For decades it has been the common practice of lenders when granting loans to charge a processing fee(1) or an arrangement fee for the provision of a loan. This fee is usually deducted from the amount of the loan on the first utilisation and, in commercial transactions (where the borrower and the lender are entrepreneurs(2) rather than consumers), the fee is usually a certain percentage of the loan amount (eg, 1%). Such fees are not related to the term of the loan.
Until 2014, according to the guidelines derived from the rulings of the Federal Court of Justice,(3) lenders were safe if the processing fee did not exceed 2% of the loan amount.(4) However, on May 13 2014 the Federal Court of Justice ruled(5) that processing fees in consumer loan agreements are invalid on the basis that they unreasonably disadvantage consumers.
Until July 2017 the lower German courts dealt with an increasing number of cases in which they had to decide whether the principles applicable to processing fees in consumer loans also applied to commercial loans. The majority of rulings declined such application and upheld the validity of such clauses in commercial loan agreements.(6) However, on July 4 2017 the Federal Court of Justice issued two rulings(7) declaring that processing fee clauses in standardised commercial loan agreements are invalid as they unreasonably disadvantage borrowers.
This update examines the legal reasoning for the Federal Court of Justice's decisions and makes some suggestions for lenders to consider in order to deal with this issue in the future.
Statutory concept of loan The statutory concept of a loan under German law is reflected in Section 488(1) of the Civil Code.(8) This states that:
"The loan contract obliges the lender to make available to the borrower a sum of money in the agreed amount. The borrower is obliged to pay interest owed and, at the due date, to repay the loan made available."
According to this general concept, the 'price' for the loan payable by the borrower is the interest charged by the lender. The amount of interest should cover all of the lender's expenses relating to the granting of the loan so that no other fees should be charged.
Since German law also recognises the principle of freedom of contract, the parties to a contract are generally free to agree to anything they wish, including additional fees. However, this freedom is restricted if the contract is classified as general terms of business.(9)
General application of rules on general terms of business First introduced in 1976, modified following the implementation of Directive 93/13/EEC and incorporated into the Civil Code in 2002 as Sections 305 to 310, these rules regulate the validity of so-called 'general terms of business'. Section 305 of the Civil Code provides that these are:
"all contract terms pre-formulated for more than two contracts which one party to the contract (the user) presents to the other party upon the entering into of the contract. It is irrelevant whether the provisions take the form of a physically separate part of a contract or are made part of the contractual document itself, what their volume is, what typeface or font is used for them and what form the contract takes."
If a contract or even a certain clause in a contract is considered to be general terms of business, any such provisions are, in accordance with Section 307 of the Civil Code, invalid if, contrary to the requirement of good faith, they unreasonably disadvantage the other party to the contract. An unreasonable disadvantage is to be assumed if a provision is incompatible with fundamental principles of the statutory provision from which it deviates.
While this would seem to make sense for the consumer market, the German legislature went even further and stated in Section 310 of the Civil Code that the rules on general terms of business also apply to commercial transactions. Therefore, clauses in commercial loan agreements, to the extent that they constitute general terms of business, are also subject to the fairness test applied by the German courts.
Application of general terms of business rules to commercial loan agreements Pre-formulated contract terms presented to other party It is market practice for lenders to use standard form loan agreements or clauses such as the Loan Market Association standard documentation or in-house templates. German case law even states that such standard terms must not necessarily be written down. If these standard terms are intended to be used at least three times, they will be considered to be general terms of business unless they have been individually negotiated.
Individual negotiation Contract terms are not considered to be general terms of business to the extent that they have been individually negotiated between the parties. German case law is strict as to what it will accept as being individually negotiated.(10) It is not sufficient that a certain clause has been discussed between the parties. A clause that deviates from the statutory provisions must have been "freely negotiable" in its entirety.(11) In a recent ruling of the Dresden Higher Court,(12) the parties to a commercial loan agreement negotiated the amount of the processing fee, but it was unclear whether the borrower was able to refuse to pay a processing fee (ie, the fact that a processing fee had to be charged by the lender seemed non-negotiable). This led the court to decide that the relevant clause was not individually negotiated, and therefore was subject to the control of the courts as general terms of business.
