High Court considers entitlement of investment firm to terminate Bitcoin trading account due to alleged money laundering concerns

The High Court has found in favour of a claimant investor in a dispute arising from the termination of her Bitcoin trading account with an online trading platform and concurrent cancellation of open trades (as a result of an alleged money laundering risk): Ang v Reliantco Investments Ltd [2020] EWHC 3242 (Comm). Although the claim relates to an account used to trade Bitcoin futures, the decision will be of broader interest to financial institutions, given the potential application to other types of trading accounts and accounts more generally.

The judgment is noteworthy for the court’s analysis of the defendant’s contractual termination rights in relation to the account and open trades. While the Customer Agreement provided the defendant with the right to terminate the account, the court found that the defendant remained under an obligation to return money deposited in the account (which was held under a Quistclose trust). As to the related open trades, the court found that the defendant only had a contractual right to close out the trades rather than to cancel them (or alternatively, the court said that the same result would be required under the Consumer Rights Act 2015 (the Act), as the investor was a “consumer” for the purposes of the Act).

The decision illustrates the risks for financial institutions seeking to terminate relationships with their customers, particularly in circumstances where there are money laundering or other regulatory compliance concerns. Often accounts may need to be closed without notice (as per N v The Royal Bank of Scotland plc [2019] EWHC 1770; see our banking litigation blog post). Claims against banks by customers in this type of scenario can be significant, and not limited to claims for money deposited in the account, extending to gains on outstanding trades and the loss of future investment returns but for the termination of the account. In the present case, the court found that the claimant was entitled to recover the loss on her investment returns, as it was deemed to be within the reasonable contemplation of the parties when they contracted that, if the defendant failed to repay the claimant sums which she had invested, she might lose the opportunity of investing in similar products.

In order to manage the litigation risks, it may be prudent for financial institutions to review the relevant contractual documentation associated with trading accounts to ensure that it: (i) allows for termination of the account in the relevant circumstances at the absolute discretion of the bank; and (ii) confers an appropriate contractual right to deal with any deposits and open trades. This is particularly the case where the customer is a consumer for the purposes of s.62 of the Act, as there will be a risk that any term in the contract consequently deemed unfair will not be binding on the customer.

Background

In early 2017, the claimant individual opened an account with an online trading platform (UFX), owned by the defendant investment firm. Through this account, the claimant traded in Bitcoin futures. The claimant’s husband (a specialist computer scientist and researcher with cybersecurity and blockchain expertise, and alleged inventor of Bitcoin) also opened accounts on UFX; however, these were blocked when the defendant identified though its compliance checks that he had previously been accused of fraud in 2015.

The claimant made substantial profits trading Bitcoin futures, which were then withdrawn from the UFX account. In late 2017, the defendant terminated the claimant’s UFX account and cancelled all related open transactions, apparently as a result of an alleged money laundering risk.

The claimant subsequently brought a claim alleging that the defendant did so wrongfully and seeking to recover: (i) the remaining funds in the account; (ii) the increase in the value of her open Bitcoin positions; and (iii) the sums from her proposed reinvestment of those funds.

The defendant sought to resist the claim primarily on the basis that the account had actually been operated by the claimant’s husband rather than the claimant and the claimant had provided inaccurate information to the defendant in her “Source of Wealth” documentation.

Decision

The claim succeeded and the key issues decided by the court were as follows.

Issue 1: Entitlement of defendant to terminate UFX account

The defendant argued that it was entitled to terminate the UFX account because: (i) there was a breach of certain clauses of the Customer Agreement relating to access to the UFX account – there had been misrepresentations during the course of the existence of the claimant’s account; and (ii) the claimant had made misrepresentations in her “Source of Wealth” form and documents – this constituted a breach of a warranty the claimant had given as to the accuracy of information she had given to the defendant.

The court held that the defendant was contractually entitled to terminate the UFX account on the basis that the claimant’s husband did have some access to the account, which must have involved breaches of the Customer Agreement.

However, the court found that the statements made by the claimant in the “Source of Wealth” documentation were not untrue or inaccurate. The court said that the alleged misrepresentations in relation to: (i) the “Source of Wealth” form was not pre-contractual and could not have induced the making of the Customer Agreement; and (ii) access to the UFX account failed on the facts – the UFX account did not belong to and was not solely or predominantly operated by the claimant’s husband.

Issue 2: Sums deposited in the UFX account

The defendant accepted that there was the equivalent of a Quistclose trust in respect of these amounts and that it did have an obligation to return them.

The court held that even if there was no Quistclose trust, the defendant was obliged to return the amounts in any case pursuant to the terms and conditions (incorporated into the Customer Agreement between the claimant and the defendant) and that there was no suggestion that any amount needed to be withheld from those amounts in respect of future liabilities.

Issue 3: Unrealised gains on the claimant’s open Bitcoin positions

The court highlighted that the terms of the Customer Agreement obliged the defendant to close out (rather than “cancel”) the open positions, realise the unrealised gain on the Bitcoin futures and pay the balance to the claimant.

However, the court added that if this construction of the Customer Agreement was wrong and the defendant did have discretion to “annul or cancel” open positions, then the relevant clauses would be unfair, as they would cause a significant imbalance in the parties’ rights and obligations to the detriment of the consumer, contrary to the requirement of good faith. In the court’s view such clauses would have the effect of permitting the defendant to deprive the claimant of what might be very significant gains for trivial breaches. The clauses therefore would not be binding on the claimant by reason of s.62 of the Act.

Issue 4: Loss of investment returns

The claimant argued that she was entitled to claim what she would have earned had the monies to which she was entitled been paid to her upon the termination of her account.

The court held that the claimant was entitled to succeed on this aspect of her claim as the defendant had breached the Customer Agreement by not closing the open positions, realising the gain and paying the balance to the claimant. In the court’s view, remoteness of damage was not an issue as it was plainly within the reasonable contemplation of the parties when they contracted that if the defendant failed to pay the claimant sums which she had invested in (and/or made from investing in) Bitcoin futures, she might lose the amount which she might gain from investing in similar products.

Ceri Morgan

Ceri Morgan
Professional Support Consultant
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Nihar Lovell

Nihar Lovell
Senior Associate
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Claire Nicholas

Claire Nicholas
Senior Associate
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Commercial Court considers contractual discretion of bank to close customer account without notice where there is suspicion of money laundering

In a recent decision, the Commercial Court has upheld a financial institution’s decision to exercise its contractual right to close a customer’s accounts and terminate its relationship without notice, where the financial institution had a suspicion that its customer’s accounts were being used for money laundering purposes: N v The Royal Bank of Scotland plc [2019] EWHC 1770. The decision will be welcomed by financial institutions seeking to take action to prevent financial crime occurring through use of accounts provided to customers, under tight time pressure and notwithstanding that the consequences of the bank’s action for the business in question could be severe.

This is not the first case in which a financial institution has successfully defended a breach of contract claim brought by its customer in the context of a money laundering suspicion. In Shah & Anor v HSBC Private Bank (UK) Ltd [2012] EWHC 1283 (QB) (see our corporate crime e-briefing), the court firmly rejected the customers’ claim that the bank was in breach of contract by refusing to process payment instructions while awaiting consent from the Serious Organised Crime Agency (now the National Crime Agency, “NCA”) in respect of a Suspicious Activity Report (“SAR”). In that case (in the absence of an express term) the court implied a term into the contract. The implied term permitted the bank to refuse to execute payment instructions in the absence of “appropriate consent” under the Proceeds of Crime Act 2002 (“POCA”), where it suspected a transaction constituted money laundering. Pursuant to the POCA ‘consent regime’, once a bank makes a SAR, it will not be able to process payments in relation to the relevant account until “appropriate consent” (now known by the NCA as “DAML”) has been given by the NCA. In Shah, the defendant bank was then put to proof that it had the requisite suspicion of money laundering in order to rely upon the implied term (which the bank satisfied).

However, in the instant case, the bank was assisted by express contractual provisions giving the bank discretion to close the customer’s account and delay/refuse to process payments in certain circumstances. As such, the test applied by the court was different to previous authorities (including Shah), because it derived from the wording of the contract itself and the contractual discretion expressly provided for.

While the terms governing accounts will vary between institutions and account type, a number of the court’s findings may be of general assistance to banks considering AML compliance procedures and assessing the risk of exposure to account-holder claims. In particular:

  • Interestingly, the court did not find it necessary to grapple with the question of the standard which the bank was required to meet in the exercise of its contractual discretion to close the account, i.e. whether the bank’s discretion was required to be exercised in a way which was not arbitrary, capricious or irrational in the public law sense (the so-called Braganza duty); or if the bank was required to meet the higher standard of objective reasonableness. This was because, even applying the higher threshold, the court found that the standard had been met by the bank and the decision to close the account did not breach the bank’s contractual terms. The applicable standard is important because contractual discretions are subject to increased judicial scrutiny if the latter standard applies (see previous blog post: High Court applies public law standard to the exercise of discretion by a financial institution under a receivables finance agreement). It may be prudent for those drafting the bank’s account terms to consider expressly incorporating the lower threshold where appropriate.
  • The court reached its conclusion notwithstanding the absence of any suspicion that the customer (a money service business (MSB), whose accounts received funds from its underlying clients) was implicated in its clients’ suspected criminality. This was because the end result of the customer’s poor AML due diligence and regulatory compliance was similar to the result of deliberate action on its part.
  • The court expressly stated that the bank was entitled to consider the impact (on the bank itself) of not freezing and terminating the customer’s accounts – here the bank could not countenance a risk that it would be money laundering and this was a relevant factor to take into account in the exercise of the bank’s discretion.
  • The court specifically rejected the customer’s broad contention that unless complicity/fraud is proven, closing an account without notice “could never rationally be adopted by a bank” (emphasis added). The court confirmed this will depend upon the wording of the contractual terms governing the account. In this case, the contract provided that the bank could take action where it considered there to be exceptional circumstances, not just where there is established complicity or proven fraud.

