Recovery of interest swap break costs on early redemption of loan
30 May 2017
Could the bank recover under an indemnity in a loan agreement for the costs of unwinding a related interest rate swap when the loan was redeemed early by the borrower? In earlier proceedings, Warren J had ruled that the bank could not, as the hedge relied upon by the bank was an internal swap. The bank then discovered a related swap with an external counterparty and tried to recover for that in these proceedings. Mann J refused. Although the bank claimed that no one at the bank had been aware of the external swap at the time of the previous proceedings, the court held that the bank had ‘corporate knowledge’ of the external swap, as it was recorded in the bank's books and a written record of the external swap existed. It would be an abuse of process to allow the bank to rely on the external swap in these later proceedings: Barnett-Waddington Trustees (1980) Ltd v Royal Bank of Scotland Plc  EWHC 834 (Ch).
The earlier litigation – an internal hedge
Earlier litigation concerned the interpretation of an indemnity clause in a loan agreement (the Loan Agreement) between the defendant (the Bank) and a group of borrowers (the Borrowers). The Bank agreed to lend more than GBP 9.2 million to the Borrowers at a fixed rate of interest (the Loan).
The Loan Agreement permitted early redemption on certain terms, including an indemnity by the Borrowers against any loss incurred by the Bank in unwinding a "funding transaction" undertaken in connection with the Loan. The Bank stated that it had hedged its interest rate exposure under the Loan with an internal interest rate swap (the Internal Swap). If the Borrowers repaid the Loan early, the Bank would have to unwind this swap. The earlier litigation centred on the Bank's ability to add the amount required to unwind the Internal Swap to the other redemption charges required to redeem the Loan early. The Bank claimed that the Internal Swap was a "funding transaction" and that, accordingly, the Borrowers should bear the cost of unwinding the swap. However, Warren J found in favour of the Borrowers, holding that the Internal Swap was not a "funding transaction" under the terms of the Loan Agreement. As the swap was between different divisions of the same lending bank, it did not amount to a "transaction" as a transaction required the involvement of two different legal entities. In addition, the Bank would not incur any loss or cost in the event that the internal swap was unwound. In these circumstances, the Borrowers were not liable to pay the Bank any sums in respect of unwinding its Internal Swap.
Bank discovers swap with external counterparty
The Bank subsequently discovered a swap with an external counterparty (the External Swap) that was related to the Loan and sought to add the cost of unwinding the External Swap to the redemption charges. In response, the Borrowers sought a declaration that they were not obliged to pay costs relating to the recently discovered External Swap.
The Borrowers argued that the claim was an abuse of process as the Bank ought to have raised the External Swap in the first proceedings, and that it was now too late to bring the claim. The Bank claimed that there was no duty on the Bank, as a defendant to the earlier CPR Part 8 proceedings, to raise issues other than the issues specifically raised by the claimant for determination by the court. It was the Borrowers who had chosen to formulate the issue for the court in a narrow way, focusing on the Internal Swap, and to use Part 8 proceedings which intensified the particular focus that they chose. The Bank asserted that, as a defendant, it was required only to meet the questions raised by the Borrowers in the claim form and not to raise other potential additional questions. Further, the Bank argued that it was not the case that it had failed to disclose the External Swap in the first proceedings; it simply did not know of its existence and should not be penalised for this ignorance.
An abuse of process
Mann J considered whether the first set of proceedings were focused on the Internal Swap as the only point which "belonged to the litigation",1 as a matter of choice on the part of the Borrowers, or whether the point of the proceedings was wider than this.
Mann J rejected the Bank's argument that because the Borrowers had chosen to use Part 8 proceedings, it had chosen to narrow the proceedings to such an extent that the External Swap no longer "belonged to the litigation". The choice of Part 8 proceedings did not entitle the Bank to sit back and consider only the Internal Swap without any consideration of whether this was the sole issue between the parties. Moreover, it was the Bank itself that had indicated that the Internal Swap was the relevant transaction in the first proceedings, and it was for this reason, not the Borrowers' choosing, that the Internal Swap had become the focus of the first proceedings. It was the Bank, not the Borrowers, that had chosen to narrow the grounds of the first proceedings by justifying its claims on the basis that it did.
Mann J drew a parallel with a redemption action, where it is the mortgagee that is compelled to articulate the sums that it is claiming. While the Borrowers were not actually seeking to redeem, they were seeking to understand the terms on which they might repay the Loan early, and it was up to the Bank to set out the costs that it would incur if the Borrowers were to do so. Mann J noted that the onus is on the Bank because only it knows the costs that it will incur in the event of early repayment of the Loan.
Mann J also dismissed the Bank's argument that the Bank could not have raised the issue of the External Swap in the first proceedings because it did not know about it at the time. While he accepted that no one individual might have had knowledge, in the strict sense of having it in his or her mind, of the External Swap during the first proceedings, as a matter of corporate knowledge, the Bank did know, or should be taken to have known, of the External Swap as it was in the Bank's books and a written record of the External Swap existed.
Consequently, Mann J held that the Bank should have put forward the External Swap in the first proceedings as it was as naturally the subject of the proceedings as the Internal Swap. The Bank was not entitled to add the cost of unwinding the External Swap to the redemption charges, and the Borrowers were entitled to resist such a claim on the basis that it would represent an abuse of process. The Borrowers were granted summary judgment.
Mann J emphasised that the doctrine of abuse of process was as capable of applying to defendants and defences as to claimants and claims, even if in practice it might be less often invoked against a defendant. His decision is also significant given it comes in the context of a Part 8 claim.
In the course of his decision, Mann J examined the steps that the Bank had taken (or could have taken) in the course of the first proceedings to investigate the existence of the External Swap. Remarking upon the Bank's "corporate knowledge", Mann J noted that if a written record of the information was contained within the Bank’s own books, it can be considered part of the organisation's knowledge and the ignorance of particular individuals will be irrelevant. This position reinforces the need for parties to thoroughly investigate matters relating to a claim, and places a particularly heavy burden on large organisations.
Mann J also questioned the level of documentary evidence which the Bank had presented in support of its claim, suggesting that it was not sufficiently detailed to demonstrate a clear link between the External Swap and the Loan. This underscores the importance of financial institutions presenting evidence in a format that is easily digestible for the court.
1. Henderson v Henderson (1843) 3 Hare 100 and Johnson v Gore Wood  AC 1.
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