The High Court decision in K/S Preston Street v Santander [2012] EWHC 1633 and the more recent decision in Barnett Waddington v RBS [2015] EWHC 2435 highlight the importance of careful drafting of prepayment indemnity clauses and the need to seek early legal advice when faced with customer challenges.   Both cases concern the construction of prepayment indemnity clauses in fixed rate loan agreements. In each case, the borrowers wanted to prepay the loan early. The banks sought an indemnity for their costs/losses as a result of the early prepayment. The borrowers denied that the banks were entitled to recover any such costs/losses. 

In K/S Preston, the relevant clause stated that: 

"In addition to any prepayment costs…the partnership shall indemnify the bank on demand against any cost, loss, expenses or liability… which the bank incurs as a result of the repayment of the loan during the fixed rate period…"

First the court had to decide whether this clause applied to prepayments at all. The borrower argued that the indemnity clause applied only to "repayment" of the loan not "prepayment". It said the loan agreement clearly distinguished between the two and had a separate prepayment clause which set out the fees payable on prepayment. It argued that any ambiguity should be construed against the bank as the drafting party (contra proferentum). The bank argued that this analysis was clearly wrong and made no commercial sense in the context of the agreement. 

The judge rejected the borrower's argument, finding no ambiguity in the wording. The clause clearly envisaged prepayment of the loan "during the fixed rate period". 

This left the issue as to what cost(s)/loss(es) the bank could recover. Could it recover both its past and prospective loss of interest at the contractual rate, less what it could earn re-lending the money on the interbank market? The judge noted that because the claim was not based on a breach of contract (as early redemption was permitted under the loan agreement), the law on penalties (and an assessment of future losses) did not apply. He therefore held that the bank had to establish its actual incurred loss arising from the borrower's contractual entitlement to prepay early.

The judge thought the use of the word "incurs" rather than the phrase "incurs or to be incurred" significant. He also noted that the indemnity had to be triggered "on demand". He therefore held that the indemnity was limited to the bank's actual crystallised cost(s) or loss(es).  

In Barnett Waddington when the bank entered into the loan agreement with the borrowers it also entered into an internal hedging arrangement with another department within the bank. The loan agreement provided that the borrowers would indemnify the bank for costs "incurred in the unwinding of funding transactions undertaken in connection with the Facility". When the borrowers wanted to prepay the loan, the bank sought to charge them approximately £2m in termination fees which it said was the cost of breaking the internal swap. 

The court held that the borrowers were not liable for such fees as the internal swap did not qualify as a "funding transaction". It was not a "transaction" as the definition of loss in the loan agreement and the indemnity in question envisaged a transaction between two different legal entities and different departments in the same bank did not qualify as such. Nor could it qualify as a "funding" transaction as it was not a transaction entered into by the bank in order to fund the facility to the borrowers. 

Lessons/ practical tips:

The cases emphasise the need to draft indemnity clauses carefully. Note the following key points:

  • lenders are likely to face difficulty in evidencing what is actually done with the prepaid sums. In most cases, lenders will not reinvest the prepaid monies and/or terminate any external back-to-back hedge (as most fixed rate loans are hedged on a portfolio basis)
  • in principle, banks may be entitled to future losses so long as the clause is drafted widely enough to ensure it captures costs, losses "to be incurred" and is not limited to costs "incurred"
  • when seeking to recover future losses, the safest option will be to include a detailed formula, or even a table, in the loan agreement from which any future loss can easily be calculated. Lenders may also want to include a provision  that a certificate calculating the lender's loss will be deemed to be conclusive evidence save for a manifest error
  • both cases referred to above were decided on the construction of their relevant indemnity clauses. Interpretation cases are by their very nature very difficult to call. Each case will be different and the eventual outcome will turn on the individual facts and circumstances and the relevant wording of the clause, and
  • lenders should seek early legal advice when faced with an early prepayment fee challenge. A response which gives the impression that a lender has not suffered/will not suffer an actual cost/loss upon early prepayment can both fuel the customer's appetite for litigation and seriously undermine future litigation strategy.

An earlier version of this article first appeared in the December 2015 issue of Butterworths’ Journal of International Banking and Financial Law.