Regrettably, the court chose not to grapple with a number of other areas of interest from an AML compliance perspective which are raised by the case. Foremost among these is the question of co-mingling and ring-fencing (and in particular the circumstances in which ring-fencing might be a permissible approach, within the framework of POCA, as an alternative to freezing an account). This is a perennial debate, and the recent Law Commission consultation on reform of the SARS regime included an interesting discussion on the question of ring-fencing and fungibility (that money is considered to be an asset capable of mutual substitution, i.e. one £5 note can be substituted for any other £5 note). The Law Commission’s final report recommended an amendment to POCA to create additional clarity in this area. In the meantime, while the position taken by the court in N v RBS was helpful to the bank, the correct legal analysis as to the nature of the criminal property in play when funds are mixed remains open to debate.

Background

The claimant (“N”) was an authorised payment institution providing foreign exchange and payment services to its customers. N held several main accounts and client sub-accounts with the defendant, The Royal Bank of Scotland plc (the “Bank”).

Pursuant to the terms which governed the operation of N’s accounts, the Bank:

  • was under a duty to give N written notice to close an account, unless it considered there were exceptional circumstances; and
  • could delay or refuse to proceed with processing a payment if, in its reasonable opinion, it would be prudent to do so in the interests of crime prevention or in compliance with laws.

In September 2015, the Bank suspected that several of N’s clients were involved in “boiler room” scams, and that victims had paid money into N’s accounts held with the Bank. The Bank froze several client sub-accounts, and identified there had been “co-mingling” (i.e. mixing) between sub-accounts and the main accounts. On 8 October 2015, after the sub-accounts had been frozen, an attempted payment was made from the main account (the “Attempted Payment”), arousing the Bank’s suspicion that some of N’s clients were attempting to circumvent the freeze on the sub-accounts.

On 9 October 2015, the Bank froze the main accounts and terminated its relationship with N immediately. N commenced proceedings challenging the lawfulness of the Bank’s actions, alleging breach of contract and negligence.

Decision

The High Court found the Bank was entitled to terminate its relationship without notice in the circumstances.

Standard of contractual discretion

The court undertook a detailed assessment of the factual evidence presented, and found that the decision to terminate the relationship was taken on 9 October 2015. It then considered whether the Bank exercised its discretion to close the accounts (and therefore refuse to process payments) in accordance with the contractual terms governing the account.

In the court’s view, the case did not turn on the differences between the parties’ rival contentions as to the meaning of the contractual terms and it did not consider those questions further. In this regard, N argued that the Bank was required to meet the standard of objective reasonableness in the exercise of its contractual discretion to close the accounts. The court held that, even applying this standard (which is higher than the rationality threshold), the standard was met by the Bank.

Alleged failure by the Bank to exercise discretion in reasonable manner

The court considered various challenges made by N to the exercise of the Bank’s discretion. The key challenges which are likely to be of broader interest are explored further below.

  1. N’s primary challenge to the exercise of the Bank’s discretion was that there was no suspicion that N was implicated in money laundering. However, the court found that N’s poor control environment meant, in effect, whether N was implicated in the fraud or not was irrelevant to the Bank’s exercise of its discretion. In this regard it is noteworthy that the experts on both sides agreed that there were numerous failures in N’s due diligence and regulatory compliance, which the court held were “serious”.
  2. N argued that because there was no suspicion that it was complicit/implicated in the underlying frauds of its clients, the co-mingling issue “was not insurmountable”. However, the court considered and rejected the various ways suggested by N (ex post) as to how freezing N’s sterling pooled client account (one of the accounts in question) could have been avoided. In particular:
    • The court rejected N’s contention that the Bank could have ring-fenced suspected funds as the Bank had tried this by initially freezing the suspect sub-accounts. The success of this option had already been compromised by the co-mingling of accounts and the Attempted Payment. The court said the position was the same in relation to N’s separate contention that the Bank could have broken the account (if necessary with NCA consent), and commented that the Bank also had (and was entitled) to consider its obligations as to the prevention of crime, separate to the view of the NCA.
    • The court rejected N’s proposal that the Bank could have manually operated the account or sought consent on a daily basis by way of an ‘omnibus’ SAR. These two proposals were impractical, in light of the volume of transactions and the challenges posed by investigating each one, and of engaging with the NCA.
    • The court rejected N’s assertion that the Bank could have prevented further credits to the account or could have adopted a cooperative approach to the exit of the relationship by working with N over the suspect accounts. The court commented that the Bank was entitled to conclude that things had gone too far for this suggestion to be workable, and the proposal as to further credits did not address the position as to existing balances in the accounts.
  3. The court rejected N’s contention that the absence of suspicion in relation to N’s involvement in evasion in relation to the Attempted Payment was relevant – it was the evasion itself which was the problem for the Bank.
  4. The court also concluded that as co-mingling had been identified in the accounts, this fact could be taken into account by the decision-maker at the Bank, even without further investigation.
  5. N argued that the decision to terminate the relationship without notice did not take account of the potentially significant consequences for N’s business. As a matter of fact, the court found this was incorrect. The court also helpfully commented that the impact on the Bank of not freezing and terminating must be part of the consideration – here the Bank could not countenance a risk that it would be money laundering and this was a relevant factor to take into account in the exercise of the Bank’s discretion.
  6. The court specifically rejected N’s broad contention that unless complicity/fraud is proved, closing an account without notice “could never rationally be adopted by a bank” (emphasis added). The court noted that the contract provided for a right to close an account without notice where the Bank considers there are “exceptional circumstances”, not “where there is established complicity or proven fraud”.

The court recognised there were a range of honest, rational and reasonable decisions which could have been taken. However, it did not mean that the decision-maker’s chosen course was incorrect; it was within the realm of reasonable decisions. Accordingly, the court held that the decision taken by the Bank on 9 October 2015 was not in breach of the Bank’s terms (nor a breach of any tortious duty, for the same reasons).

Section 338(4A) POCA

The court found it unnecessary to consider s.338(4A) POCA, the post-Shah provision which was introduced into POCA with a view to assisting firms who are alleged to have caused loss to customers or counterparties by making authorised disclosures (typically, if there is a delay in a transaction while consent/DAML is sought). The provision did not assist the Bank, since the basis of the customer’s claim was the decision to terminate the account relationship, rather than a loss arising from the seeking of consent.

Susannah Cogman

Susannah Cogman
Partner
+44 20 7466 2580

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Ceri Morgan

Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

Nic Patmore

Nic Patmore
Associate
+44 20 7466 2298

 

Important High Court guidance on the limits of determining party’s discretion when calculating Loss under the 1992 ISDA Master Agreement

The High Court has provided important guidance on the application of the standard to which a determining party’s calculation of Loss under the 1992 ISDA Master Agreement will be held in Lehman Brothers Finance AG (in liquidation) v (1) Klaus Tschira Stiftung GmbH & Anor [2019] EWHC 379 (Ch).

Upon an Event of Default under the 1992 ISDA, the standard to which the determining party is held in calculating Loss (if elected) under the 1992 ISDA has previously been confirmed in Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (read our summary here). The test is one of rationality, rather than objective reasonableness (in contrast to the position under the 2002 version of the ISDA Master Agreement). This gives the determining party greater latitude, with the result that the amounts can be determined quickly and with only limited basis for challenge. In the classical formulation of the test, the defaulting party can challenge the determination if it is irrational, capricious or arbitrary.

The Tschira decision provides additional clarification of the limitations on the determining party’s discretion to determine Loss, illustrating that the width of the discretion does not mean that the determination can only be challenged if it can be shown that “no reasonable Non-defaulting Party acting in good faith could have come to the same result“. In particular:

  1. Whilst an administrative-law style assessment would consider whether the determining party took into account all relevant factors and ignored all irrelevant factors, that does not mean that the determining party has the freedom to determine what the definition of Loss in the 1992 ISDA actually means. In other words, the determining party cannot apply its own interpretation of Loss and the court will scrutinise whether the correct interpretation has been applied.
  2. The definition of Loss in the 1992 ISDA did not provide a de facto indemnity against all losses suffered as a result of the Event of Default. Accordingly, common law principles of remoteness applied and it was necessary for the court therefore to consider whether all of the losses incorporated into the determination were in the reasonable contemplation of the parties.
  3. Whilst the determining party is plainly able to use indicative quotations obtained from market participants for the purpose of its calculation of Loss, care must be taken:
  • Only in limited circumstances will it be appropriate to rely on indicative quotations as at a later date than the Event of Default.
  • Whilst Enasarco established that the replacement trade to which the quotation applies need not be identical to the trade being valued, where the differences would obviously produce a substantially different result there is a real risk that use of such quotations to determine Loss would be deemed irrational.
  • It is clear that the determining party need not in fact enter into the replacement trade in order to be able to use the indicative quotation for the determination of Loss. However, in order for use of an indicative quotation to be rational, it may need to have been possible for the determining party to have been able to enter into it.

Background

The defendants were two German entities established by one of the founders of SAP. Since their principal assets consisted of shares in SAP, they had each entered into a number of single stock derivative transactions with Lehman Brothers Finance AG (the “Bank“), a Swiss entity which was part of the Lehman Brothers group, to hedge against significant falls in the price of SAP shares. The hedging transactions were governed by the 1992 version of the ISDA Master Agreement. Given the poor credit quality of the defendants, the terms of the transactions required the SAP shares they held to be placed as collateral with the UK subsidiary of the Lehman Brothers group (“LBIE“).

The collapse of Lehman Brothers on 15 September 2008 caused an Event of Default on the hedges triggering the need for the defendants to determine the close-out payments (on the basis of Loss, which the parties had elected as the methodology to apply in the 1992 ISDA). Soon after the Event of Default, the defendants sought indicative quotations from Goldman Sachs and Mediobanca, Banca di Credito Finanziario SpA (“Mediobanca“) for replacement hedges on the basis that they would be collateralised in a similar way to the original trades.

However, the defendants later learnt that the SAP shares held by LBIE as collateral would be dealt with as part of its administration, raising the prospect of them being unavailable to the defendants for use in any replacement trade for the foreseeable future. As a result, Mediobanca and Goldman Sachs were asked to provide revised indicative quotations for replacement trades on an uncollateralised basis. Unsurprisingly, these quotations were substantially higher than the earlier quotations which had been obtained on a collateralised basis (reflecting, amongst other things, the significantly greater credit risk to which the counterparty would be exposed).

