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Barnett Waddingham Trustees v RBS.

This case, decided in the Chancery Division of the High Court, centres on the question of whether an internal swap can be classed as a “funding transaction” for the purposes of a loan agreement. If so classed, the costs of unwinding it would become payable if the borrowers prepaid the loan. This situation arises frequently in commercial banking and the case highlights the importance of ensuring provisions in the loan agreement reflect the ways in which fund and hedge fixed rate loans work in practice.

The Claimants, (‘the Borrowers‘), obtained a long term fixed rate loan from Royal Bank of Scotland (‘the Bank‘) in order to purchase a property. RBS hedged its interest rate exposure and funded the loan as follows:

  1. The Bank’s corporate division obtained the money for the loan by borrowing from the Bank’s Group Treasury at a floating rate of interest. This was an internal division of the Bank and not a separate legal entity;
  2. To fund the loan and any shortfall between the fixed rate loan (Loan agreement) and the floating rate of interest (Group Treasury loan), the corporate division entered into an internal swap with the Bank’s Markets desk, essentially matching the provisions of the loan (the Internal Swap); and
  3. The Market’s desk entered into an interest rate swap with an external market counterparty on a ‘portfolio basis’. This did not exactly mirror the internal swap (so was not a back-to-back swap) but was on terms which hedged the Bank’s risk across a portfolio of fixed rate loans.

The loan agreement stated that in certain cases of pre-payment the Borrowers were liable to cover any loss to the Bank “incurred in the unwinding of funding transactions” undertaken in connection with the loan. The Borrowers were considering prepaying the whole loan. The Bank however required payment of the cost of unwinding the internal swap, on the basis that the internal swap was a “funding transaction“. This therefore was the point in dispute.

A bank is a place that will lend you money if you can prove that you don’t need it.”
Bob Hope

The Borrowers argued that that the arrangement was not a “funding transaction” because the Internal Swap was an arrangement between different internal departments and the Bank could not transact with itself. Any “loss” was not really a loss but a matter of internal accounting within the Bank.

Mr Justice Warren held that the internal swap on its own was not a transaction – and therefore could not be a funding transaction – because the wording of the agreement envisaged a transaction between two different legal entities: … “different departments of the Bank do not qualify as separate entities. Corporate banking cannot borrow from Group Treasury nor can it pay interest to Group Treasury. These are all internal arrangements within the bank, effected for its own purposes“.

The case was therefore decided in favour of the Borrowers.

Link: Judgement re Barnett Waddingham Trustees v RBS [2015] Ch 2435

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