Negative interest rates

Executive summary

On 04 August 2016, the Bank of England cut its base rate to 0.25% and indicated that rates could be reduced further if the UK economy deteriorates. This brings one step closer the prospect of negative interest rates within the UK financial system. In this article we explore some of the legal issues arising, and the scope for connected disputes.

Negative interest rates already exist in certain jurisdictions. The take-away message is that, whilst not yet a reality for sterling, the potential impact of negative interest rates is very significant. Many recent finance contracts contain language that envisages that benchmark interest rates could fall below zero, and have a deeming provision such that, for the purposes of the subject contract, the applicable interest rates shall never be less than zero. However, older contracts will not necessarily contain such a clause. All financial services firms should therefore be seeking to anticipate and mitigate their litigation and regulatory risk exposures, first by checking (and possibly seeking to amend) their existing contracts, and secondly by drafting new contracts appropriately.

What are negative interest rates?

A negative interest rate indicates a reversal of the direction in which interest is ordinarily expected to be paid. Subject to any margin or other similar provisions:

• A borrower might therefore receive interest on borrowed money and correspondingly a lender might (on the face of the contract) have to pay the borrower to lend money to that borrower.
• A depositor might pay interest on its deposits (in other words receive back at the end of the deposit period less than it initially deposited); if the deposit is custodied with a third party custodian which has invested the money that lesser amount may come as an unwelcome surprise to the depositor.

In certain jurisdictions, negative interest rates have been used by central banks as a monetary policy tool. This phenomenon started in 2014, and has persisted since then. Some central banks, such as the Swiss National Bank, have introduced negative rates to combat the appreciation of their national currency by making it a less attractive asset to hold. Others, such as the European Central Bank, have used negative interest rates to stimulate economic growth - the intention being that by introducing a cost for commercial banks’ overnight deposits, the central bank incentivises lending, which tends to boost the economy.

The use of negative interest rates by central banks has led to negative interest rates in the inter-bank lending markets in respect of their domestic currencies, for example Euro Interbank Offered Rate (EURIBOR).

Contract claims

Where a contractual obligation makes reference to interest, but is silent or ambiguous on the impact of a negative interest rate, there may be uncertainty regarding the proper construction of the obligation in question when the applicable interest rate turns negative.

To combat this uncertainty, standard form financing documentation has been widely updated with language to prescribe the effect of a negative interest rate environment. For example:

• The International Swaps and Derivatives Association (ISDA) has introduced the ISDA Collateral Agreement Negative Interest Protocol (the Protocol) which can be used to update standard ISDA agreements. Further information on the Protocol can be found here. This contractual mechanism introduces changes to the relevant ISDA Definitions, so as to clarify the effect of a negative interest rate on the parties’ payment obligations.
• The Loan Markets Association (LMA) English-law governed agreements have introduced optional clauses dealing with negative interest rates.

It is likely that, notwithstanding such measures, there will be a large number of financing agreements for which negative interest rates give rise to uncertainty. That is because:

• longstanding agreements using standard form documentation will not include such language unless expressly updated
• parties using standard form agreements entered into more recently may not have used the available tools to provide for negative interest rates
• financing documentation often contains bespoke drafting which impacts upon interest-rate-linked obligations, and
• the current macro-economic environment may incentivise parties to enter novel, perhaps exotic, arrangements so as to hedge their future interest rate exposure.

In any of these scenarios, the contract may be silent on negative interest rates, or may contain obligations which, in a negative interest rate environment, are ambiguous. In such cases, standard principles of contractual interpretation will apply to determine the parties’ obligations. Claims focused on the interpretation of such clauses will depend on their facts, and most importantly on the language of the relevant provision in the context of the particular contract.

Disputes on questions of interpretation will inevitably arise in this area. Where express provision is made, parties may dispute the meaning of the words used. Where the contract is silent, parties may allege that the contract contains an implied term relating to the application (or not) of negative interest rates.

A common line of argument is likely to be that the contract provides for (or implies) a “zero interest rate floor”, such that a rate of zero is to be used even if the reference rate is negative. The outcome will necessarily depend on the facts of each case, but it is notable that attempts to imply a zero interest rate floor were unsuccessful in a recent Dutch case.

In addition to the abovementioned situations - in which the dispute concerns the interpretation of an obligation linked to an interest rate such as a primary obligation to pay interest on borrowed principal or a late payment default interest clause - we anticipate cases focused on the interpretation of other clauses. These may focus on provisions governing payment waterfalls, events of default, and/or hedging obligations - all of which may be affected by interest rates pointing in the opposite direction to that contemplated by the draftsman at the time of the contract.

Contractual disputes concerning the application of interest rates can give rise to very high value claims. This is simply the result of applying such rates to very large underlying sums (eg borrowings or custody assets). This feature is demonstrated by two recent UK High Court judgments in which parties have sought declarations that a contract is void, so as to escape a bad bargain arising from interest rate movements. The cases in question (Banco Santander Totta SA v Companhia de Carris de Ferro de Lisboa, and Dexia Crediop v Commune di Prato) do not arise from the application of a negative interest rate, but they demonstrate the willingness of parties to litigate their contractual obligations relating to interest-rate linked payments. This trend is sure to continue if negative interest rates were to give rise to large contractual exposures.

Tort claims

Litigation in relation to interest rate swaps, and other such hedging products, is a well-established trend that arose within an environment of positive interest rates. Nonetheless, the introduction of negative interest rates has given rise to a fresh wave of such claims in jurisdictions where the rate is negative. For example, the Netherlands - where negative interest rates have applied for some time - has seen damages claims alleging breach of a tortious duty of care. Those cases have touched upon issues such as (i) the need for express risk warnings in relation to payment flows in a negative interest rate scenario, (ii) the mis-matching of the swap and the loan to which it relates (eg by over-hedging), (iii) the calculation of fees by reference to interest rates, and (iv) early termination costs.

Other tort claims - not necessarily relating to swaps - may focus upon alleged failure to advise about negative interest rates and their impact.

Regulatory issues

In addition to the above, issues are likely to arise as regards firms’ application of negative interest rates. If firms’ systems fail accurately to apply negative rates, this may give rise to regulatory investigations into whether such failings were the result of inadequate systems and controls, and any customer impact.

Regulators may also focus on whether firms have treated customers fairly, particularly as regards the imposition of additional charges by reason of negative interest rates, and the quality of customer communications. Any regulatory intervention risks giving rise to claims by private persons under the Financial Services and Markets Act (FSMA) section 138D and/or claims via the Financial Ombudsman Service.

Conclusion

The above high-level summary suggests a diverse risk landscape for financial services firms. Those firms whose contracts make reference to central bank or money market interest rates that are currently negative will already be adjusting to the abovementioned issues. The time for such issues to arise within the UK financial system may be fast approaching.

1The rest of this article considers the English law perspective only, save for the reference to Dutch cases.