The defendants ultimately served a determination of Loss based on Mediobanca’s quotation for an uncollateralised replacement trade. Accordingly, the determination of Loss which it sought to recover from the Bank (over €511m) was far higher than it would have been had it been determined on the basis of the earlier quotations which were based on a collateralised replacement trade (which were €28.22m and €17.46m).

The Bank challenged the calculation of Loss.

Decision

The court held that the determination of Loss by the defendants was invalid. First, it had not been performed in accordance with the definition of Loss. In any event, it was found to have been irrational.

Application of the rationality standard

It is well established by the authorities (for example, Enasarco) that the relevant standard which applies to the determining party’s calculation of Loss under the 1992 ISDA is one of rationality, reflecting the test of Wednesbury reasonableness of an administrative decision. However, it was noted that this did not resolve all uncertainties as to the standard to which the determining party will be held. In particular, it was unclear whether this test imported into the court’s assessment of all the elements of a review of an administrative decision, including the process by which the determination was reached.

The court held that the 1992 ISDA did not import a requirement that the court undertake a detailed assessment of whether the determining party took into account all relevant factors and ignored irrelevant factors. To allow such an expanded basis for challenge would undermine the desire for speed and commercial certainty which is clearly one of the driving principles of the Loss definition. However, the determining party does not have free rein to determine for itself not only the method it will adopt to determine Loss, but also the actual meaning of Loss. Accordingly, the Bank was not limited only to being able to challenge the determination of Loss on the basis that the method chosen was irrational (or in bad faith), for which the defendants had a large measure of latitude. It could also challenge the determination on the basis that the defendants had interpreted the definition of Loss incorrectly.

Remoteness test in the meaning of Loss

The court held that the correct meaning of Loss incorporated usual common law principles applicable to the assessment of contractual damages, including remoteness. The key question, therefore, was whether all of the Loss claimed was of a type that was in the reasonable contemplation of the parties. Applying this test, the court found that it was not within the reasonable contemplation of the parties that the defendants would be able to recover the additional financial consequences of having to enter into an uncollateralised replacement trade as a result of being unable to retrieve the collateral from LBIE.

The court noted that this conclusion was consistent with the ‘value clean’ principle, pursuant to which the loss of bargain within the Loss calculation must be valued on the assumption that “but for termination, the transaction would have proceeded to a conclusion, and that all conditions to its full performance by both sides would have been satisfied, however improbable that assumption may be in the real world“. Applying the ‘value clean’ principle in this case, the provision of the collateral by the defendants was a condition precedent for the trades. Accordingly, the assumption should be made for the replacement trades that this condition would be satisfied, notwithstanding that this was not possible in the real world. This meant that any quotations for replacement transactions should have been on a collateralised basis.

Appropriate date for determining Loss

The court also considered a criticism made that the quotations used for the defendants’ determination should have been ‘as of’ the Early Termination Date. The Bank argued that, whilst the Loss definition permitted (for practical reasons) some flexibility in the use of a firm quotation obtained after the Early Termination Date, it did not allow an indicative quotation to be used other than as of the Early Termination Date. The rationale for this was that it should always be possible to obtain an indicative quotation as at the earlier date (on a retrospective basis).

The court did not agree with such a restrictive interpretation of Loss, which would have the effect of requiring, rather than permitting, the Non-defaulting Party to use firm quotations rather than any other method in circumstances where, for whatever reason, it was unable to obtain quotations at the time of the Early Termination Date (for instance where it did not learn of the Event of Default until a later point in time or where there was no available market as at the Early Termination Date). However, it noted that this flexibility would only apply in those sorts of limited circumstances.

Rationality

The court also found that it was, in any event, irrational for the defendants to use the uncollateralised replacement transactions as a basis for the calculation of Loss.

First, whilst the existence of some differences between the terms of the trade and the terms of the replacement trade may not invalidate the determination of Loss (as illustrated in the Enasarco case), there were limits to that latitude. In this case, seeking quotations for replacement trades on an uncollateralised basis would obviously, and did, produce a substantial difference when compared to seeking quotations on a collateralised basis. This meant that they were not a reliable guide as to the value of what had been lost, and to use this as a basis for the calculation of Loss was irrational.

Second, the method of using quotations or valuations of the cost of a replacement trade to measure loss depends on the replacement being one that the party could enter into in an available market (albeit that they need not actually enter into the replacement trade). Having made a finding of fact that the defendants, given their poor credit risk, could not have entered into a replacement hedge on an uncollateralised basis, it was irrational to use a quotation for such a transaction as a method of determining its Loss.

The court’s calculation of Loss

Having found that the determination was invalid, the task for the court was to determine what Loss determination would have been arrived at by the defendants acting reasonably and in good faith. It therefore substituted the defendants’ invalid determination with its own calculation, using the initial quotations which had in fact been obtained by the defendants (on a collateralised basis). Whilst there were criticisms made of aspects of those quotations by the Bank’s expert, these were characterised by the court as differences of methodology, rather than fundamental errors that would lead to a substantially different price.

The court’s approach emphasised the potential importance of all contemporaneous quotations received by the Non-defaulting Party. Whilst it is clear from previous case law (see our e-bulletin on National Power) that the determining party gets only one bite at the cherry, the steps taken to obtain other quotations at or around the time of the Event of Default are likely to provide important evidence for the court to use in its own calculation of Loss.

It is noteworthy, also, that in this aspect of the judgment the court left open the question of whether the determining party could validly favour its own interests in the selection of which quotation to use in its determination, or whether choosing the one which was most favourable would necessarily be irrational. The court adopted the pragmatic approach of averaging the two quotations which the defendants received on the basis that the defendants had, as a matter of fact, used that average when providing a ‘without prejudice’ informal calculation of Loss in the initial days after the Event of Default. However, in doing so, it has left the question to be determined in future litigation.

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Amel Fenghour

Amel Fenghour
Associate
+44 20 7466 2389

Ceri Morgan

Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

High Court finds bank unreasonably withheld consent to sale of secured property where sale would not have satisfied the secured liability in full

Paul Crowther & Anor v Arbuthnot Latham & Co Ltd[2018] EWHC 504 (Comm) provides an interesting example of how the High Court applied the test of objective reasonableness to the exercise of a bank’s discretion to consent to the sale of a secured property. In reaching this conclusion, the court refused to apply the so-called Braganza duty to the exercise of the contractual discretion, i.e. whether it was exercised in a way which was not arbitrary, capricious or irrational in the public law sense. Central to the court’s decision was its conclusion that the wording of the clause in the instant case (that the bank’s consent should not be “unreasonably withheld or delayed“) was “essentially the same” as the wording of a clause in a landlord and tenant case in which the Court of Appeal applied the objective test of reasonableness: Straudley Investments Ltd v Mount Eden Land Ltd [1996] EWCA Civ 673(citation corrected from the judgment).

Applying this objective test, the court held that the bank’s refusal was unreasonable. The bank’s position was that any consent to sell was conditional on the provision by the claimants of further security, because the proceeds of the sale would not discharge the outstanding debt in full. However, the court emphasised that at the time the relevant agreement was entered into, the estimated value of the property was “very considerably less” than the outstanding indebtedness, and so the position had not really changed. Essentially, the court took the view that the bank should have sought further security (in excess of the value of the secured property) at the outset, if it wished to have security for the full amount of the outstanding debt.

This decision will be of interest to lenders, particularly those considering the exercise of a contractual veto to prevent the sale of secured property, although each case will turn on its own facts and the express wording of the clause.  One way in which the interpretation of a similarly worded clause might be distinguished in the future is where (at the time the relevant agreement was executed) the full outstanding liability was secured by the property in question. The instant decision is also vulnerable to criticism that the principles applied were specific to the landlord and tenant context and attempts to transfer such principles outside of that sector are inappropriate. In particular, the court failed to address the fact that the analysis of the requirement not to unreasonably withhold or delay consent in Mount Eden, on which much emphasis was placed, was (at least in part) informed by the requirements of the Landlord and Tenant Act 1988 which also uses the same wording.

However, if this decision is followed, it may increase the risk for lenders who withhold consent to the sale of secured property in circumstances where there is an express provision that such consent should not be withheld unreasonably. This is because the application of an objective test (as opposed to one based on rationality) will arguably make it more difficult for a lender to prove that consent has been withheld legitimately.

Factual background 

In December 2001 the claimants issued proceedings against Arbuthnot Latham & Co Ltd (the “Bank“) before the Brighton County Court alleging that, as a result of a number of loan facilities entered into between them, an unfair relationship within the context of the Consumer Credit Act 1974 arose. These loans were secured by a charge over the claimants’ property in France (the “Property“). The proceedings were subsequently transferred to the High Court, and the claim was settled in September 2013 by a Tomlin order, with settlement terms included in a schedule to that order (the “Settlement Agreement“). Further to the Settlement Agreement, the charge and only one facility (with approximately €5.9 million outstanding) remained in place and their original terms were superseded by those included in the Settlement Agreement.

Over the years the claimants tried to sell the secured Property to reduce their indebtedness and towards the end of 2016 they received an offer of €4.5 million, which was in line or slightly over the market valuations at the time and was considered by the Bank as “an agreeable offer“.  However, the sale would have left the Bank with a considerable shortfall (€1.7 million) and no security. The Bank was prepared to agree to the sale on the condition that further security was provided by the claimants. Since no further security was provided, the sale was lost. The claimants did not accept that the Bank’s requirement for further security as a condition of consent was a legitimate or reasonable basis for its refusal.

The current dispute between the parties concerned the construction of the following clause of the Settlement Agreement (the “Clause“): “If with the prior approval of the bank (such approval not to be unreasonably withheld or delayed) the property is sold, you shall immediately repay to the bank the net proceeds of sale“. The claimants sought a declaration that the Bank had unreasonably withheld its consent to the sale of the Property.

Decision

The court held that the Bank’s refusal to consent to the sale was unreasonable, granting declaratory relief against the Bank. The key question considered by the court was the proper scope of the Bank’s discretion to consent to the sale, in other words, the proper purpose of the Clause.

