The latest judgment in the test case on overdraft charges highlights the need for retail banks to pay attention to the precise wording of their terms and conditions. In his judgment of 21 January 2009, Mr Justice Andrew Smith considered whether various terms were capable of being penalty clauses. His reasoning deserves detailed examination, as he based his conclusions on some rather subtle distinctions.

Background to the case

In July 2007 the Office of Fair Trading, with various banks and building societies, began a test case. The aim was to decide whether unarranged overdraft charges for personal customer current accounts were fair. In the latest judgment, the judge examined terms that Abbey National, Lloyds TSB, Royal Bank of Scotland and NatWest had used at various times. He considered whether these terms were penalty clauses at common law. He did not consider the separate question of whether the terms were subject to, or infringed, the Unfair Terms in Consumer Contracts Regulations 1999 (Unfair Terms Regulations).

The NatWest term

The judge considered each of the terms and found that only one of them was capable of being a penalty. The term in question came from the NatWest 2001 conditions (which were in use between 2001 and 2003) under the heading “Using your Card”.

The term provided: “You must not use your Card to go overdrawn on your Account unless we have previously agreed this with you. If you do go overdrawn without our agreement, you will be liable to pay interest for each day you are overdrawn on the total amount of unauthorised borrowing together with our normal account charges.”

Conversely, in a previous judgment the judge had decided that a term used by First Direct in 2001 was not capable of being penal. That term provided:  

“You must not use your card to borrow from us unless an overdraft has been agreed separately. You must not use your savings card to borrow from us at all. Unauthorised overdrafts will be charged at our Unauthorised Overdraft Interest Rate. We will also charge our usual fees for unauthorised overdrafts.”  

A contractual prohibition  

While the two clauses seem broadly similar, the judge thought there was a crucial difference: the NatWest term was a contractual prohibition, whereas the First Direct term was not. He gave two main reasons for this conclusion.  

First, the NatWest provision expressly forbade making unauthorised withdrawals. In contrast, the First Direct clause did not ban withdrawals on an unarranged overdraft. It simply told the customer that he would have to pay a charge if he chose to make an unarranged withdrawal.  

Second, the tone and appearance of the NatWest term made it look like a contractual prohibition. The term made “references to a contract in the immediate context of a particular term”. Conversely, although the First Direct conditions followed a statement that they were a contract between bank and customer, the First Direct term did not contain a specific reference to suggest that it had contractual effect.

Further various specific features of the 2001 terms made them appear contractual rather than informative or advisory:  

  • definitions at the start of the relevant section that used language of “a precision to be expected in a contract”;  
  • a statement beneath the definitions that stated “Please read these Conditions of Use carefully as they represent the terms of the contract between you and the Bank”;  
  • a statement in the term that stated “You must only use your Card in accordance with these Conditions of Use and any operating instructions including the User Guide which we or our agents give you at any time”;  
  • the use of the phrase “unauthorised borrowing”.  

The judge drew a distinction between NatWest’s 2001 terms and its 2004 terms. The 2004 terms stated:  

“You (and any additional cardholder) must not use the card if to do so would overdraw the account without our prior agreement, or would increase any borrowing on the account to more than we have agreed.”  

The judge felt the tone of the 2004 terms was “informative and advisory” rather than contractual. Certain parts of the 2004 terms simply advised the customer of the legal position and did not create contractual rights for the Bank or contractual duties for the customer.  

The scope of the decision  

Importantly, Mr Justice Smith did not declare the NatWest term to be a penalty. He merely found that it was capable of being a penalty because it would be a breach of a contractual term. Any customer who wished to claim a refund of an unarranged overdraft charge because it were penal would still need to show the charge did not genuinely reflect the bank’s costs.

Banks do not currently have to deal with these claims. The Financial Services Authority has introduced a waiver to allow banks to defer dealing with complaints about unarranged overdraft charges. FSA extended the waiver in January; it is due to expire on 26 June 2009.  

The banks have appealed the earlier April 2008 ruling that overdraft charges are subject to fairness rules. That appeal ended in November 2008 and the Court of Appeal decision is due soon. However the banks have not appealed over whether NatWest’s 2001 terms were capable of being penalties. In view of this, the OFT decided not to appeal over whether the other terms were potentially penal.  

The need for careful drafting  

The retail finance industry knows that it needs to draft customer contracts carefully to avoid challenges under the Unfair Terms Regulations. This latest decision shows just how important specific wording can be in deciding whether a particular action is a breach of contract or is merely advisory. Charges that apply where there is a breach of contract may be subject to the common law prohibition on penalties. Further, it is inconceivable that a penalty would be fair under the Unfair Terms Regulations.  

It is also worth remembering that FSA is due to extend its conduct of business regulation to deposit-taking. This will mean that current account terms will become open to scrutiny under FSA’s Treating Customers Fairly initiative. The scope of TCF is wide; in fact FSA sees it as encompassing unfair terms regulation. Following FSA guidance and announcements closely will help minimise the risk of regulatory action.  

The principles discussed in this note do not apply merely to unarranged overdraft charges. Credit card issuers and other lenders will also need to draft their customer agreements carefully to avoid the interpretation that they are imposing a charge on customers who breach the agreement.