Banking law update: Undue influence and break costs – risks for retail and commercial lenders

In the first judgment Clydesdale Bank and National Australia Bank successfully defended test claims arising from the sale of fixed interest loans and related interest rate swaps in Farol Holdings Ltd & Ors v Clydesdale Bank PLC & Anor [2024] EWHC 593 (Ch).  In the second, the Court of Appeal dismissed an appeal in One Savings Bank Plc v Waller-Edwards [2024] EWCA Civ 302 and in doing so provided a helpful summary of the principles governing when lenders to non-commercial borrowers will be placed on inquiry for undue influence.

Both judgments clarify important principles of banking law which arise in the day-to-day operations of many lenders but will be particularly relevant to those who operate in the retail and small-to-medium commercial market.  We discuss each case in turn below, before highlighting some of the implications for banks.

The claimants, Farol Holdings Limited and several other small-medium sized enterprises (“Claimants”), brought claims against Clydesdale Bank PLC and National Australia Bank Limited (“Defendants”) on the basis they had misrepresented and wrongfully charged break costs on fixed rate tailored business loans.

Clydesdale Bank offered a product between 1999 and 2012 called a “fixed rate tailored business loan” (“FRTBL”), where the loan was made for a set period (subject to a right of early repayment) for a fixed rate of interest throughout that period.

Following the GFC in 2008, interest rates fell dramatically, and stayed low for many years. As a result, the Claimants wished to refinance their FRTBLs and repay the capital amount of the loan early. They did so pursuant to the right of early repayment in the standard terms and conditions governing the FRTBL. This clause essentially allowed early repayment on the terms that the Claimants paid Clydesdale Bank an amount equal to any loss, cost or liability incurred or suffered by it as a result of that early repayment (“Break Costs”).

Upon termination of the FRTBL, a payment also became due between Clydesdale Bank and National Australian Bank (“NAB”) for losses in relation to a back-to-back hedging transaction which covered Clydesdale Bank’s risk under the FRTBL. This was calculated as the net present value (“NPV”) of the difference between the interest payable by Clydesdale Bank to NAB at the fixed rate for the remainder of the term, and the estimated amount of interest NAB would have been due to pay Clydesdale Bank at the floating rate for the remainder of the term. Clydesdale Bank factored those costs into the Break Costs charged to the Claimants.

The claims in these actions fell into two parts:

1. the Break Costs: charged by Clydesdale Bank to the Claimants; and
2. the “fixed rate” element in the rate of interest charged under the FRTBLs.

The Claimants argued that Clydesdale Bank was not entitled to charge the Break Costs in the way that it did. The Claimants also contended that the back-to-back hedging transaction did not create any legally binding obligation on Clydesdale Bank to pay a sum to NAB in the event of the termination of the corresponding FRTBL and, even if it did, that Clydesdale Bank could not charge the Claimants under Break Costs in the conditions of the FRTBL.

The Claimants raised three separate bases for their position:

1. The Defendants made fraudulent, alternatively negligent, misrepresentations to the claimants of what break costs would be payable if they repaid a FRTBL early, and by relaying to them the amount of break costs that were in fact payable on early repayment.
2. The Claimants paid the break costs under the mistaken belief that Clydesdale Bank was entitled to charge them and therefore a claim of unjust enrichment arises, to recover the break costs paid.
3. There is an implied term with Clydesdale Bank that Clydesdale Bank would not demand payment of break costs to which it was not contractually entitled. Accordingly, they claim damages for breach of contract and later a claim for breach of mandate by Clydesdale Bank, in deducting the break costs from their accounts.

The Court dismissed the Claimants’ claims and found that Clydesdale Bank was entitled to charge the Break Costs under the terms of the loan. The NPV costs associated with the back-to-back swap transaction with NAB would have been payable regardless of the hedging transaction between Clydesdale Bank and NAB. Given the Break Costs were chargeable under the terms of the contract, there was no misrepresentation by Clydesdale Bank and the Court could find no indication that there had been representations they were not payable by employees of the Defendants.

There were two components to the FRTBL – the “Fixed Rate” and the “Margin” with the Margin being Clydesdale Bank’s only profit from the FRTBL. However, the Fixed Rate itself comprised two elements:

1. first, a rate that broadly reflected the midmarket swap rate for the size and tenor of the loan on the date of execution of the agreement; and
2. second, additional basis points (up to 50) which represented additional income to Clydesdale Bank, referred to internally by the Banks as “Added Value” (“AV”).

The Claimants alleged that presenting the FRTBL in this way implied that the Fixed Rate was the bank’s cost of funds and that the Margin represented the bank’s income on the loan. Neither, the existence nor the amount of AV was disclosed to the Claimants at the time they entered into their loans.

The Defendants gave two bases for the Fixed Rate claims:

1. The Defendants made fraudulent, alternatively negligent, misrepresentations.
2. In addition, two of the Claimants contended that by reason of the non-disclosure of AV the relationship between them and Clydesdale Bank was an “unfair relationship” within the meaning of section 140A of the Consumer Credit Act 1974.