The court first referred to Mount Eden, a landlord and tenant case  where the wording of the landlord’s veto clause was essentially the same as the Clause in the instant case, i.e. that consent should not be unreasonably withheld. The landlord was only prepared to give consent for its tenant to sublet, subject to a condition which would improve the landlord’s own security position, whereby the deposit from the new subtenant was required to be held in a joint account. The court held that the landlord’s consent to the subletting was unreasonably withheld, stating that it would not normally be reasonable for a landlord to seek to impose a condition which was designed to increase or enhance the rights that he enjoyed under the headlease (i.e. retaining a security interest in the deposit to which only the tenant would normally be beneficially entitled). In the instant case, the court said that the decision in Mount Eden was of assistance in two ways:

  • Mount Eden stated that it was not necessary for a landlord to prove that the conclusions which led him to refuse consent were justified, if they were conclusions which might be reached by a reasonable man in the circumstances. This suggested that the test for reasonableness was an objective assessment.
  • Mount Eden stated that a landlord is not entitled to refuse his consent to an assignment on grounds which have nothing to do with the relationship of landlord and tenant in regard to the subject matter of the lease, referring to a recent example of a case where the landlord’s consent was unreasonably withheld because the refusal was designed to achieve a “collateral purpose” unconnected with the terms of the lease. As such, a “collateral purpose” would include where a party withholding consent does so in order to obtain rights he did not otherwise have.

It is noted that Mount Eden appears to have been decided (at least in part) on the requirements of the Landlord and Tenant Act 1988, rather than purely on the basis of a landlord’s veto clause in the head lease. The implications of this are discussed in the introduction.

The court distinguished Barclays Bank Plc v Unicredit Bank AG (formerly Bayerische Hypo-und Vereinsbank AG) [2014] EWCA Civ 302, in which the fact that the bank had only regarded its own commercial interests in refusing consent to an early termination of derivative transactions was found to be reasonable. In Unicredit, the clause required consent to be determined in a “commercially reasonable manner” and the nature of the reasonableness test was by reference to Wednesbury unreasonableness or a form of Braganzaduty, i.e. a test of rationality as opposed to the common law, reasonable person test. The key points of distinction made were as follows:

  • In the instant case, the court saw no basis for a Wednesbury reasonableness test, given that the wording of the Clause followed the landlord and tenant-type clause (per Mount Eden, which applied a reasonable person test) and was different to the wording of the clause in Unicredit.
  • Further, the court noted that the discretion considered by the Court of Appeal in Unicredit concerned the process or manner of the determination of whether to consent to the early termination, by contrast to the Clause in this case, which was about outcome.

The court noted that the Clause did not qualify or define its object or target in respect of the reasonableness of the refusal in any way, but stated it was “very hard to see why the scope of the [Clause] should go any further than a concern which [sic] the aim of permitting disposal of the [Property] at a proper price“. In this context, the court held that the Bank’s reasons for refusing the sale had no connection with the aim of getting a sale at a proper value at all. Although the proposed sale would have left a shortfall, the court noted that the value of the Property at the time of the Settlement Agreement was “very considerably” less than the outstanding indebtedness. As such there was no expectation at that time that a potential sale of the Property would pay off the entirety of the outstanding loan and so the position had not really changed. The court commented that, although the Bank’s desire for more security was about the loan and its relationship with its debtors, that did not stop it from being a collateral purpose as the decision in Mount Eden made clear.

Accordingly, the court held that the disputed Clause should be construed so that the reasonableness of the discretion exercised by the Bank was determined by reference to whether the proposed sale was “at fair market value and at arm’s length“. The court did not accept that the reasonableness criteria in that context was limited to ensuring that the Bank acted in a Wednesbury reasonable or rational way in reaching its decision. Consequently, upon the facts of the case, the Bank’s refusal to the sale was deemed unreasonable.

 

Rupert Lewis

Rupert Lewis
Partner
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Ceri Morgan

Ceri Morgan
Professional Support Lawyer
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Court of Appeal confirms wide discretion afforded to a non-Defaulting Party when determining “fair market value” of securities under the GMRA (2000 version)

The recent Court of Appeal decision in LBI EHF v Raiffeisen Bank International AG [2018] EWCA Civ 719 affirms the wide discretion of the non-Defaulting Party to determine “fair market value” in accordance with the close-out mechanism under paragraph 10(e)(ii) of the standard Global Master Repurchase Agreement (2000 version) (“GMRA“). Agreeing with the first instance judgment, the Court of Appeal reiterated that (in the absence of some express or implied limitation in the contract), the only constraint to be implied on the non-Defaulting Party’s discretion to determine “fair market value” was that of rationality; the decision-maker must have “acted rationally and not arbitrarily or perversely“: Socimer International Bank Ltd v Standard Bank London Ltd [2008] EWCA Civ 116 as applied to the GMRA in Lehman Brothers International (Europe) v Exxonmobil Financial Services BV [2016] EWHC 2699 (Comm).

Interestingly, the Court of Appeal confirmed that there is no basis to imply that the determination of “fair market value” under the GMRA must be by reference to a price agreed between a willing buyer and willing seller in a market which is not suffering from illiquidity or distress. In accordance with the wording of the GMRA, the Court of Appeal found that in determining “fair market value” the non-Defaulting Party may have reference to “such pricing sources and methods” as it considers appropriate, as long as it acts rationally. It should be noted that the width of the discretion afforded to the non-Defaulting Party arises from the specific wording of the GMRA; the Court of Appeal did not, and did not seek to, provide any more general interpretation of “fair market value“.

The court thereby rejected the attempt to import into the contractual framework other uses of fair market value which would incorporate the willing buyer and seller language in accounting terms – so the non-Defaulting Party is entitled to have regard to its commercial interests in establishing Net Value. This is particularly important in circumstances where the close-out takes place in a distressed market – the non-Defaulting Party is therefore able to take into account prices which reflect the distressed conditions prevalent at the time.

Background 

The appellant, the bank formerly known as Landsbanki Islands hf. (“LBI“), entered into 11 ‘repo’ trades with Raiffeisen Bank International AG (“RBI“) on the terms of the 2000 version of the GMRA (capitalised terms not otherwise defined in this e-bulletin are to the GMRA defined terms). On 7 October 2008, LBI went into receivership. This was an Event of Default under the GMRA and RBI served Default Notices on LBI. Under the GMRA, LBI was required to pay RBI (as the non-Defaulting Party) the agreed Repurchase Price for the securities minus the Default Market Value of Equivalent Securities.

Sub-paragraph 10(e) of the GMRA sets out the methods by which the non-Defaulting Party can ascertain the Default Market Value. The framework mechanism in the 2000 version of the GMRA allows for two scenarios: (a) where a Default Valuation Notice has been served by the Default Valuation Time (defined as the close of business on the fifth dealing day after the day on which the Event of Default occurred); and (b) where a Default Valuation Notice has not been served on time.

Where a Default Valuation Notice has been served on time, sub-paragraph 10(e)(i) provides for three methods of valuation:

  1. The bonds may be sold (or bought, as the case may be) in good faith and the sale price used to determine the Default Market Value;
  2. The Default Market Value may be determined from the mean average of commercially reasonable quotations obtained from market makers for the bonds; and
  3. Where the non-Defaulting Party has endeavoured but been unable to sell the bonds or obtain commercially reasonable quotations, or determined that it would be commercially reasonable not to seek such quotations the non-Defaulting Party can determine the Net Value of Equivalent Securities and elect to treat that Net Value as the Default Market Value.

Where a Default Valuation Notice has not been served on time, sub-paragraph 10(e)(ii) provides that the non-Defaulting Party should determine the Net Value as at the Default Valuation Time. It is of note that the 2011 version of GMRA has since disposed of the 5-day window in which to serve the Default Valuation Notice; providing instead that the determination of Default Market Value (using broadly similar methodology as described above) “on or about the Early Termination Date”.

RBI had not served the Default Valuation Notice by the Default Valuation Time and therefore Default Market Value fell to be assessed under GMRA sub-paragraph 10(e)(ii). In order to provide context for the decision, the relevant paragraphs of the GMRA are set out in full, below:

10(e)(ii)…If by the Default Valuation Time the non-Defaulting Party has not given a Default Valuation Notice, the Default Market Value of the relevant Equivalent Securities or Equivalent Margin Securities shall be an amount equal to their Net Value at the Default Valuation Time; provided that, if at the Default Valuation time the non- Defaulting Party reasonably determines that, owing to circumstances affecting the market in the Equivalent Securities or Equivalent Margin Securities in question, it is not possible for the non-Defaulting Party to determine a Net Value of such Equivalent Securities or Equivalent Margin Securities which is commercially reasonable the Default Market Value of such Equivalent Securities or Equivalent Margin Securities shall be an amount equal to their Net Value as determined by the non-Defaulting Party as soon as reasonably practicable after the Default Valuation Time.” (Emphasis added)

Net Value is defined in sub-paragraph 10(d)(iv) by reference to “fair market value“:

10(d)(iv)…”Net Value” means at any time, in relation to any Deliverable Securities or Receivable Securities, the amount which, in the reasonable opinion of the non-Defaulting Party, represents their fair market value, having regard to such pricing sources and methods (which may include, without limitation, available prices for Securities with similar maturities, terms and credit characteristics as the relevant Equivalent Securities or Equivalent Margin Securities) as the non-Defaulting Party considers appropriate, less, in the case of Receivable Securities, or plus, in the case of Deliverable Securities, all Transaction Costs which would be incurred in connection with the purchase or sale of such Securities;”

The principal issue for the court to decide was the meaning of “fair market value” in this context.

High Court decision

The court at first instance held that the fair market value determined by RBI for each security was a “rational and honest determination of fair market value” as at the Default Valuation Time. These figures were a statement of RBI’s position derived from the sources available to it as at the Default Valuation Time, rather than a product of evidence from an expert or witness of fact. The sources used by RBI to determine Net Value included:

  • Bids from 10 institutional counterparties which the respondent had requested (for some securities there were no indicative bids; for other securities there were indicative bids from multiple institutions);
  • Algorithm-based prices shown on Bloomberg which RBI used for internal purposes, and which it did not consider to represent a practical and commercial realisable value; and
  • The only activity experienced by the RBI on 15 October 2008 (the Default Valuation Time) itself, namely a bid shown by Citi at 45 for ICICI (USD) bonds and a request by Citi that RBI place an order with it at 80 for RAK Bank bonds.

