An internal swap between two departments in the same legal entity is not a transaction which allows a lender to recover under an indemnity relating to transaction losses.
The case involved a Lender making a 30 year term loan at a fixed rate to allow a Borrower to finance the acquisition and development of a property. The problem arose when the Lender made an attempt to recover what it said were part of its funding costs upon early repayment – 5 years into the 30 year term. There was an “internal swap” used by the Lender in the process of managing their funding risk. The Lender tried to recover £2.4m (on a loan of just over £9m) under the indemnity contained in the Loan Agreement which they said they had incurred in breaking the “internal rate swap” which was concluded by way of inter departmental arrangements between two divisions of the Lender.
The Loan Agreement contained an indemnity provision in the following form:
The Borrowers shall indemnify the Bank on demand against any Loss (including any Loss on account of funds borrowed, contracted for or utilised to fund any amount payable under this Agreement, any amount repaid or prepaid under this Agreement or any Advance and any loss of Margin) which the Bank has sustained or incurred as a consequence of:
(d) any prepayment or repayment of the Advance otherwise than on an Interest Payment Date relative to that Advance; …… (f) any cost to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility, including inter alia costs incurred when there has been a reduction in the market level of interest rate underlying the Loan. Such costs will be equivalent to the loss of interest income to the Bank as a result of re-deploying funds at a lower interest rate than that which prevailed when the Facility was made available, such costs to be determined by the Bank in their sole discretion.
Loss was defined as:
“losses, claims, demands, actions, Proceedings, damages, or other payments, costs, expenses and other liabilities of any kind including, without prejudice to the foregoing generality any costs to the Bank incurred in the unwinding of funding transactions undertaken in connection with the Facility and including inter alia costs incurred when there has been a reduction in the market level of interest rate underlying the Facility, such costs to be equivalent to the loss of interest income to the Bank as a result of re-deploying funds at a lower interest rate than that which prevailed when the Facility was made available, such costs to be determined by the Bank in its sole discretion;”
The Court held that the internal rate swap “arrangements” were not transactions so could never be a “funding transaction” within the terms of the indemnity. A transaction requires two parties and here there was only one legal entity involved. The judge doubted (but did not decide given his first finding it was not necessary for him to decide anything else) that the internal swap was anything to do with funding as it simply was one which allowed the Lender to manage a perceived risk. He also accepted the Borrowers view that if he was wrong on both these points there could never be any loss to the Lender because there was in evidence no suggestion of an external back to back hedge between the Lender and a third party – at least not until very late amendments made by the Lender’s counsel who may have saw the writing on the wall mid-way through the hearing.
The Lender eventually argued – that as an entity it ultimately managed its interest rate risks through hedging with external parties on a portfolio basis and thus might be able to establish some loss when it had to break a part of that “portfolio hedging”. This probably should have been their case from the outset but seems to have been a bit of an afterthought. The judge left that one open to argue at a later date but gave the impression that he was not wholly convinced that would work either.
How many lenders have similar arrangements and expectations? It is probably not safe to assume the average funding indemnity would cover wholly internal arrangements because there would be no “loss” to the relevant legal entity just an allocation between different divisions of that entity – for the legal entity it would be neutral. Even if the hedge is between different legal entities in the same group there would still be an issue under this type of indemnity wording as to whether the hedge was a “funding transaction”. Other indemnities may be better drafted and expressly refer to funding transactions or agreements relating to the management of interest rate risk in connection with the funding of the relevant Loan.
The judge thought it was possible to draft an indemnity to cover losses from an internal swap but the clause had to be much more explicit that such an internal arrangement would lead to a loss which the Borrower would have to meet. If relying on recovery of funding costs or losses arising from termination of external hedges which cover portfolios of the Lenders fixed rate loans then some redrafting of the above indemnity would be needed to make sure the indemnity allowed a Lender to recover a proportionate amount relevant to the actual loan being repaid early.
The duplication between the definition of Loss and 12.1(f) probably did not help the Lender’s case as the judge clearly thought the indemnity was poorly drafted. That might have coloured his view of the Lender’s attempt to recover under it. Excess wording – even seemingly harmless duplication – should always be deleted in case it comes back to bite later.
Finally, its a reminder of how “break costs” can escalate – adding 25% to the original debt in this case if the Lender had succeeded on their portfolio hedging argument – to the detriment of a Borrower and thus how important it is to ensure that any funding indemnity or break cost obligations undertaken by a Borrower does not come as a surprise down the line.