Bank required to advise about mismatch between termination rights under a loan and associated hedge

Dresden Higher Regional Court, judgment dated 9 April 2015, file No 8 U 532/14

A bank was held liable for not advising a client that an interest rate collar would continue to bind him if he decided to terminate early the loan agreement to which the hedge related. The Dresden Higher Regional Court found that the bank had breached its obligations under an implied advisory agreement by failing to bring this risk to the client’s attention. The ruling is a marked further step towards imposing greater liability on banks in connection with derivatives. Previous case law relating to derivatives in Germany has mainly related to speculative transactions. This judgment extends the rather strict stance of German courts to hedging transactions. 

The defendant, a businessman, borrowed EUR 900,000 from the claimant bank. The loan agreement provided for a floating interest rate, linked to EURIBOR. The loan was to be repaid over ten years in equal installments. The bank had advised the defendant on various forms of protection against a rise in EURIBOR. Following these discussions with the bank, the defendant entered into an interest rate collar agreement (Collar) with a third party. Under the Collar, the third party agreed to make payments to the client if EURIBOR exceeded a certain level. As these payments would match any increase in the client’s obligation to pay interest to the bank under the loan, they operated as a “cap”, limiting the client’s maximum interest payments. If EURIBOR fell below a certain level, however, the client agreed to make payments to the third party. This “floor” limited the client’s potential savings which would have otherwise resulted from a low EURIBOR level, and also served to finance the cap with the result that the Collar was free of charge for the client.

The notional amount of the Collar matched the notional amount of the loan. This was to be reduced periodically in line with the agreed annual loan repayments. Neither the loan agreement nor the Collar provided for early termination. Under German statutory law, however, a borrower may terminate a floating rate loan in certain circumstances without a duty to pay any compensation. This termination right only applies to loan agreements and does not extend to related transactions, such as the Collar.

When interest rates fell, the client decided to repay the loan prematurely and thereby terminated the loan agreement on the basis of the statutory termination right. He then no longer wanted to be bound by the Collar. The Collar counterparty charged the client a compensation payment of EUR 16,020.55 and a breakage fee of EUR 25,300. The bank paid these amounts to the Collar counterparty under a guarantee. When the bank sought to reclaim these amounts from the client, he refused to pay. The client argued that the bank should bear this amount as damages for a breach of the duty to give correct and comprehensive advice. The bank sued the client but the client won in the first and the second instance.

Breach of advisory agreement

The Dresden appeal court dismissed the bank’s claim for reimbursement. It held that the bank could not reclaim the payments to the Collar counterparty from the client, as the bank owed him the same amount in damages. The court found an advisory agreement between the client and the bank, tacitly concluded during their discussions. In the court’s view the bank was obliged to provide comprehensive information and proper advice in line with the client’s goals. It had to disclose the “special risk” for the client that he would continue to be bound by the Collar if he decided to terminate the loan agreement. According to the court, this risk was not obvious even to a sophisticated bank client and despite the fact that the loan agreement and the Collar had been entered into as legally separate transactions with two different counterparties.

Context 

For a long time, German courts have held that when banks recommend a product, an advisory contract is tacitly concluded between the bank and the client. Under this contract, a bank must, inter alia, disclose material risks and also explain how the recommended product works. These obligations are often similar, but not identical to, requirements under applicable financial markets supervisory law (for example, the rules implementing the EU Markets in Financial Instruments Directive, MiFID).

Comment

While there have been numerous court decisions in Germany on banks’ obligations to disclose conflicts of interest or risks of loss resulting from adverse market movements, this case establishes a new obligation in connection with hedging transactions.

The court found a duty of the bank to inform the client about the effects of a potential future exercise of a termination right of the loan that the hedge related to. Arguably, the judgment puts the defendant in a better position than he had initially bargained for. The client had agreed under the Collar to make payments to the counterparty if the rate fell below a certain threshold (the floor). In exchange, he was protected against an increase of the interest rate above a threshold (the cap). At a time when interest rates had fallen, the client decided to terminate the loan on the basis of his statutory termination right. Although there was no termination right agreed in the Collar, the court’s decision effectively allowed the client to pass on the costs of terminating it. Had the client agreed on an early termination right for the Collar to mirror the statutory termination right for the loan agreement, however, he would have paid a fee for that right or would have been offered different commercial conditions. As the Dresden court allowed the defendant to charge the Collar’s termination fee to the bank, the client ended up having the best of both worlds: he had been protected against rising interest rates for the entire life of his loan agreement without ever having paid for this.

It appears an open question whether other appeal courts will follow this judgment. Some judges might have doubts as to the wisdom of this decision. It is based on the premise that a bank should disclose something fairly obvious: that a client who enters into two separate legal agreements – a loan agreement and hedge agreement – with two different parties, may not be able to terminate the hedge free of charge just because it decides to terminate the loan agreement.

To minimise the risk of liability, banks should consider taking this new judicial view into account when advising their clients. It is worth noting, however, that the court analysed the matter as a case of mis-selling and created a disclosure duty only. The court did not read a statutory termination right into the hedge transaction. The judgment accepted that the client remained legally bound by the hedge transactions even after the loan was terminated. It only required from the bank that the client be made aware of this potential scenario.