The figures RBI put forward did not apply prices from days other than 15 October but they did include adjustments from price information available on other days.
The sources available at that time were – in the words of the High Court – “imperfect” and included Bloomberg prices (which RBI did not consider to represent a practical and commercial realisable value). However, the court held that: “…the circumstances at that time were imperfect. Any assessment of fair market value would have been imperfect but the non-Defaulting [P]arty was nonetheless entitled to make one.”

Grounds of appeal / response

LBI appealed on the basis that the judge at first instance erred in holding that, on the true construction of the GMRA, the non-Defaulting Party’s assessment of “fair market value” of securities could be based on actual prices achieved, indicative quotes or screen prices obtained in the distressed or illiquid market prevalent at the time. RFI argued that the discretion afforded by the GMRA is wide and LBI’s approach involved a significant restriction as a matter of law on this apparently wide discretion, in particular the non-Defaulting Party’s ability to have reference to “such pricing sources and methods as it considers appropriate“. RFI argued that the restriction sought by LBI was fundamentally inconsistent with the language of the GMRA.

Court of Appeal decision

The Court of Appeal dismissed the appeal, affirming RFI’s wide interpretation of the GMRA.

The Court of Appeal found (in line with Socimer and Exxonmobil), that in the absence of some express or implied limitation in the GMRA on the exercise of the non-Defaulting Party’s discretion in determining “fair market value“, the only limitation is that the decision-maker must have “acted rationally and not arbitrarily or perversely“. Repeating the general principle set out in Barclays Bank plc v Unicredit Bank AG[2014] EWCA Civ 302, the Court of Appeal noted that what was meant by “fair market value” under the GMRA must be “determined as a matter of construction of this particular contract in its particular context“. Accordingly, the Court of Appeal resisted providing any fixed definition of “fair market value“.

Key to this decision is the specific wording of the GMRA. In particular, the entitlement of the non-Defaulting Party, as per the definition of Net Value in the GMRA, to have regard to whatever “pricing sources and methods” and to “available prices for Securities” as it considers appropriate, with no limitation as to the factual circumstances in which it may do so. The Court of Appeal therefore rejected LBI’s argument that the determination by a non-Defaulting Party of “fair market value” in the context of the GMRA should be interpreted (consistently with its use in other contexts) by reference to a price agreed between a willing buyer and a willing seller, neither being under any particular compulsion to trade, such that illiquidity or distress in the market at a particular time would not be taken into account. It held that such an implied limitation would be contrary to the express language of the GMRA.

Similarly, any argument that a non-Defaulting Party could not use evidence or information as to actual market value, albeit in an illiquid or distressed market, in determining “fair market value” was rejected. The Court of Appeal held that the non-Defaulting Party was not required to determine Net Value in distressed market conditions by reference to some notional or theoretical value of securities. Arguments that the non-Defaulting Party was obliged in these circumstances to mark-to-model (made by reference, inter alia, to the Frequently Answered Questions (FAQs) on Repo published by ICMA), were also rejected.

CONCLUSION

This decision is important in reiterating and reinforcing the width of the discretion of the non-Defaulting Party to determine “fair market value” under the GMRA and will therefore provide useful comfort to non-Defaulting Parties (and their legal teams) who are faced with the need to determine close-out amounts under the GMRA following their counterparty’s Event of Default. In particular, the only implied limitation on the non-Defaulting Party in formulating its “reasonable opinion” using the “pricing sources and methods” it considers appropriate, is that the decision-maker must act “rationally and not arbitrarily or perversely“. It is obviously important to appreciate that the width of this discretion arises from the specific wording of the GMRA and the framework for determining the close-out amount which that sets out.

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Simon Clarke

Simon Clarke
Partner
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Ceri Morgan

Ceri Morgan
Professional Support Lawyer
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Emma Deas

Emma Deas
Senior Associate
+44 20 7466 2613

High Court clarifies calculation of Close-out amount under 2002 ISDA Master Agreement

Lehman Brothers Special Financing Inc. v National Power Corporation & Anor [2018] EWHC 487 (Comm) is a significant case on the calculation of Close-out Amount under the 2002 ISDA Master Agreement.

Two important points of principle arise from this judgment, which will have general application to transactions governed by the 2002 ISDA Master Agreement:

  1. In calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination.
  2. The standard to be applied to a Determining Party in calculating a Close-out Amount is higher under the 2002 ISDA Master Agreement compared to the 1992 ISDA Master Agreement. The 2002 ISDA Master Agreement replaced the requirement for a rational decision (the applicable standard under the 1992 ISDA Master Agreement) with the requirement for objectively reasonable procedures in order to produce an objectively reasonable result.

This result is consistent with what market participants anticipated was the impact of the wording contained in the 2002 ISDA Master Agreement, which was to introduce a higher standard through greater objectivity, although it arguably gives rise to greater scope for disputes to arise in relation to parties’ determinations pursuant to that higher standard.

Background

In 2007, the claimant (“LBSF”) entered into a US$100 million principal only US$/Philippine peso forward currency swap (the “Swap”) with the first defendant, which was later transferred to the second defendant (“NPC”, meaning the first or second defendant, or both). Both defendants were owned and controlled by the Republic of the Philippines. The parties elected to apply the 2002 ISDA Master Agreement to the Swap (terms defined in that agreement are capitalised in this e-bulletin).

Following LBSF filing for Chapter 11 bankruptcy in the United States, the terms of the 2002 ISDA Master Agreement triggered an Event of Default. NPC subsequently served a notice on LBSF for early termination of the Swap and designated 3 November 2008 as the Early Termination Date. NPC, as the non-defaulting party, had the right under the 2002 ISDA Master Agreement to determine the Close-out Amount using “commercially reasonable procedures in order to produce a commercially reasonable result”.

On 3 November 2008 (i.e. the designated Early Termination Date), NPC requested and received indicative quotations for a replacement swap from various banks and on 7 November 2008, NPC requested and received firm quotations from those banks. NPC subsequently entered into a swap with UBS based on the firm quotation received on 7 November 2008 (the “UBS Swap”). In January 2009, NPC served its determination of the Close-out Amount for the Swap on LBSF (the “2009 Determination”). NPC demanded circa US$3.5 million, which represented the cost it had incurred in entering the UBS Swap as a replacement transaction.

LBSF disputed the 2009 Determination on the basis that commercially reasonable procedures were not used to arrive at this figure and that it was not a commercially reasonable result. In 2015, LBSF commenced court proceedings asserting that LBSF itself was in the money on the Swap. LBSF claimed that NPC owed a Close-out Amount of circa US$13 million to LBSF (the “LBSF Determination”).

NPC subsequently served a revised calculation statement in 2016 which contained two alternative determinations payable by LBSF to NPC: (a) a Close-out Amount of circa US$11 million based on the indicative (not firm) quotation received from UBS on the Early Termination Date (the “Primary Determination”); or (b) a Close-out Amount of circa US$2 million based on the original 2009 Determination of circa US$3.5 million but with the deduction of an Accrued Amount which had not been taken into account in 2009 (the “Alternative Determination”).

Decision

The principal questions examined by the court were:

  • Is it open to a Determining Party to remake a determination of a Close-out Amount?
  • Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

Can a Determining Party remake a Close-out determination?

In the present case, the 2009 Determination fell for scrutiny on two counts: (a) whether the Accrued Amount should have been taken into account; and (b) whether the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result” was complied with.

As to (a), it was common ground that the Accrued Amount should have been taken into account. The question for the court was whether the failure to include the Accrued Amount was a manifest error entitling NPC to make a fresh determination, or whether it was the type of error that should simply be corrected by agreement or by the court/tribunal. This question is considered below. The following section considers whether the requirement at (b) was complied with, and the consequences if this requirement was not complied with.

On the true interpretation of the 2002 ISDA Master Agreement, the court stated that the position was as follows:

  1. With its notice of early termination of the Swap, NPC caused a debt obligation to arise and with delivery of NPC’s 2009 Determination an obligation to pay arose (Videocon Global Ltd v Goldman Sachs International [2016] EWCA Civ 130).
  2. These are significant contractual events and that once they have arisen the relationship between the parties is thereafter affected and not reversible (save by agreement, or in some cases an order of a court or tribunal).
  3. The 2009 Determination completed NPC’s obligation and right to make a determination.
  4. If there is an error in the determination then (absent agreement) the court or tribunal chosen by the parties will be left to declare that and to state what the Close-out Amount would have been absent that error.
  5. However, the Determining Party is also a party to the contract and it can make and accept proposals in its capacity as a party to the contract, including correcting an error in the determination.
  6. The Primary and Alternative Determinations might serve as evidence to inform the question of whether there was an error and the question as to what the Close-out Amount would have been on a determination without error (Socimer International Bank Ltd v Standard Bank London Ltd (No.2) [2008] EWCA Civ 116).

The court went on to consider comments on the question of remaking a determination in the practitioner text: Derivatives Law and Practice (by Simon Firth), which states as follows:

“Once a determination has been validly made of the…Close-out Amount, it will be final and binding on both parties. The determining party cannot subsequently change its mind (for example, on the basis that a mistake has been made). On the other hand, if the original determination was invalid (for example, because it was based on a misinterpretation of the Agreement), or (probably) it was founded on or infected by a manifest numerical or mathematical error [], the determining party should be able to make a fresh determination that complies with the requirements of the Agreement.”

In the court’s view (and in contrast to the suggestion in Derivatives Law and Practice), the case of manifest mathematical or numerical error would still be a case for correction of the determination (by agreement or by court or tribunal, and in the respect where there was error) rather than a fresh determination. Accordingly, the failure by NPC to take into account the Accrued Amounts in making the 2009 Determination was the type of error that simply admits a case for correction of the determination as above and NPC was not entitled to make a fresh determination.

Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

The court observed that the definition of Close-out Amount in the 2002 ISDA Master Agreement included the provision:

Any Close-Out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”.

