It is common practice for a receivables finance agreement to allow the lender to charge a collection fee in the event that they step in to collect debts on behalf of the borrower client. In a recent case concerning a collect-out situation, a lender was required to reimburse collection fees to the extent that they were considered to be excessive. This judgment may materially change the way in which collection fees and other fees are charged to clients. As such, it is of interest to lenders, borrowers, and insolvency practitioners. Below, we set out the key points from the case and give guidance on how to address the risk of a lender being required to repay fees to a client.
The case - BHL v Leumi ABL Limited
Leumi ABL Limited (Leumi) provided a receivables finance facility to Cobra Beer Limited (Cobra). Following a downturn in sales, Cobra entered administration owing substantial sums to Leumi. During the course of the administration, the Cobra business was sold and as part of that deal the buyer's shareholder, BHL, provided an indemnity which included a commitment to indemnify Leumi in respect of any sums due under the Cobra receivables facility agreement (RFA).
Leumi served notice on Cobra demanding repayment of the loan or repurchase of the outstanding debts. The letter stated that, if neither event happened within seven days, then Leumi would go ahead and collect the receivables itself and charge collection fees to Cobra pursuant to the RFA. Cobra was unable to repay Leumi and, accordingly, they took over collection of the receivables.
The RFA included the usual ability to recover costs and expenses incurred in collecting, enforcing, securing or protecting Leumi's rights. In addition, it also included a separate right for Leumi to be able to charge a collection fee for the collection of receivables in the event that the client failed to repurchase debts when they were required to do so. The clause in question entitled Leumi to charge "up to 15% of amounts collected by Leumi…in addition to any other fee payable by the client to Leumi" under the RFA (the Collection Fee). It also included an acknowledgment from Cobra that the fee was a "fair and reasonable pre-estimate of Leumi's likely costs and expenses in providing such service to the client".
The Collection Fees charged to Cobra as a result of this clause totalled around £1.2 million. Following a demand made under the indemnity, BHL paid most of this amount but then raised a challenge to Leumi on the grounds that Leumi was not entitled to charge the Collection Fee at 15%, that BHL had made the payment to Leumi by mistake and that, accordingly, Leumi should now repay that sum to BHL.
What did the case decide?
The judge concluded that it had been common practice for Leumi to charge the maximum amount to a client where an RFA provided for a fee which could be 'up to ' a certain percentage of debts collected. In a sharp correction to this practice, the High Court decided that:
- Purpose of the Collection Fee: The purpose of the Collection Fee was to recover costs and expenses incurred by Leumi as collector of the receivables.
- Flexibility given to lender: The provision gave Leumi the power to set the percentage Collection Fee in advance of making the collections. It did not necessarily matter if the Collection Fee charged was greater than the actual costs and expenses subsequently incurred. A margin of flexibility had to be given to the lender in determining the appropriate rate since, by definition, it could not know in advance what the costs would be. However, the percentage must be determined by reference to something, otherwise the Collection Fee would always be 15%. Having considered expert evidence as to the complexities of collection and likely timeframe for recovery of the debts, the judge suggested that 4% would be appropriate in this case.
- Requirements when exercising discretion: The lender was required to exercise discretion in setting the Collection Fee rate. In doing so, the lender must act in a way that was not arbitrary, capricious or irrational in the public law sense. The outcome could not be outside what any reasonable decision maker could decide.
- No double recovery: The RFA stated that the Collection Fee would be charged in addition to other costs and expenses. Despite this, the judge found that the reference in the relevant clause to "likely costs and expenses" meant that they were conceptually tied to the costs and expenses charged elsewhere in the agreement. The lender would not be permitted to charge the client twice for these costs and expenses.
- Not a penalty: The Collection Fee was not a penalty.
- Repayment of excess fees: The part payment of the Collection Fee by BHL to Leumi had been a mistake. BHL was therefore able to recover those sums which had been paid in excess of the amount which should have been charged.
