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Fixed Rate Loans – Getting the Funding Indemnity Right

If a lender offers a fixed rate loan (as compared to a loan where the interest rate is floating (LIBOR plus a margin), the lender will usually put in place a back to back funding arrangement or

If a lender offers a fixed rate loan (as compared to a loan where the interest rate is floating (LIBOR plus a margin)), the lender will usually put in place a back to back funding arrangement or hedging to fund that loan. This will be a private, behind the scenes arrangement that the borrower will not see. If the loan is repaid or prepaid early, then typically the lender will need to unwind that funding arrangement which will result in a "cost", or "loss" to the lender. It would usually expect to be indemnified for this loss or cost by the borrower.

This article explains why it is important to get the drafting right in the funding indemnity.

The courts recently considered a funding indemnity in Barnett Waddington Trustees (1980) Limited v The Royal Bank of Scotland plc [2015]  EWHC 2435 (Ch) (Barnett Case) (which also considered an earlier case, Bank of Scotland v Dunedin Property Investment Co Ltd (1998) IH (1 Div) (Dunedin Case)).

Barnett Case and Dunedin Case – a comparison

In the Barnett Case, the relevant phrase being considered by the court was whether the costs associated with breaking an internal swap constituted a "Loss … which the Bank has sustained as a consequence of … (f) any cost to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility".

In the Barnett case, it was held that the internal swap was not a "funding transaction" as it was between two divisions of the same entity.

There was also some discussion about manner in which the indemnity clause was drafted. In this case, the indemnity clause was drafted such that for a cost to be covered by the indemnity, it first needed to pass the hurdle of constituting a "Loss" before consideration could be given as to whether is satisfied the requirements of the sub-clause. This narrowed the scope of the indemnity.

In the Dunedin Case, the phrase in the costs clause that was used was much broader, being "cost, charge or expenses incurred in connection with" the financial accommodation provided to the borrower. In that case, the court held that the cost to Bank of Scotland in breaking its external funding arrangements put in place to hedge its risk against a 10 year, fixed interest facility provided to the borrowers was both a "cost" and "incurred in connection with" the financial arrangements, it being noted in particular by Lord president Roger that the words "incurred in connection with" have a very broad construction.

Key take-away

The key take-away for any lender from these cases is to ensure that costs clauses and indemnity clauses in loan documents are drafted in a sufficiently broad manner so as to capture all costs and losses that the lender would seek to recover from a borrower in the event of early prepayment including, if applicable, as a result of an internal hedging break. If any such costs are not acceptable to the borrower, then the negotiation should be had at the outset, leaving both parties clear as to the costs for which they would be liable in the event of early prepayment – rather than leaving this for determination by the courts.

The Loan Market Association REF Loan Agreements do contemplate fixed rate loans as an option, but do not contain a broad enough indemnity. There is a placeholder for insertion of a definition of "Break Costs" that envisages the relevant wording being inserted on a transaction by transaction basis – so take care.

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