Is a ‘fixed rate commercial loan’ actually a loan with an embedded swap?

 My comments here must not be construed as a legal opinion, but instead some practical observations based upon examining a few cases in their early stages.

The issue here is that many lenders have been providing commercial loans to SME’s with a fixed rate of interest to protect the borrowers of course against rising rates. The challenge comes in the event of early repayment when the borrower finds that in the current low interest and low gilt yield scenario there is what they see as a disproportionate breakage fee. This arises because the bank have entered into a separate financial instrument ‘alongside’ the loan to protect its own cost of funds situation, and early repayment of the loan requires that separate contract to be unwound also, with genuine costs to the lender.

It is difficult at present to get a definitive answer on whether this could be deemed to be an ’embedded swap’. The definition of that could be ‘where an Early Repayment Charge (ERC) is worked to a specific formula linked to a specific separate instrument’. This would suggest that it was, however it seems there are detailed questions to consider, such as:

  • Was the ERC calculation fully explained and documented at the outset
  • Is the lender explaining the ERC calculation clearly (sometimes the instrument will have been taken out to cover a portfolio of loans rather than the specific loan in question, which makes it harder for the lender to present the facts)
  • How well established and publicised was the practice with this lender – some (such as Aviva) have been lending in this way for decades and their documentation and websites etc are a reflection of clarity on this.
  • Was the instrument taken out by the bank to protect against interest rate moves or an attempt to make a profit – where their ‘gamble’ may have failed
  • Was the contract with an external party in the market, or another part of the bank, in which case it might be argued that the cost of severance is an internal accounting issue rather than a true cost to the lender. And how would this be construed if it was between two entities in the same Group (e.g. NatWest and RBS). Some lenders documentation makes provision for this and some doesn’t.

Some finely balanced arguments to be had here – few definitive rulings as yet.