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Is an internal swap a ‘funding transaction’ for the purposes of a loan agreement?
Barnett Waddington Trustees (1980) Ltd and another v Royal Bank of Scotland  EWHC 2435 (Ch),  All ER (D) 82 (Aug)
The key issue in the case was whether an internal swap qualified as a ‘funding transaction’ under a loan agreement and the costs of unwinding it would therefore be payable if the borrowers prepaid the loan. The court held that an internal swap between divisions of the lending bank was not a transaction as a transaction involved two different legal entities. The bank was therefore not entitled to claim the costs from the borrower. The case highlights the importance of ensuring provisions in the loan agreement reflect the ways in which fund and hedge fixed rate loans in practice.
This case concerned a situation which very often arises in commercial bank lending—the bank, in this case RBS, advanced a long-term fixed rate loan to a group of borrowers to finance the purchase of a property and funded the loan and hedged its interest rate exposure by a four-step process.
Step one was to obtain funding from external sources, presumably by a mix of borrowing in the interbank and capital markets and taking deposits from customers. For the bank’s accounting purposes, funds so obtained where treated as being held by its group treasury, an internal division of the bank and not a separate legal entity.
Step two was a floating rate loan from group treasury to the bank’s corporate banking division, also an internal division of the bank. In this way the corporate banking division obtained floating rate funding for its fixed rate loan to the borrowers.
Step three was a fixed to floating rate ‘internal swap’ between the bank’s corporate banking division and the bank’s interest rates desk, another internal division of the bank. In this way the corporate banking division hedged its interest rate exposure and swapped the fixed interest amounts payable by the borrowers for the floating interest amounts it would have to pay to group treasury.
Step four was an ‘external swap’ between the bank’s interest rate desk and a market counterparty on a ‘portfolio basis’. In other words, the bank’s interest rate desk did not enter into a reverse transaction (or ‘back-to-back swap’) exactly matching the internal swap, and presumably to enter into back-to-back swaps with market counterparties for all of its individual fixed rate loans was not a practical or economic option. Instead, the interest rates desk entered into the swap with the market counterparty in a notional amount and on terms which in broad terms hedged the bank’s risk across a portfolio of fixed rate loans.
The loan agreement provided that, in certain cases of pre-payment of the loan, the borrowers were liable to cover any cost to the bank ‘incurred in the unwinding of funding transactions’ undertaken in connection with the loan. The borrowers wished to prepay the loan. The bank required payment of the cost of unwinding the internal swap, described as an ‘Interest Rate Swap termination cost’, on the basis that the internal swap was a funding transaction for the purposes of the loan agreement, either on its own or when taken together with the external swap. This latter possibility was a secondary submission of the bank’s counsel, made at a late stage in the proceedings. The issue to be decided, therefore, was whether the internal swap (either on its own or together with the external swap) was a funding transaction and the cost of unwinding it should be covered by the borrower.
The borrowers’ counsel argued that an external back-to-back swap could be a funding transaction, but that the external portfolio swap actually entered into by the interest rates desk could not be.
Warren J held that the internal swap on its own was not a transaction—and therefore could not be a funding transaction—because the wording of the loan agreement envisaged a transaction which takes place between two different legal entities. He commented:
‘[…] different departments of the Bank do not qualify as separate entities. Corporate Banking cannot borrow from Group Treasury nor can it pay interest to Group Treasury. These are all internal arrangements within the Bank, effected for its own purposes.’
Warren J held that, as a general matter, an external swap might on its own be a funding transaction for the purposes of the loan agreement. He declined to decide whether this particular external swap, on a portfolio and not a back-to-back basis, was a funding transaction because it was not an issue on the claim form and he felt he did not have the material to decide it.
The bank’s routine four-step process for funding and hedging its fixed rate loans (which is actually similar to the process used by all major banks and part of the mechanism for allocating the cost of capital to a bank’s various business lines and helping to ensure compliance with the capital requirements under the Capital Requirements Directive IV 2013/36/EU)) seems not to have been clearly reflected in the drafting of the loan agreement. This case shows that it would be advisable for practitioners to ensure that fixed rate loan agreements at least refer to hedging as well as funding arrangements, and include a mechanism for making a fair determination of a bank’s costs in a situation where the funding or hedging arrangement—the external portfolio swap—will probably not be unwound when an individual fixed rate loan is pre-paid, or may be unwound at a different time for different reasons.
Tony Smith, solicitor in the Lexis®PSL Banking & Finance team.
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