Since it is standard practice that a processing fee will be charged and generally only the amount and payment mechanism are negotiated, the relevant clauses in loan agreements (which provide for the charging of such fee) will therefore be considered by the courts to be general terms of business even if the amount of the fee is heavily negotiated.
Which fees are affected? German courts are generally not permitted to apply the rules governing the general terms of business to clauses in a contract which regulate the price of services or goods as it would mean intervening in the free market. However, so-called 'ancillary fee provisions' in a contract are fully subject to assessment by the courts.
A fee clause in a contract will not be subject to such court assessment if the fee regulates either the price for the principal performance of the obligations of the party entitled to such fee or the price for an additional service. In the case of a lender, such additional services would be those that are not provided:
- in accordance with the loan agreement itself as an ancillary service; or
- by the application of any relevant law.
Since a processing fee is not calculated by reference to the term of the loan it does not constitute interest, and therefore is not the price a borrower pays for using the proceeds of the loan. In addition, a processing fee aims to cover the costs that the lender incurs in its own interest or in order to comply with relevant laws (eg, processing the loan application, preparing credit analysis, making know your customer checks and negotiations). These are not, in the opinion of the German courts,(13) services that can be qualified as "additional services".
The recent Federal Court of Justice decisions were made in relation to bilateral loans. Therefore, it is debatable whether the same reasoning may be applied to an arrangement or structuring fee for a syndicated loan. However, it is possible that the court would find it applicable on the basis that the lender arranging the transaction is doing this in its own interest in order to be in a position to provide the appropriate financing required by the borrower.
Therefore, it is safe to say that a clause governing any fees in a loan agreement which are independent from the term of the loan will be subject to the scrutiny of the German courts, which will determine the clause's conformity with the rules governing the general terms of business.
Conformity of fee clauses with rules governing general terms of business The recent Federal Court of Justice rulings confirmed that a clause requiring the payment of a processing fee is unreasonably disadvantageous to the borrower even in a commercial transaction, and that such clause is therefore invalid according to Section 307(2)(1) of the Civil Code. According to the Federal Court of Justice, charging such a fee deviates from the statutory concept of German law that the only price for using the proceeds of the loan is the interest, and in the court's opinion there is nothing to justify such deviation.
The Federal Court of Justice stressed that even an entrepreneur could be disadvantaged by the "shaping power" of the lender as a user of the general terms of business. In the court's opinion, it did not matter whether a particular borrower was experienced in commercial transactions or had negotiation power and was fully aware of the implications of the relevant processing fee clause. Since entrepreneurs as borrowers could also be dependent on financing, there is a danger that lenders might abuse their contractual shaping power and introduce clauses deviating from the statutory provisions of German law, thus exploiting such dependency. Therefore, such clauses are invalid.
The Federal Court of Justice also stressed that no other view may be taken in the light of Section 310 of the Civil Code, which requires that the court must consider the usual practices(14) and customs(15) of commercial transactions. Since a processing fee is also charged in consumer loan agreements, it is not usual practice inherent to commercial transactions. The court also denied the existence of a trade custom pursuant to Section 346 of the Commercial Code, stating that such custom would exist only if there was a mutual understanding that such fee would have to be charged even if it was not documented in the loan agreement.
Below are some of the solutions that are available to lenders, although each specific case will need to be analysed individually.
Avoid application of German law One solution may be to avoid German law being applicable to the loan agreement containing the relevant fee clauses by choosing as the governing law of such loan agreement the law of a jurisdiction that does not consider such clauses to be invalid.
