The bank loan that cost a mound of money

It would have come as something of a shock to Dunedin Property Investment Company to discover that it would cost #1.25m for it to repay a #10m loan several years early. But that’s exactly what a senior Scottish court recently decided in a case that, if it isn’t overturned on appeal, may well be seen as influential, though not binding, should English courts have to judge on a similar dispute.

Back in the late 1980s, Dunedin borrowed #10m from the Bank of Scotland via a 10-year, fixed-rate loan stock. The terms of the deal allowed Dunedin to repay the loan early by giving six months notice, but Dunedin would have to reimburse the bank for “all costs, charges and expenses incurred by it in connection with the stock”. The words “in connection with” are central to this case.

Bank of Scotland raised the #10m that it was to advance to Dunedin via the interbank market, and hence was exposed to floating rate interest costs, whereas the income from Dunedin was fixed-rate. The bank then entered into an interest rate swap arrangement to hedge its exposure. In this instance, it did a fixed-for-floating deal with Security Pacific National Bank: Bank of Scotland would pay a fixed rate to SecPac, receiving floating rate payments (linked to six-month Libor) in turn.

When Dunedin repaid the loan stock several years early, Bank of Scotland decided to unwind the hedge that it no longer needed. The bank argued – ultimately, successfully – that Dunedin was responsible for the costs of breaking the swap with SecPac early. Because interest rates had fallen, Security Pacific was about to lose several years’-worth of fixed rate income at higher than prevailing rates. The cost, discounted back, amounted to #1.25m – 12.5% of the sum borrowed.

Last year, the Outer House of the Court of Session in Edinburgh ruled that Dunedin Property was not responsible for Bank of Scotland’s swap “breakage” costs. The judge, Lord Coulsfield, ruled: “No doubt (the swap) had been prudent and in accordance with normal banking practice, but it had been entirely independent of the loan (to Dunedin) and had been undertaken by (the bank) for their own purposes.” (Scots Law Report, The Times, 16 May 1997)

Moreover, “Its terms were outwith the knowledge and control of (Dunedin)”.

Lord Coulsfield had no problem accepting that the #1.25m that Bank of Scotland would have to pay to SecPac was “a cost, charge or expense”, but not one that was incurred “in connection with” the loan stock issue.

The court had heard evidence that the bank and Dunedin had, in fact, discussed the likelihood of the bank hedging its position, and that, while the bank would endeavour to minimise any early termination costs, it could not guarantee any particular limit to these costs. But he rejected any idea that the two parties to the contract would have “had in contemplation … the non-negotiable cost of termination of an independent contract entered into by (Bank of Scotland) for their own purposes.” Rather, costs had to be regarded as those “directly” connected with the loan, such as agreement drafting costs, registration costs or administrative expenses.

But Bank of Scotland appealed the decision in the Inner House of the Court of Session, where three judges agreed that it had been wrong for the court to insert the adverb “directly”. (Scots Law Report, The Times, 24 September 1998)

They added that, since Dunedin had approached Bank of Scotland about entering into a loan stock deal and since the bank wouldn’t have agreed to do so without doing a swap or similar hedge, then the swap itself had “a substantial relation, in a practical business sense” to the loan stock – hence, it was “in connection with” it. They reinforced this line of argument with the observation that, even though the bank could have retained the swap after accepting early repayment of the loan stock, the swap was designed to expire on the same day as the original loan: it had been tailored to meet the needs of that transaction.

Though the court accepted that the bank and Dunedin had not specifically discussed interest rate swaps, Dunedin did know that the bank would enter into some kind of hedge. Hence, any cost relating to early termination of that hedge should be borne by Dunedin. That was the only interpretation which was “commercially sensible”.