The court considered (and rejected) NPC’s arguments that the references in the definition of Close-out Amount to “commercially reasonable procedures” and a “commercially reasonable result” required only that the Determining Party use rational procedures in order to produce a rational result. In the court’s view, the 2002 ISDA Master Agreement required the Determining Party to use procedures that are (objectively) commercially reasonable in order to produce (objectively) a commercially reasonable result. It considered that the 2002 ISDA Master Agreement had wording that showed a higher standard is intended when that standard form is chosen by the parties.

There were two principal elements to the court’s decision:

  1. The court highlighted that the change in the wording used in the 1992 ISDA Master Agreement to the form used in the 2002 ISDA Master Agreement was material. The 1992 ISDA Master Agreement states that the non-defaulting party has to “reasonably determine in good faith” the Close-out Amount payable. This was summarised in Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (Ch) as “essentially a test of rationality”. By contrast, under the 2002 ISDA Master Agreement: “[f]or the first time the calculation of the liabilities on closing out had to be carried out ‘in order to produce a commercially reasonable result’“: Lehman Brothers International (Europe) v Lehman Brothers Finance SA [2013] EWCA Civ 188. Further, the court said it was clear from the 2002 User’s Guide supporting the 2002 ISDA Master Agreement that the change was specifically designed to include greater objectivity.
  2. The court emphasised the difference between the tests of rationality and reasonableness (citing Lord Sumption in Hayes v Willoughby [2013] UKSC 17):

“Rationality is not the same as reasonableness. Reasonableness is an external objective standard applied to the outcome of a person’s thoughts or intentions. The question is whether a notional hypothetically reasonable person in his position would have engaged…A test of rationality, by comparison, applies a minimum objective standard to the relevant person’s mental processes”.

The court concluded that it was commercially reasonable to make the 2009 Determination as NPC did, relying on the UBS Swap. The court was not persuaded that, especially in the market circumstances at the time, it would have been commercially reasonable to determine the Close-out Amount as of 3 November 2008 (the Early Termination Date, i.e. as per the Primary Determination); at that stage only indicative quotations were available.

The court remarked that the UBS Swap replaced more than what was provided for under the original Swap because it included an option which NPC did not have at the Early Termination Date. NPC, therefore, was not entitled to pass onto LBSF the option exercise price or pre-payment premium of US$1 million attached to that option. The Close-out Amount was therefore the 2009 Determination, less the Accrued Amount, less the option premium.

The court did not proceed to consider what the position would have been if the 2009 Determination had not complied with the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result”, i.e. whether NPC would have been entitled to make a fresh determination or whether the error could be corrected by agreement or by the court/tribunal.

Comment

The instant case confirms that in calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination. Further, the standards imposed on a Determining Party calculating Close-out Amount are higher under the 2002 ISDA Master Agreement than the 1992 ISDA Master Agreement. The change in the relevant wording under those agreements had the effect of replacing a requirement for a rational decision with a requirement for an objectively reasonable one.

 

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Ceri Morgan

Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

Nihar Lovell

Nihar Lovell
Senior Associate
+44 20 7374 8000

High Court applies public law standard to the exercise of discretion by a financial institution under a receivables finance agreement

BHL v Leumi ABL Ltd [2017] EWHC 1871 (QB) serves as an interesting illustration of how the Court can import public law principles to the exercise of a commercial party’s contractual discretion, here in the context of a bank exercising its discretion under a receivables finance agreement. Applying the principles most recently set out by the Supreme Court in Braganza v BP Shipping [2015] UKSC 17, the Court conducted an analysis of whether the bank’s discretion was exercised in a way which was not arbitrary, capricious or irrational in the public law sense (the so-called Braganza duty).

Since the financial crisis, we have seen examples of this principle being applied to scrutinise the exercise of contractual discretion in a financial services context: Socimer International Bank Ltd v Standard Bank London Ltd [2008] EWCA Civ 116Euroption Strategic Fund Ltd v Skandinaviska Enskilda Banken AB [2012] EWHC 584 (Comm)Marex Financial Ltd v Creative Finance Ltd & Anor [2013] EWHC 2155 (Comm) (read our e-bulletins for Euroption and Marex).

However, BHL provides an unusual example where the Court found that the bank’s discretion was exercised in breach of the duty. Financial institutions should therefore be alive to potential judicial scrutiny of how their contractual discretion is exercised in relation to counterparties. It would be prudent to consider and document the decision making process where the exercise of such contractual discretion is involved. For example, where there is a contractual right to charge a percentage fee “up to” a particular level, the decision-maker should be able to justify why the fee was imposed at the chosen level within that spectrum.

The Court of Appeal has refused permission to appeal.

Facts

The case considered the construction of a receivables finance agreement (“RFA“) entered into on 11 April 2008 by Cobra Beer Limited (“Cobra“) – the maker of a well-known brand of beer – and the defendant, Leumi ABL Ltd (the “Bank“), which provided for the Bank to act as Cobra’s invoice discounting provider.

Following serious financial difficulties, Cobra entered into administration on 29 May 2009 (with significant sums owed to it by customers, but in turn, owing substantial sums to the Bank under the RFA). The Bank took over the collection of Cobra’s receivables, triggering a clause in the RFA providing that the Bank was “entitled to charge [Cobra] an additional collection fee at up to 15% of amounts collected by [the Bank]…”. The Bank applied a 15% collection fee to amounts collected, in addition to other monies owning under the RFA (including monies advanced to Cobra pursuant to the RFA discounting, and other fees). This collection fee fell within BHL’s indemnity obligations.

Following demands made by the Bank for payment, BHL (a shareholder of the Cobra entity and guarantor of the payments under the RFA) paid a total of £950,000 in relation to outstanding collection fees. Subsequently, BHL commenced a claim seeking reimbursement of the £950,000 on the basis that the collection fees were not actually payable and BHL had been operating under a mistaken belief that they were payable.

Decision

The Court found in favour of BHL and held that the collection fees had been paid under a mistake of law such that they should be repaid.

In doing so, the Court considered (and rejected) arguments that the mistaken payments had arisen as a result of the construction of the clause in question and that the clause amounted to a penalty clause. In relation to the former, the Court concluded that the 15% provision did not merely operate as a ceiling to the Bank’s right to recover its actualcollection costs. Such an interpretation was inconsistent with other clauses in the contract, which made clear where a right to recover was limited to actual costs. In relation to the latter, the Court considered the clause in light of Makdessi v Cavendish Square Holdings BV [2015] UKSC 67 (read our blog post) and determined that: (a) the clause gave rise to a primary, rather than a secondary obligation (such that it could not engage the penalty clause principle); and (b) it was not a fixed and penal fee, but one which was instead tempered by the need for the contractual discretion to be exercised in accordance with the Braganzaduty.

Accordingly, the Court turned to consider the exercise of the Bank’s discretion in charging the full 15% fee. In considering the context of the Braganza duty, the Court first considered the ‘target’ of the clause. The Bank argued that the fee had no ‘target’ at all, that it was not to be considered by reference to the Bank’s anticipated costs and expenses. It said, once triggered, the clause entitled the Bank to charge what it liked, subject only to the 15% ceiling. The Bank therefore sought to argue that it had an untrammelled discretionary power.

This interpretation was rejected as being commercially absurd. The Court found that the ‘target’ of the clause was the recovery of future additional costs and expenses to be incurred by the Bank in its capacity as collector of the receivables (not already claimed elsewhere under the RFA). Since this provision gave the Bank a power to set in advance a percentage fee, which would apply to later recoveries, there had to be some qualification thereto, otherwise it was an entirely open discretion which could be exercised oppressively or abusively.

The Court explained that the Bank’s discretion was qualified in the sense that the power had to be exercised in a manner that was not arbitrary, capricious or irrational in the public law sense, meaning that the Bank should have had regard to relevant and not irrelevant materials and then performed a proper estimating exercise. This type of contractual discretion was most recently articulated by the Supreme Court in Braganza v BP Shipping [2015] UKSC 17:

The fulfilment of that duty will entail a proper process for the decision in question including taking into account the material points and not taking into account irrelevant considerations. It would also entail not reaching an outcome which was outside what any reasonable decision-maker could decide, regardless of the process adopted. However, the duty does not mean that the court can substitute what it thinks would have been a reasonable decision.”

Fulfilling the Braganza duty would therefore require a process, and the particular exercise in the instant case would have involved estimating the likely costs of the collection. While the Bank had suggested that a number of factors were taken into account when deciding the fee, the evidence illustrated that there was in fact no real consideration of the matter and that – as a matter of practice – the Bank had “always” charged the maximum where it was permitted to do so “up to” a particular percentage. The Court found that this was not a real exercise of discretion at all.

The Court went on to say that if there had been an exercise of the discretion, it was wholly arbitrary, irrational and manifestly failed to take into account important factors, such as calculating the Bank’s likely costs and expenses or to using data from its experience of previous collect-outs.

Having found that the sum of £950,000 was not payable, the Court held that the payments by BHL had plainly been paid under a mistake of law.

Conclusion

This decision will be of note to draughtsmen, the business and to litigators, given the lessons which should be drawn from the case in relation to how the contractual discretion can be scrutinised by the Court. The facts of BHL are, no doubt, extreme. However, the Court’s willingness not only to apply public law standards to a commercial setting (not in itself necessarily controversial), but to find that a bank had fallen short of those standards, is striking.

Harry Edwards

Harry Edwards
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Amel

Amel
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Ceri Morgan

Ceri Morgan
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Commercial Court finds commitment letter unsigned by one party to be legally binding

The recent decision of the Commercial Court in Novus Aviation Limited v Alubaf Arab International Bank BSC(c)[2016] EWHC 1575 (Comm), serves as a cautionary tale to any financial institutions that regularly use letters of commitment.

The Court found that a letter of commitment, which was expressed to be “conditional upon satisfactory review and completion of documentation“, was nevertheless legally binding. Further, although it was intended that the commitment letter would become contractually binding once executed by both parties, this did not prevent it from having legal effect when executed by only one party. There was no term of the commitment letter that stipulated that the only means of acceptance was by countersignature, such that acceptance could be communicated by conduct.