The Court dismissed these claims. Presenting the Fixed Rate and Margin of the FRTBL did not amount to misrepresentation that the Defendants’ only income was from the Margin and there was nothing unfair about Clydesdale making a profit from that service. The fact that the AV was not disclosed did not render the relationship unfair. Justice Zacaroli stated:

“I have ultimately taken a different view from that taken by the claimants as to the function of AV, the nature of FRTBLs and what a reasonable customer in the position of the claimants would have understood it was getting (in terms of additional benefit) from them and what the Banks were assuming (in terms of additional burden) in offering them. This provides important context for the alleged implied representations and underpins much of the outcome of the claims based on Fixed Rate Representations and the unfair relationship claim”.

Ms. Waller-Edwards (the appellant) and Mr. Bishop, who were in a personal relationship, jointly owned a property in Dorset. The ownership was divided such that Ms. Waller-Edwards held a 99% interest and Mr. Bishop held a 1% interest. In 2013, they took out a mortgage from One Savings Bank (the respondent). The loan was ostensibly for joint purposes, with 90% of the funds used to pay off an existing charge on the property and 10% to settle Mr. Bishop’s debts.

Following the default on the mortgage, the bank sought possession of the property. Ms. Waller-Edwards contested the possession order, claiming her consent to the mortgage was obtained through undue influence exerted by Mr. Bishop. She argued that the bank should have been on notice of this undue influence and failed to make appropriate inquiries.

The Court of Appeal dismissed Ms. Waller-Edwards’ appeal that One Savings Bank had constructive notice to be put on inquiry of undue influence. The case applied the principles laid down in three well-known cases: Royal Bank of Scotland v Etridge (No 2) [2002] 2 AC 773; C.I.B.C. Mortgages plc v. Pitt [1994] 1 AC 200 and Barclays Bank v O’Brien [1994] 1 AC 180.

The court concluded that the bank was not put on inquiry simply due to the nature of the relationship between Ms. Waller-Edwards and Mr. Bishop. Absent any actual notice, the court identified two different scenarios (with differing requirements) in which a lender will have constructive notice of one borrower being unduly influenced by the other and should be put “on inquiry”.

First, in “surety” cases in non-commercial situations where, for example, (a) one borrower guarantees the debts of the other or of a company, or (b) the borrowers take secured borrowing on jointly owned property to pay off the debts of only one of them. The court considered a line of reasoning in Etridge and O’Brien for the underlying rationale (but not requirements) for putting a lender on inquiry in surety cases to be:

1. the transaction is on its face not to the financial advantage of one party; and
2. there is a substantial risk in procuring one party to act as surety, the other has committed a legal or equitable wrong.

In other words, there was a low threshold for the risk that was required, because in every case where a wife (or other borrower in a relationship) stood surety for the debts of a husband (or another borrower in a relationship), the bank was put on inquiry.

Second, “joint borrowing” cases where a loan is taken for the joint non-commercial purposes of two borrowers in a relationship. In Pitt, the bank was told that the purpose was to remortgage previous debts and to release capital for a jointly owned holiday home and there was nothing to indicate that this was “anything other than a normal advance to husband and wife for their joint benefit”. In such circumstances, the lender will not normally have constructive notice of the possibility of one borrower being unduly influenced by the other and will not be put on inquiry. Further citing Etridge, the court considered that a joint borrowing case only puts a bank on inquiry if “the bank is aware the loan is being made for the husband’s purposes, as distinct from their joint purposes”.

The loan in the present case was a “hybrid” that was 90% for joint non-commercial purposes and 10% for the benefit of one borrower. Ultimately, the Court found that the fact that some 10% of the advance was to be used to pay debts in Mr Bishop’s sole name did not put the bank on notice. The Court is required to look at a non-commercial hybrid transaction as a whole and to decide, as a “matter of fact and degree”, whether the loan was being made for the purposes of the borrower with the debts, as distinct from their joint purposes. In this case, the loan was, looked at as a whole and from the point of view of what the bank knew, a joint borrowing made for their joint purposes.

These two cases provide an important reminder for retail and commercial lenders of the risks that can arise from the sales process in relation to vanilla fixed rate products and seemingly uncontroversial lending decisions in relation to spouses.

The judgment in Farol Holdings v Clydesdale Bank [2024] EWHC 593 (Ch) provides direction for 900 outstanding cases.  It is also an important reminder for the banking sector more broadly, highlighting (as so many cases of this kind do) the importance of retaining recoverable and clear records of sales interactions, and of ensuring accuracy in the sales process for fixed-rate loans and related derivative products more generally.

The decision in Waller-Edwards v One Savings Bank Plc [2024] EWCA Civ 302 helpfully restates the obligations owed by lenders to borrowers where guarantees and joint advances are made. Lenders are not put on inquiry for joint borrowing cases unless there is clear evidence that the loan as a whole was made for one party distinct from the joint purposes and in such cases the protocol set out in Etridge should be followed.  In practice, lenders should exercise care where there are red flags, for example where one borrower guarantees the debt of a spouse’s loan to pay off personal debts or where both spouses mortgage their home to obtain a loan solely to pay off the debts of one. Lenders can rest assured that they will not be put on inquiry for vanilla retail lending to non-commercial parties that are clearly for the benefit of both parties such as for family homes or a jointly owned business.