Pursuant to Article 3 of the EC Regulation (593/2008) (Rome I), the parties to a contract are generally free to choose the law applicable to their contract. However, pursuant to Article 3(3) of Rome I, where all other elements relevant to the situation at the time of the choice are located in a country other than the country whose law has been chosen, the choice of the parties will not prejudice the application of the law of that other country, which cannot be derogated from by agreement. This would mean that, in the absence of circumstances that would justify the application of a foreign law, if all parties to a loan agreement are located in Germany, no deviation from the German rules on the general terms of business is possible.
Alternatively, a separate fee letter governed by foreign law regulating the relevant fees could be considered. However, a fee letter could also be regarded as being general terms of business and, if all parties are located in Germany, it is likely that the German rules on general terms of business would also apply to such fee letter.
Loan agreement provided by borrower If the loan agreement is drafted by the borrower and already includes a clause relating to a processing fee, the issue of this clause being the lender's general terms of business is avoided.
This may not be a practical option in many cases as generally lenders prefer to provide the draft loan agreement to the borrower. However, sophisticated sponsors often provide the first draft of the loan agreement.
Separate mandate letter including relevant fee clause Another solution would be to structure the fee in such a way that is classified as the 'main price' for particular services provided by the lender in connection with a loan agreement. The obligation to pay the fee would be included in a separate agreement (eg, in a mandate letter clearly setting out the obligations of the lender – that is, the services that it is providing for the borrower) and the fee which is being charged for these services. Therefore, the provision of such services and the respective payment of the fee would be the main obligations of the parties under the mandate letter and would not be subject to the scrutiny of the German courts as general terms of business. However, the mandate letter would need to be drafted in such a way as to ensure that the services for which the processing or arrangement fee is charged go beyond the 'usual services' provided by the lender. Otherwise the risk that this could be regarded as a circumvention of the rules governing general terms of business would be too high.
Increased interest rate A lender could charge an increased interest rate for the loan to cover what it would have charged as a processing fee (eg, it could apply a higher interest rate in the first year of the loan). This increase would be equal to the processing or arrangement fee that the lender would have charged. As state above, the interest rate is not subject to the courts' control on general terms of business conformity.
However, charging higher interest may reduce the competitiveness of the lender's proposal in comparison to other lenders. In addition, a lender would usually want its fees to be paid on the date of the first utilisation rather than in instalments over a year. Further, an increased interest rate would be inappropriate for a syndicated loan as the services for which such increased interest is being charged would not be provided by all syndicate lenders.
Individual negotiation The rules on the general terms of business do not apply if a clause is negotiated individually. As outlined above, this is difficult to prove in practice. The lender would have to show that it seriously intended to negotiate the fees clause by, for example, providing proof that it was prepared to give up the clause and provide or accept other alternatives and that, if the clause was nevertheless accepted by the other party, this was done in such a way that it "agreed with its fairness and included the clause in its transactional intent".(16) All of this must be sufficiently documented (eg, in a side letter setting out what was agreed and why). This is time consuming, and therefore probably impractical in most cases.
One solution would be to provide the borrower with a document containing various options (eg, payment of the fee upfront or an increased interest rate) from which the borrower can choose. This should be regarded as an individually negotiated clause and would not be subject to the general terms of business rules.
There are a number of ways to deal with the issues raised in these new court decisions. The easiest way to reduce the risk of the processing or arrangement fee being declared invalid by the German courts is for lenders to:
- always have a separate mandate letter clearly setting out the additional services and obligations of the lenders for which this processing or arrangement fee is being paid; and
- document the individual negotiation of the fee clause clearly (eg, the option to choose between a processing or arrangement fee and higher interest and the choice itself should be evidenced in writing).
However, there is no guarantee that these solutions will eliminate the risks entirely.
In cases where the choice of law of a different jurisdiction is possible, a separate fee letter subject to a foreign law is also an option.
For further information on this topic please contact Julia Karen Müller or Andrey Latyshev at Herbert Smith Freehills Germany LLP by telephone (+49 69 222 282 400) or email (email@example.com or firstname.lastname@example.org). The Herbert Smith Freehills Germany LLP website can be accessed at www.herbertsmithfreehills.com.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.