Background

In March 2013, the Claimant (“Novus“), a company that arranges finance for the acquisition and leasing of commercial aircraft, was contacted by the Defendant (the “Bank“), who expressed an interest in investing with Novus in the acquisition/ financing of passenger aircraft. Around this time, Novus was in discussions with Malaysia Airlines to finance the purchase of two Airbus A330-300 aircraft.

Novus and the Bank discussed an investment structure whereby the Bank would provide the majority of the US$40m equity funding for the purchase, and Novus would arrange the remaining US$70m debt funding. The Bank’s investment committee approved the deal in early May 2013 and, following some discussion over terms, the Bank subsequently provided Novus with executed copies of a commitment letter and management agreement.

Throughout May 2013, work was undertaken to progress the transaction. However, in June 2013 the Bank’s board of directors decided not to proceed with the transaction. Novus claimed that the commitment letter and management agreement constituted binding contracts and that the Bank’s withdrawal was a repudiatory breach of contract. The Bank argued that there was no agreement on three principal grounds:

1. the commitment letter was not intended to be legally binding and/or was void for uncertainty;

2. the individual that signed the commitment letter and management agreement on behalf of the Bank did not have authority to bind the Bank to provide funding for the transaction; and

3. there was, in any event, no binding contract made because neither the commitment letter nor the management agreement was countersigned by Novus and returned to the Bank before the Bank withdrew from the transaction.

Decision

The Court held that the commitment letter was a legally binding document and that the Bank’s decision to withdraw from the transaction was a repudiatory breach of contract. Novus was accordingly entitled to damages in respect of the lost opportunity to earn fees that would have been payable under the management agreement had the transaction been completed.

(i) Intention to create legal relations

The Bank accepted that the management agreement was intended, when executed, to be legally binding. However, the Bank argued that the commitment letter was not intended to be legally binding or to bind the Bank to proceed with the transaction.

The leading case on the test of whether parties intend to create legal relations is the decision of the Supreme Court in RTS Flexible Systems Ltd v Molkerei Alois Muller GmbH & Co KG [2010] UKSC 14:

Whether there is a binding contract between the parties and, if so, upon what terms depends upon what they have agreed. It depends not upon their subjective state of mind, but upon consideration of what was communicated between them by words or conduct, and whether that leads, objectively to a conclusion that they intended to create legal relations and had agreed upon all the terms which they regarded or the law requires as essential for the formation of legally binding relations.”

Applying this test, the Court held that it was plain from the terms of the commitment letter that it was intended to create legally binding relations. In particular, the Court found that “any possible doubt” was removed by the ‘Governing Law’ clause which provided that:

This Commitment Letter Agreement (including the agreement constituted by your acceptance of its terms) and any non-contractual obligations arising out of or in connection with it, (including any non-contractual obligations arising out of the negotiation of the Transaction) shall be governed by, and construed in accordance with, English law…” (emphasis added).

The Court accepted that it is possible, in principle, for parties to create a document of which only part is intended to be legally binding (for example recitals are common place but not legally binding). However, where that is intended, the Court indicated that it would expect to see the distinction between the two qualitatively different types of provision clearly signalled. In this case, the language of obligation was used throughout the commitment letter, with various provisions including the mandatory word “shall”.

(ii) Uncertainty

The commitment letter stated that the Bank’s obligation to provide the equity funding was “conditional upon satisfactory review and completion of documentation for the purchase, lease and financing“. The Bank argued that as there was no objective criteria by which to judge whether the documentation was “satisfactory”, the commitment letter was void for uncertainty.

The Court found that there was no uncertainty in applying this test; whether the documentation was satisfactory to the Bank was a question of fact. Further, the Bank’s ability to reject the documentation as unsatisfactory was not completely unqualified, but in the nature of a contractual discretion. In the absence of very clear language to the contrary, such discretion must be exercised in good faith for the purpose which it was conferred, and must not be exercised arbitrarily or capriciously or unreasonably (Braganza v BP Shipping Ltd [2015] 1 WLR 1661).

(iii) Authority to bind the Bank

The commitment letter and management agreement were each signed on behalf of the Bank by Mr Abdullah, Head of Treasury and Investments. The Bank raised a number of arguments as to why Mr Abdullah did not have authority to bind the Bank by his sole signature. The Court rejected these arguments holding that it should be slow to find that the Bank’s own Head of Treasury was mistaken as to his own authority to sign documents on the Bank’s behalf.

Further, and in any event, it was “academic” whether Mr Abdullah had actual authority to bind the Bank because he had apparent authority to do so. Where one party (the principal) represents to a third party that an agent is authorised to act on its behalf, and the third party relies on the representation, the principal is bound by the agent’s act whether or not the agent was actually authorised to do the act. In this case, it was reasonable for Novus to assume, unless specifically informed otherwise, that Mr Abdullah was duly authorised to sign the commitment letter and management agreement (as sole signatory) on the Bank’s behalf.

(iv) Execution by Novus

The commitment letter provided for a signature on behalf of Novus to indicate that the terms were ‘accepted’. However, there was no term of the commitment letter that stipulated that the only way in which Novus could signal acceptance was by counter-signing the letter.

In the absence of such a stipulation, acceptance of an offer can be communicated by conduct which objectively shows an intention to accept the offer (Reveille Independent LLC v Anotech International (UK) Ltd [2016] EWCA Civ 443). Here, Novus proceeded with the steps required to progress the transaction and gave no indication that it did not consent to the terms of the commitment letter. Equally, nothing was said on the part of the Bank to suggest that it was waiting for Novus to return a countersigned copy of the commitment letter or that it did not regard the commitment letter as binding until countersigned.

Notably, the position was different for the management agreement. In that case, the drafting made clear that the obligations of the parties were to take effect when the agreement was executed by both parties, and not until then.

The Court recognised that it is possible, as a matter of law, for the requirement that a document be signed in order to become binding to be waived by clear words or conduct. If the requirement is solely for the benefit of one party, it may be waived by that party. However, where, as here, the requirement for a signature is for the benefit of both parties, it must be clear that both parties have waived it (Reveille Independent LLC v Anotech International (UK) Ltd).

This is not an easy burden to discharge. The Court noted that it is one thing to infer acceptance of an offer from conduct in the absence of any stipulation that the document will only become binding upon signature, but it is another and harder thing to infer from conduct that such a stipulation has been waived. In this case, the parties did not treat the management agreement as binding before it had been signed by both parties, such that the Bank never became contractually bound by that agreement.

Comment

Commitment letters are frequently used by financial institutions. This case demonstrates that such letters are capable of creating binding contractual obligations. In order to reduce the risk of inadvertently creating binding obligations, financial institutions should be alive to the following points when drafting and issuing commitment letters:

  1. If a commitment letter (or certain provisions thereof) is not intended to create legal relations, this should be expressly stated in the letter.
  2. Where a transaction is conditional upon the exercise of discretion by a financial institution (for example that documentation be “satisfactory”), that discretion must be exercised in good faith for the purpose which it was conferred, and must not be exercised arbitrarily or capriciously or unreasonably.
  3. A financial institution may be unable to refuse to proceed with a transaction on the basis that it is no longer in its commercial interests, absent an express reservation of rights to this effect.
  4. If it is intended that a commitment letter should only become binding upon countersignature, that requirement must be expressly stated. Absent such express requirement, acceptance of an offer may be communicated by conduct or other communication between the parties.
  5. Even if there is an express requirement for countersignature, it is possible for that requirement to be waived by clear words or conduct. Accordingly, financial institutions should refrain from proceeding with the underlying transaction prior to countersignature.
  6. If the individual executing a commitment letter does not have authority to bind the financial institution, that must be expressly stated to the counterparty.
Rupert Lewis

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Alexander v West Bromwich Mortgage Company Ltd: when can lenders rely on contradictory mortgage conditions?

In Alexander v West Bromwich Mortgage Company Ltd[2016] EWCA Civ 496, the Court of Appeal considered the right of a lender to rely on standard term mortgage conditions that contradicted the special conditions of a “tracker mortgage”.

In particular, the case concerned whether the lender could rely on two provisions in its standard term mortgage conditions entitling it (1) unilaterally to vary the loan interest rate for any “valid reason” and (2) to terminate the mortgage on one month’s notice absent borrower default.

The contract contained an “inconsistency clause”, favouring the lender’s bespoke “Offer of Loan” over its standard conditions in the event of inconsistency. The Court agreed with the borrower that both the standard conditions in question were inconsistent with the specific terms of the “tracker mortgage” sold to the borrower and hence could not be relied on by the lender.

Notably, the borrower represented a number of other borrowers with similar loans (known collectively as the “Property118 Action Group”). The case reinforces the importance of ensuring communications to borrowers (including transaction documents) accurately reflect the parties’ intentions. This is particularly the case where a lender wishes to rely on a wide power or discretion conferred on it in its standard terms which might allow it to deviate from the main purpose or object of the particular contract in question.

We discuss the decision in more detail below.

Background

In May 2008, Mr Alexander (“the Borrower”) applied to West Bromwich Mortgage Company (“the Lender”) for a “buy to let” interest only mortgage.

In June 2008, the Lender sent the Borrower three documents that were all later incorporated into the Mortgage Deed the Borrower signed in July 2008:

(1) an “Offer of Loan Letter”, which included an “Offer Document” setting out “the costs, features, terms and conditions of the Loan“;

(2) “Special Conditions of Offer”, which were not relevant to the case before the Court; and

(3) the “Lender’s Mortgage Booklet”, which contained the Lender’s standard form “Mortgage Conditions” (including both the standard conditions the Court was asked to consider).

The Offer Document described the mortgage as a “tracker mortgage” for a term of 25 years, with interest to be fixed at 6.29% for the first two years after which it would revert to a variable rate of 1.99% above the Bank of England Base Rate.

In 2013, in light of market conditions, the Lender increased the margin on the Borrower’s loan by 2% (from 1.99% above Bank of England Base Rate to 3.99% above it).

The inconsistency clause

The standard form “Mortgage Conditions” in the Lender’s Mortgage Booklet contained an inconsistency clause, which stated that the Offer of Loan Letter (including the Offer Document) would prevail in the event of any inconsistency with the Mortgage Conditions.

