for them to be challenged, and the Merchant Place Syndicate decision may just be what is needed to get such claims off the ground.
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