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08 September 2015
Barnett Waddington Trustees (1980) Ltd v The Royal Bank of Scotland Plc ( EWHC 2435 (Ch)) is an important borrower-friendly decision in the Chancery Division of the English High Court, arising from a bank's attempt to force a borrower to pay costs allegedly arising from the termination of an internal interest rate swap on early redemption of a £9,237,000 facility which had been taken out to finance the acquisition, development and letting of a property.
Unlike many such loan agreements (in particular, loans at floating interest rates), there was no provision for the borrower to enter into an interest rate swap to hedge its interest rate risk arising from the loan arrangement. Rather, this case concerned whether the borrower was liable to pay the bank any sum in respect of the termination of the bank's own internal arrangements for hedging its interest rate risk arising from the loan. The court found that on the true construction of the loan agreement between the parties, the internal swap did not qualify as a "funding transaction", for which – under the agreement – the borrowers were to indemnify the bank.
However, the judgment also noted that the borrower had accepted that a specific hedging transaction by the bank, with a third party (rather than internally), back to back with the loan (rather than, as discussed below, on a portfolio basis), would engage the indemnity. The judgment did not address the question of whether external hedging arrangements entered into by the bank with third parties on a portfolio basis to fund the internal swap would have engaged the indemnity. It also left open the question of whether – had the internal swap been between different legal entities within the bank, rather than merely two departments – the indemnity would have been engaged.
Following the judgment, borrowers would be well advised to scrutinise carefully demands for payment of large break costs by banks when fixed-rate loans are repaid or terminated early.
The claimants were the trustees of a trust, which was a member of a syndicate, the members of which (acting by its trustees) had entered into a loan agreement in 2004 with the bank. The maximum term of the loan was 30 years and the borrowers were liable under the agreement to pay a prepayment fee if it repaid the loan in the first five years of the term. The agreement also provided for a fixed interest rate and included an indemnity in the following terms:
The Borrowers shall indemnify the Bank on demand against any Loss… which the Bank has sustained or incurred as a consequence of:
(f) any cost to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility."
'Loss' was defined as "any costs to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility".
More than five years elapsed since the loan agreement was entered into and the borrowers raised the prospect of redeeming the whole loan.
However, the bank contended that as a condition of such redemption, the borrowers had to pay an 'interest rate swap termination cost' quantified by the bank at £2.236 million. The bank noted in solicitors' correspondence that the borrower had agreed to indemnify the bank for any loss if funding transactions undertaken in connection with the loan had to be unwound, including the break costs for the early termination (to match the early redemption of the loan) of an interest rate swap which the bank had entered into to "fund the transaction and hedge the risk of changing interest rates". It emerged that this swap was an internal interest rate swap between the bank's corporate banking division (which advanced the loan to the borrower, having itself obtained the funds from the bank's group treasury department) and its interest rate desk (which had responsibility for hedging all of the bank's interest rate risk). The internal swap had been funded by the bank entering into external hedging arrangements with third parties on a portfolio basis (ie, not on a back-to-back basis, but by aggregating the interest rate risk of a number of different internal swaps).
The borrowers disagreed that it was liable to pay the costs of terminating the internal swap on the basis that these did not fall within the scope of the indemnity contained in Clause 12(f) of the agreement, since it was not a "funding transaction" within the definition of 'loss' provided in the loan agreement.
The borrowers argued that the bank could not transact with itself and the internal swap was not a transaction for these purposes. The bank did not sustain or incur loss upon the internal swap being unwound. The bank's financial position remained the same regardless of whether the internal swap was unwound: no cost to the bank (as set out in Clause 12(f)) was incurred. Although the bank's financial position might be affected as a result of any consequential change to external interest rate swaps entered into in relation to the internal swap, that was a different issue.
The borrowers also contended that the bank's construction would be unfair and uncommercial, as the borrowers would suffer the downside of unwinding the internal swap when interest rates had moved against the bank's corporate banking department, but would not obtain an upside when interest rates had moved in its favour.
Although it was accepted that a specific hedging transaction by the bank, with a third party, back to back with the loan, would fall within Clause 12(f), the borrowers maintained that the scope of Clause 12(f) did not encompass the internal swap or consequential external hedge arrangements which the bank had transacted with third parties on a portfolio basis.
The bank argued that the internal swap was a relevant funding arrangement and that, although no loss would arise if the matter were purely internal, there was a cost because unwinding the internal hedge would affect the external portfolio hedge and thereby cause loss.
The judge made four preliminary points:
The judge explained that in order to establish that the Clause 12 indemnity covered the impact of the early payment of the loan, on the internal swap, the bank needed to show that the internal swap was a "funding transaction undertaken in connection with the Facility". Although the clause was not particularly well drawn, the judge considered that the indemnity was given in relation to any cost incurred in unwinding a relevant funding transaction (at least where there was a good reason for unwinding it).
The judge noted that no hedging contract was entered into by the borrowers and that they knew nothing about the internal arrangements within the bank (albeit that hedging was within the contemplation of the parties). The judge's view was that had the loan been at a floating interest rate coupled with an interest rate swap to fix the rate of interest, it would have been accurate to describe the swap as a funding transaction undertaken in connection with the facility (although whether an interest rate swap between the bank and a third party to cover its risk on the loan to the borrower, where that was part of the bank's risk management on a portfolio basis, amounted to such a funding transaction was a different question). However, the judge concluded that the internal swap was not a funding transaction within the meaning of the definition of 'loss' or Clause 12(f). The internal swap between two departments of the bank did not amount to a 'transaction', and it followed that there was no 'funding transaction'. Further, the internal swap did not give rise to any loss or cost to the bank, even though external hedging may only have been entered into because of the internal swap.
The judge therefore made the declaration sought by the claimant that the borrower was not liable to pay the bank any sum in respect of the internal swap. The judge commented that the grant of the declaration should not be taken as a decision that the external hedging arrangement on a portfolio basis was not a funding transaction within the definition of 'loss' or within the meaning of Clause 12.1(f). However, the judge also noted that the borrower may have a case for saying that the bank was precluded from relying on this point, as it had come to court on the clearly stated basis that it was only relying on the internal swap as the relevant funding transaction.
For further information on this topic please contact Alan Williams or Andy McGregor at RPC by telephone (+44 20 3060 6000) or email (email@example.com or firstname.lastname@example.org). The RPC website can be accessed at www.rpc.co.uk.
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