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Borrowers not liable for lender's costs of unwinding an internal hedge upon pre-payment of loan

16 November 2015

A lender's internal interest rate swap was not a "funding transaction" under the terms of a loan agreement. This meant that the borrowers were not liable to pay the costs of unwinding the internal swap in the event they pre-paid the loan. In Barnett Waddington Trustees (1980) Ltd & anr v The Royal Bank of Scotland plc [2015] EWHC 2435 (Ch), 14 August 2015 Warren J held that an internal swap between divisions of a lending bank did not amount to a "transaction" as a transaction involved two different legal entities. Further, the bank would not suffer any loss or cost if the internal swap was unwound. In the circumstances, the borrowers were not liable to pay the bank any sums in respect of unwinding its internal swap.

This ruling focuses on a point of construction arising out of a loan agreement dated 1 April 2004 (the Loan Agreement) between the defendant (the Bank) and a group of borrowers (the Borrowers). The Bank agreed to lend money to the Borrowers at a fixed rate of interest (the Loan). The Bank funded the Loan and hedged its interest rate exposure as follows:

(i)     the Bank's Corporate Banking division obtained the money for the Loan by borrowing it from the Bank's Group Treasury division (Group Treasury) at a floating rate of interest;

(ii)   in order to fund any shortfall between the fixed rate of interest received under the Loan Agreement and the floating rate of interest being paid to Group Treasury, and as part of funding the Loan, Corporate Banking entered into an internal swap with the Bank's Markets desk, essentially mirroring the characteristics of the Loan (the Internal Swap); and

(iii) the Markets desk entered into an interest rate swap with an external market counterparty on a "portfolio basis". This meant that the Bank's Markets desk did not enter into a reverse transaction exactly matching the internal swap but on terms which hedged the Bank's risk across a portfolio of fixed rate loans.


The Loan Agreement provided for a repayment fee if the Loan was pre-paid within five years of drawdown. After five years there was no such fee. More than five years after the drawdown (ie in circumstances where no repayment fee was provided for in the Loan Agreement), the Borrowers were considering repaying the whole loan.

The dispute

The Bank contended that any pre-payment would activate the indemnity provisions in Clause 12 of the Loan Agreement under which the Borrowers gave an indemnity for any loss incurred in unwinding a "funding transaction" undertaken in connection with the Loan. "Loss" was defined as "any cost to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility and including…costs incurred when there has been a reduction in the market level of interest rate underlying the Facility…such costs to be determined by the Bank in its sole discretion".

If the Loan was repaid early, the Bank would have to unwind the Internal Swap. In reliance upon Clause 12, the Bank required the Borrowers to pay an "Interest Rate Swap termination cost". The Bank claimed that the Internal Swap was a funding transaction without which the Bank would not be able to offer the fixed rate Loan. They argued it followed that the cost of unwinding the Internal Swap would be an "unwinding of funding transactions undertaken in connection with the Facility". If the Internal Swap did not amount to a relevant "funding transaction", then the Bank's alternative argument was that the relevant "funding transaction" was the Internal Swap taken together with the arrangements with third parties by which the Bank managed its risk on a portfolio basis.

The Borrowers argued that the arrangement was not a "funding transaction" (emphasis added) because it was not entered into by the Bank in order to provide the actual Loan. Further, the Bank could not have entered into a "funding transaction" (emphasis added) because the Internal Swap was an arrangement between different departments of the Bank. In effect, the Borrowers argued that the Bank cannot transact with itself.

The Borrowers also contended that when the Internal Swap was unwound, one department of the Bank would simply be accounting to another department for a sum of money. This did not amount to a "Loss" for the Bank. More generally, the Borrowers noted 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 the upside when interest rates moved in its favour.

Construction of Clause 12.1(f)

In considering the construction of Clause 12, Warren J referred to the decision of the UK Supreme Court in Rainy Sky SA v Koomin Bank [2011] UKSC 50, which confirms that, in circumstances where there is an ambiguous contractual provision, the courts can consider the commercial purpose behind the provision.

Warren J found that the internal arrangements of the Bank did not form part of the factual matrix against which the Loan Agreement was to be construed. There was nothing to suggest that the Borrowers were aware of the way in which the Bank funded or hedged the loans which it made to its customers and it was not suggested that the Borrowers ought to have been aware of the Bank's internal hedging arrangements. In considering the construction of the Clause, Warren J noted the following four points:

(i)     the Loan Agreement itself said nothing expressly about hedging, whether by an internal agreement or by an agreement with a third party. The agreement did not state that the Bank would be entitled to enter into an internal or external interest rate swap and that the Borrowers would be liable for any break costs arising as the result of the early termination of the swap;

(ii)   the Internal Swap was not a contractual arrangement, but simply an arrangement between two departments within the Bank;

(iii) similarly, the Corporate Banking division's agreement to source the money to lend to the Borrowers was not a contractual agreement either (since Group Treasury was also a department of the Bank) but rather a "virtual construct" for internal accounting purposes; and

(iv) he would not deal (other than tangentially) with the question of whether a purely external hedging transaction was capable of being a "funding transaction", as it had not been argued and he did not have the evidence before him to make a determination.

Warren J noted that the words "funding transaction" should be construed together. He noted that the Bank's internal hedging arrangement did not amount to a "transaction" because the Clause envisaged a transaction that took place between two legal entities. Different departments of the Bank did not qualify as separate entities.

Even if the Internal Swap was a "funding transaction", Warren J noted that unwinding the Internal Swap would not have given rise to any loss or cost to the Bank even though the external hedge may only have been entered into because of the Internal Swap. The finding that there would be no loss was based on the Bank's explanation that it operates a "flat book", ie it hedges in a way so that it takes no risk. When an early repayment is made, the Bank adjusts its portfolio of external contracts so that its overall book remains "flat". This rebalancing of the external position could give rise to costs to the Bank. But Warren J found that the Internal Swap, viewed on its own, gave rise to no loss or cost. In particular, because the Internal Swap was internal to the Bank, the Bank itself was in precisely the same position both before and after the unwinding of the Internal Swap.

Although the external hedge would no doubt have been undertaken to protect the Bank against the risk it has incurred in relation to the Loan with the Borrowers, Warren J said it was not undertaken to protect the Bank against the risk of the Internal Swap because that risk is not really a risk – the Bank's overall position regarding the Internal Swap is entirely neutral.

Comment: Warren J focused on the fact that the Borrowers had not entered into any hedging arrangement and were unaware that any hedging taking place in relation to the Loan was anything other than an internal formality. Even if the Borrowers had notice of the hedging, the Internal Swap would not have been considered a "transaction" on the basis of Warren J's construction of the relevant provisions. The Bank's acceptance that it would not incur any loss upon the unwinding of the Internal Swap also played a crucial role in Warren J's analysis.

Interestingly Warren J noted that purely external hedging may amount to a "funding transaction". This would include a specific hedging transaction by the Bank with a third party, "back-to-back" with the facility. In such a case, the external hedge would be undertaken with a third party to protect the Bank against the risk it had incurred in relation to the Loan to the Borrowers, not to protect the Bank against any risks it incurred in relation to internal swaps.

Importantly, however, Warren J noted that he did not have enough evidence before him to decide whether an internal swap and external hedging on a portfolio basis could amount to a "funding transaction" in the present case. Portfolio hedging is no doubt more practical for banks. However, to the extent banks have structured their transactions in such a manner, there remains uncertainty as to how the court will approach this issue.

Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  For more information please contact Sarah Garvey, or tel +44 20 3088 3710.