Could other costs and expenses be affected by this decision?
The judgment does not look beyond the Collection Fee context and it is unusual for a case concerning contractual rights to invoke a public law duty for a party to exercise its discretion in a way that is not arbitrary, capricious or irrational. It remains to be seen whether the courts have the appetite to apply this decision in other contexts. However, if this is the case, the impact could be significant as it would give grounds for borrowers or insolvency practitioners to challenge and potentially recover fees already paid.
Does this necessarily mean a change for lenders? Well, that depends on the circumstances and the lender's existing business practices. It is worth remembering that the requirements imposed in this case are akin to the existing requirement for all lenders to act rationally when exercising powers granted to them under loan agreements. Accordingly, it should only necessitate a change in behaviour in circumstances where a lender is not already complying with those requirements, for example if:
- a lender has the scope to exercise a discretion; and
- the lender imposes a set response or rate without considering the context of a particular transaction.
The risk of challenge will be most relevant in circumstances where a lender is able or required to exercise its discretion to change a term in an agreement that has a financial impact on the client, for example, the setting or variation of a fee or the giving of consent.
The risks increase in an enforcement scenario where the lender typically benefits from a broader suite of discretionary rights compared with the pre-default situation. The rights are designed to enable a lender to protect its interest and preserve its rights. Inevitably, the exercise of rights at this stage of a transaction come with a greater risk of challenge where resources are more scarce and there are more interested parties who might raise a challenge, such as insolvency practitioners and powerful shareholders or guarantors. This case reminds us that powers such as these must be exercised with care and responsibly.
How to minimise the risk of challenge
There are three steps that we recommend a lender takes where they need to exercise their discretion and set a fee rate for a client:
- Include the appropriate rights. If a discretionary fee has been agreed, it benefits both parties to make it clear when the discretion can be exercised, by who, and to stipulate any applicable benchmarks that have been agreed. Clear terms agreed at inception of a deal can streamline action in an enforcement situation and can pay dividends in improving recovery and minimising the risk of challenge. Alternatively, if a flat fee is more appropriate, speak to your advisers who can help you to avoid the risks associated with penalties.
- Look out for those rights which require the exercise of discretion by the lender. Be aware that there is a distinction to be made between rights that arise automatically or upon some specific trigger event (for example, giving notice of prepayment or a change to the base rate) and those which require the lender to exercise some discretion or reach a decision before taking action (such as a lender's option to vary a dilution percentage if it considers it necessary to do so).
- Document the discretionary decision-making process. In this case, the Court found no satisfactory evidence of the discretion having been exercised and the 15% charge being decided upon as a result of the exercise of that discretion. A lender that is able to provide contemporaneous records demonstrating their decision-making process would be in a considerably stronger position. A 'good' decision making process could take many forms, but might include a calculation of likely costs and expenses, the use of data from a previous collect-out exercise, or considering a short delay before setting the appropriate rate in order to assess the likely collect-out period and degree of complexity (among other things).
In setting discretionary collections costs, be aware that:
- Double recovery will not be permitted.
- Costs charged should reflect predicted actual costs. There is no stipulated process for calculating these costs. The flexibility allows the costs to be estimated, taking into account the business model of the lender. By way of example, this may include direct costs for specific collections staff plus some management time, external agency costs or even an element of 'opportunity cost' if collections staff are in roles which would be profit-making if they had not been working on collections.
- Assumptions should be carefully made. It is not sufficient to make an assumption that a collect-out will be complex and immediately apply the highest available percentage tariff.
One thing to remember
As a result of this case, lenders should be aware of the risk of challenge to the fees charged where they include some element of discretion. While the fees charged can sometimes be significant, the income received could quickly be undermined by the time and cost of a successful challenge. If there is any doubt as to whether this decision could affect a finance agreement or potential collect-out situation that you are working on, please contact one of our experts who would be happy to assist.