The alleged inconsistencies

The Mortgage Conditions contained two clauses that the Borrower claimed were both inconsistent with the Offer of Loan Letter and therefore not incorporated into the contract between the parties:

(1) Clause 5 (“the Interest Rate Clause”) entitled the Lender unilaterally to vary the interest rate of the loan for reasons of business prudence, efficiency, competitiveness or any other “valid reason”.

(2) Clause 14 (“the Acceleration Clause”) allowed the Lender to compel the Borrower to repay the loan, with any accrued interest and unpaid charges, in full on one month’s notice (regardless of whether the Borrower was in default). The same clause also triggered the Lender’s powers of sale and leasing and its power to appoint a receiver at the Borrower’s expense.

The law

The Court applied the leading decision of the Court of Appeal in Pagnan SpA v Tradax [1987] 3 All ER 565 that the correct approach in cases where there is an inconsistency clause (as in the Borrower’s case) is to “approach the documents in a cool and objective spirit to see whether there is inconsistency or not“. Put simply, when considering the contract, it is not appropriate to assume there is an inconsistency; but equally, it would be wrong to presuppose there is not.

On the question of what would amount to an inconsistency, the Court again looked to Pagnan SpA which established that:

“…it is not enough if one term qualifies or modifies the effect of another; to be inconsistent a term must contradict another term or be in conflict with it, such that effect cannot fairly be given to both clauses.”

The Court gave an example of inconsistency where one part of a contract required a building to be painted in black and another part required it to be painted white. However, the Court said that inconsistency was not limited to such cases where there is a clear and literal contradiction between clauses.

The Court went on to explain that the concept of inconsistency would extend to cases where clauses cannot “fairly” or “sensibly” be read together; not merely cases where they cannot literally be read together. In particular, a standard term that contradicts a clause setting out the main purpose or object of the contract is likely to be inconsistent.

By way of example, the Court cited Glynn v Margetson [1893] AC 351 where a clause in a contract to carry perishable goods (oranges) from Malaga to Liverpool was said to be inconsistent with the main purpose of the contract, because it allowed the carrier to stop at any of a number of ports, including ports which were not on the route from Malaga to Liverpool.

The decision

Was the Interest Rate Clause inconsistent with the Offer of Loan Letter?

It was not in dispute that the Interest Rate Clause purported to give the Lender a largely-unfettered power to vary interest rates in line with its own commercial considerations. However, the Court held that the Interest Rate Clause was inconsistent with the Offer of Loan Letter for the following reasons:

(1) The Offer Document defined how the interest rate was to vary: namely, that after two years, the loan “reverts to a variable rate that isthe same as the Bank of England Base Rate… with a premium of 1.99%, until the term end…” (emphasis added). Given that there was no hint in the Offer Document the rate would ever deviate from 1.99% above Bank of England Base Rate, the Court held that the Interest Rate Clause was inconsistent because it provided for variation at the discretion of the Bank.

(2) The Offer Document included a “Product Description” that described the mortgage in “clear, absolute and unqualified terms“. The Court considered that the Interest Rate Clause would give the Lender the power to convert the mortgage into something else entirely (for instance, a standard variable rate mortgage rather than a tracker mortgage). For this reason, the Interest Rate Clause was inconsistent with the Offer Document (rather than something that merely qualified or modified it).

The Lender raised a number of arguments to suggest that the two clauses were not inconsistent and could sensibly be read together. However, for the reasons above, the Court did not accept this. As the Court pointed out, if the Lender wanted to have a right to vary the rate other than by reference to changes in the Bank of England Base Rate, the Lender ought to have spelt that out in the Offer Document.

As such, the Court found that the Interest Rate Clause was not incorporated into the contract and could not be relied upon by the Lender.

Was the Acceleration Clause inconsistent with the Offer of Loan Letter?

For similar reasons, the Court held that the Acceleration Clause was inconsistent with the Offer of Loan Letter. In particular:

(1) The Product Description described the mortgage as a “Buy to Let” interest only mortgage, meaning that the rental income from the property could be used to service the mortgage over the term of the loan. If the Lender was entitled to terminate the loan on one month’s notice at will, it would likely frustrate the Borrower’s contemplated business arrangements (effectively transforming a “buy to let” mortgage into a requirement to “sell unlet”).

(2) The term of the mortgage was 25 years and the Offer Document did not hint that the term might be accelerated absent default by the Borrower. Indeed, words such as “your home may be repossessed if you do not keep up repayments” would be highly misleading if the Lender had a right to call in the full loan and repossess the property, even if the borrower always made payments on time.

Commentary

This case provides a useful reminder of the courts’ approach to resolving inconsistency in cases where there is an inconsistency clause incorporated in the relevant contract. As the Court of Appeal put it pithily, where there is an inconsistency clause, the question of inconsistency should be approached without any pre-conceived assumptions: “one should not strive to avoid or to find inconsistency“. Further, the Court of Appeal observed that the general precept that the courts will be reluctant to find that parts of a contract are inconsistent with each other does not apply where the contract itself acknowledges, through the inclusion of ‎an inconsistency clause in the first place, that inconsistency may exist. Where inconsistency does exist, the courts are more likely to uphold terms which have been specifically agreed and are central to the main purpose or object of the contract than terms which are standard and subsidiary.

Standing back, it is striking how the determination of this case through the courts involved a considered assessment of the case authorities as to the proper approach to inconsistency clauses and an ‎exercise in contractual interpretation although ultimately the Court of Appeal expressed itself in reasonably strong terms that to give effect to the Interest Rate Clause on the facts of the present case would have enabled the Lender to transform and negate the Lender’s description of its tracker mortgage product in its offer documentation.

Simon Clarke

Simon Clarke
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Ben May
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Ben Worrall
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Clearing brokers’ duties when exercising close out powers

In the current economic climate, brokers will find the decision of the High Court (UK) in Euroption of considerable interest, since it considers the duties of a broker which is conducting a close-out and liquidating the position of a client who is in a state of default.

Euroption Strategic Fund Limited v Skandinaviska Enskilda Banken AB [2012] EWHC 584 (Comm).

The facts

The claimant (Euroption) was a BVI-domiciled investment fund which primarily conducted options trading on the London International Financial Futures Exchange (LIFFE). As a non-member of LIFFE, it could only do so through engaging one of the clearing members of the exchange and accordingly entered into a contract with Skandinaviska Enskilda Banken (SEB).

Pursuant to that contract, Euroption was obliged to meet margin calls when requested by SEB in order to provide SEB with protection against adverse market movements on the fund’s positions, failing which SEB was entitled to close out Euroption’s open contracts “at any time without reference to” the fund and to do so having made reasonable efforts to contact Euroption if “at any time SEB deems it necessary for its own protection.”

Basis of Euroption’s claim

It was common ground that SEB had a contractual right to close out Euroption’s open positions and could choose the moment in which it did so. However, the claim involved allegations regarding SEB’s conduct of the forced close out of the portfolio in the extraordinary market conditions which prevailed in early October 2008. Euroption claimed for loss that was suffered as a result of the use of a trading strategy which involved the purchase of additional option positions together with their sale (so-called combination trades), as well as the delay in the close out of certain positions (during which the extent of losses increased). Euroption said that SEB’s conduct was in breach of:

  • a duty not to conduct the close out in an capricious, arbitrary or irrational manner;
  • an implied contractual duty of care to perform the close out with reasonable care and skill; and/or
  • a tortious duty of care brought about by an assumption of responsibility to act with reasonable, care and skill.

Basis of SEB’s defence

SEB countered that the mandate between SEB and Euroption provided a broad and unfettered discretion in relation to the conduct of any close out process and that, having taken the decision to liquidate the portfolio, SEB could effect that liquidation in a number of ways which were not limited by the express terms of the contract. Accordingly, the only limitation on what it could do to bring about the liquidation of the portfolio was that it must not act capriciously, arbitrarily or irrationally.

Regarding the specific trading strategies adopted during the close-out, SEB pointed to the fact that Euroption’s own expert had accepted that the ‘combination’ trades which were entered into by SEB were a legitimate means of closing out an options portfolio (and were in any event authorised by Euroption’s primary trader responsible for management of the portfolio) and that the delay in the sale of the short call positions was reasonable in the circumstances (even if not, with hindsight, the optimal strategy).

The Court’s findings

In relation to the argument that a contractual duty to take reasonable care was owed by SEB in exercising its close out rights, the Court held that no such duty could be implied into the broking agreement, either by the terms of section 13 of the Supply of Goods and Services Act 1982 or otherwise. The Court held that the implied term imposed by section 13 (requiring services to be carried out with reasonable care and skill) applies only to services which it is agreed will be provided under a contract; it does not extend the obligations under the contract. Certain advisory services and the settlement and exchange services were the services which the Broker had contracted to provide, not the close out of the portfolio which was a consequence of the client’s breach. Accordingly, absent express provisions in the contract, there was no basis on which to imply a requirement of reasonable care and skill into how the close-out was conducted.

Equally, there was no assumption of responsibility by the broker to the client to take reasonable care in exercising its right of close-out, in view of the nature of the role which a clearing broker undertakes and the modest commission which it receives for that role.

Moreover, the Court determined that, following a default, the broker was entitled to put its own interests first in order to protect itself against the exposure which had been brought about by its client’s breach (the failure to post margin). It was therefore the broker’s decision, which can be made in its own interests, how the close out should be conducted, subject only to the requirement that it did not step outside the bounds of a duty to act in good faith, honestly and not arbitrarily or irrationally.

On the experts’ evidence, SEB’s method of closing out the options positions was found to have been reasonable, both in entering new ‘combination’ trades as part of the close out and the delay in closing out some of the short call positions. In those circumstances, SEB was found not to have acted arbitrarily or irrationally.

Furthermore, the judge found that, even if she was wrong in rejecting the existence of a duty to take reasonable care in conducting the close out, SEB did not breach any such a duty. It was emphasised that looking back critically at each trading decision with the benefit of hindsight, as Euroption (and its expert) had sought to do, was not a permissible way to assess the trading strategy adopted by SEB:

The issue for the court is not the relative strengths and weaknesses of another strategy compared with the strategy in fact adopted but whether the decisions actually taken were within the bounds of reasonableness.”

Accordingly, Euroption’s claim was rejected in full.

Damien Byrne-Hill

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