Dutch interest rate swap validly terminated for error by SME

Amsterdam Court of Appeal 15 September 2015, ECLI:NL:GHAMS:2015:3842

A non-professional client of a Dutch bank (the claimant) had entered into an interest rate swap (IRS) under the influence of error (dwaling) and therefore the termination of the IRS by the client was valid. This ruling signifies a change in approach in IRS litigation in the Netherlands, as courts have so far been reluctant to accept claims for termination of an IRS sold to small and medium-sized enterprises (SME) due to error. Inconsistency in Dutch court rulings on IRSs remains, creating uncertainty for the banks regarding risk. This ruling could potentially create more litigation against banks relating to allowance facilities linked to IRSs. To mitigate risks, banks should reassess the information they provide to clients on margin requirements under IRSs and related allowance facilities.

The claimant owns a chain of shops and is active in the sale and leasing of shop premises. In 2008 he entered into a loan agreement, at three-month Euribor plus surcharge, with the bank for the purchase of several shop premises. The bank required that at least 50% of the loan had to be hedged through a derivative position with the bank.

At a meeting with the claimant, the bank explained to the claimant about different types of derivative products that could be used for hedging interest risk. The claimant was given standard information on derivatives, including on margin requirements. The claimant entered into the loan, a framework agreement for OTC derivatives, and a so-called “allowance facility” with the bank. The allowance facility was interest-free and could be used for margin calls under derivative trades entered into with the bank. A few days later, the claimant entered into an IRS with the bank to hedge the interest risk under the loan. For MiFID purposes, the bank qualified the claimant as a non-professional client.

In 2009 and 2012, the bank significantly increased the interest surcharge on the loan which prompted the claimant to start looking for an alternative bank. The claimant decided to refinance the loan with funds from a third party provider. The bank informed the claimant that he could repay the loan only after he had provided the bank with additional security for the margin requirements under the IRS.

Claimant’s arguments change – but are ultimately successful

The claimant terminated the IRS, and the bank sued.

In the district court, the claimant stated, inter alia, that he had entered into the IRS under the false impression that the IRS would cover the entire interest risk under the loan agreement, including the interest surcharge. The court found that even though the materials provided to the claimant by the bank did not sufficiently state that the IRS did not cover the risks related to the variable interest surcharge, the claimant knew or should have known that there was a variable interest rate component which did not fall under the IRS. The claimant appealed.

In the Court of Appeal, the claimant changed his arguments, now stating that the bank had not informed him sufficiently about the margin requirements under the IRS and the allowance facility. The claimant alleged that the bank had said that the allowance facility was merely a formality that was required in order for the bank to comply with its duty of care towards him. The claimant stated that he was not aware of the credit available under the allowance facility, nor that his margin requirements under the IRS were being met through the allowance facility. The claimant stated that if he had known this, he would not have entered into the IRS.

Insufficient information on margin calls and role of allowance facility

This change of tack was successful for the claimant. The Court of Appeal found that the documents provided to the claimant by the bank did not include sufficient information:

on the impact of a potential decrease of three-month Euribor on the margin requirements; and
on the fact that the allowance facility was in fact a credit facility against which the bank booked the margin requirements.

The bank had stated during the court proceedings that the allowance facility was a free of charge extra service which the client was under no obligation to use. The Court of Appeal found this statement to be factually incorrect. There was no evidence that the client wished to use the allowance facility. The bank had itself, without informing the claimant, booked margin payments against it.

Hidden cost of the allowance facility

The Court of Appeal found that the allowance facility was not free-of-charge as claimed by the bank. When the allowance facility was increased to cover the increasing margin requirements under the IRS, the risk rating of the claimant became higher which in turn caused the bank to increase the interest surcharge. Therefore, in practice, there was a cost to the client of the allowance facility – even though it was indirectly caused by the increased interest surcharge.

Termination of IRS by customer was valid

The Court of Appeal concluded that the bank had not complied with its information requirements towards the claimant. The court stated that margin requirements are aimed at helping customers appreciate the hidden and less immediate risks of these types of products. The bank was wrong to downplay the role of the allowance facility by stating that it was a mere formality. The IRS had been entered into in error and therefore the termination of the IRS by the claimant was valid.

Amounts paid by both parties under the IRS have now to be returned, which leads to a net amount to be paid by the bank. However, in relation to the repayment by the bank, the Court of Appeal found that the costs that the claimant would have made for hedging his interest risk in a more suitable manner must be taken into account. The parties have to provide the Court of Appeal with information on the costs of what would have been the most suitable product for the claimant to hedge the interest rate risk in order to determine the final net amount to be paid by the bank.

Comment

In our March 2015 article in the European Finance Litigation Review, we concluded that inconsistent Dutch rulings in relation to IRSs sold to SMEs have made it difficult for banks to assess risk. This ruling does not bring any further clarity for the banks in this regard. The Court of Appeal tested the margin arrangements and the information provided by banks against a high standard of duty of care. The ruling does not show that the Court of Appeal, in its assessment, considered in any detail the knowledge and experience of the claimant nor the claimant’s obligation to investigate. In the past, Dutch courts have been reluctant to accept claims for termination of an IRS based on error. The courts have found that the information provided has been sufficiently clear about the risks or that the clients have a responsibility to assess the relevant information and to seek specialist advice when entering into IRSs. In this ruling, the Court of Appeal takes a different view and finds that the lack of sufficient information is a sufficient ground for termination of the IRS based on error.

Offering allowance facilities to non-professional clients in relation to IRSs has been standard practice for some of the banks in the Netherlands in the past and still is. The ruling could create a wave of new litigation against these banks. The question of whether or not a claim on error will be successful will need to be judged on the specifics of each case. A foundation specialising in class actions in relation to IRSs in the Netherlands has already announced on its website that it is preparing a class action for the termination of IRSs based on the ruling, as it considers the ruling to be universally applicable to all IRSs with an allowance facility sold by the bank to SMEs. As a consequence of this ruling, banks should reassess the information that they provide to clients in relation to margin requirements, allowance facilities used for margin calls and the associated cost.

In 2014, the Dutch Authority for the Financial Markets (AFM) requested that six Dutch banks reassess the 17,000 IRSs (in total) that they have sold to SMEs in order to assess whether the IRSs were suitable for the clients and whether the services provided in relation to the IRSs were appropriate. The banks are currently performing this reassessment and AFM will come with a report on the results of the reassessment sometime in early 2016. It will be interesting to see whether this ruling will impact the reassessment and the AFM’s analysis thereof.