Risk disclosure obligations – new leverage for borrowers of structured loans
The disclosure obligations arising from an implied advisory agreement between a bank and a non-consumer borrower of a structured loan have been recently spelt out by the Federal Court of Justice (Bundesgerichtshof, BGH). The court granted damages to a German municipality against a bank for the breach of such implied advisory duties. The bank had marketed a structured loan to the municipality with an interest rate depending on the EUR/CHF exchange rate. The BGH found that the bank did not sufficiently explain the risks of the loan, in particular the risk that there was no upper limit for the interest rate. The judgment gives borrowers of existing structured loans additional leverage to renegotiate their agreements when interest rates change to their disadvantage.
In the years following the 2008 financial crisis, interest rates for loans in Swiss Francs were often lower than for loans in other currencies. One way to apply the low Swiss interest rates to borrowers in other countries was to denominate the loan in Swiss Francs. A second way was to structure the loan so that the interest rate was dependent on the Swiss Franc exchange rate.
The dependence on the Swiss Franc exchange rate proved problematic for many borrowers of foreign currency or structured loans in the wake of the strong appreciation of the Swiss Franc in 2015, known as the “Franken-Schock”. With the Mortgage Credit Directive (2014/17/EU), the European Union has provided additional rules for foreign currency consumer loans relating to immovable residential property.
The decision of the BGH (19 December 2017, XI ZR 152/171 ) sets a standard for a structured loan granted to a professional borrower, which is not covered by the Mortgage Credit Directive.
Restructuring included new loan
A non-German bank proposed a debt restructuring plan to a German municipality. The debt restructuring plan used a loan denominated in EUR with an interest rate linked to the EUR/CHF exchange rate. The bank offered various alternatives, including a structure with an interest rate cap. However, the municipality chose an initially more attractive contract without an interest rate cap. The loan was for 38 years, with an interest rate of 3.99% p.a. for the first 20 years, if the value of the Euro did not fall below CHF1.43. If the Swiss Franc appreciated further, the interest rate would also rise. Prior to the restructuring, the bank explained in a presentation to the municipality that the EUR/CHF exchange rate had been stable in the past and that it was the policy of the Swiss National Bank not to let the ratio fall under CHF1.45.
After the Franken-Schock, the interest rate under the loan agreement soared to 18.99% p.a. The municipality stopped paying interest and sued the bank for a refund of interest already paid. The first and second instance courts had dismissed the claim. On appeal, the BGH granted the municipality damages.
Loan agreement valid and enforceable
The BGH held that the loan agreement was valid and binding on the parties. The BGH rejected the municipality’s argument that the prohibition of usury should apply. The speculative element of the agreement on the interest rate did not invalidate the contract, since the subsequent development of the exchange rate was not predictable at the time of the conclusion of the contract. There was a real chance that the structure could have been financially beneficial for the municipality.
No splitting into loan contract and derivative
The municipality had further argued that the structured loan contract consisted of two separate components: a loan agreement and a derivative. Splitting up the contract might have led to applying the strict requirements for the marketing of derivatives (in particular, swaps). The BGH did not agree, and made clear that the case law on the sale of derivatives does not apply to structured loans.
Implied advisory duties
However, the municipality won with its third argument. The BGH found that the bank and the municipality had impliedly concluded a financing advisory agreement. A financing advisory agreement is distinct from an investment advisory agreement. In the latter, the duties of banks and investment advisors have been defined in detail in German case law over decades.
Under a financing advisory agreement, the bank is obliged to explain the risks of the relationship between the interest rate and the EUR/CHF exchange rate.
Even though the bank had offered an alternative contract with an interest rate cap, the BGH found that the bank had not complied with its duty to explain the risks of the loan agreement. The bank ought to have highlighted the consequences of the absence of an interest rate cap, based on a scenario of the Swiss Franc appreciating considerably. However, the documentation gave the impression that this risk was far-fetched and only theoretical. The court found this unjustifiable, considering the loan’s long term.
The BGH explained that the quantum of damages should be calculated based on the difference between the interest rate of the structured loan and the interest rate the municipality would have paid had the bank complied with its advisory duties. For this assessment, the BGH has remanded the case to the Higher Regional Court.
For similar structured loans already concluded the decision gives some leverage for borrowers to attempt to renegotiate the contract terms if the interest rate develops to their disadvantage. The decision creates the risk that courts may find implied advisory agreements between banks and borrowers in many cases. The courts would then need to assess if the banks complied with all disclosure obligations.
For new loans, banks will have to make sure that they comply with their advisory duties. For contracts without an interest rate cap, banks will need to put a particular emphasis on the resulting risks. Banks have to make sure that their advice to the client is evidenced by sufficient documentation.
1 Notes on this decision are published by Buck-Heeb, NJW 2018, 853, Krüger, GWR 2018, 95 and Harnos, BKR 2018, 99. The case was appealed from the Higher Regional Court of Berlin. This decision was discussed by Seibert WuB 2017, 587 and Windthorst, EWiR 2017, 259.