The lure of historically low interest rates has often led borrowers, whether local authorities, healthcare institutions or entrepreneurs, to turn to financing solutions presented as more advantageous. Structured loans, often referred to as 'toxic' loans, have proved to be formidable arrangements. Built around complex and opaque indexation formulas, they can transform manageable debt into an uncontrollable financial burden. Behind the promise of a low initial cost lie in reality the risks inherent in financial engineering borrowers don't always realise the extent of the risks involved. This article sets out to decipher the mechanisms behind these loans, the legal grounds for challenging their validity and the means available for holding banks liable. The complexity of this banking litigation requires a precise analysis of the lender's obligations and the borrower's rights.
Definition and characterisation of structured (toxic) loans
A structured loan is a loan where the interest rate and sometimes the capital to be repaid are not determined in a fixed way or by reference to a simple index such as Euribor. What makes it special is the use of complex mathematical formulae that link its performance to a variety of underlying assets that are often highly volatile. In reality, it is a loan contract backed by one or more financial derivatives, such as swaps or options, which radically change its risk profile.
Product types (deactivating barrier, slope barrier, currency barrier)
Although there is an infinite variety of arrangements, there are three main families of structured loans that have been the subject of litigation:
- The deactivating barrier products They offer an advantageous fixed rate as long as a reference index (an exchange rate, an interest rate) does not cross a certain threshold, called a "barrier". If this barrier is breached, the rate switches to a variable formula that is often very unfavourable and potentially unlimited.
- The slope products The interest rate is indexed to the difference (the "slope") between interest rates of different maturities, for example between a 10-year rate and a 2-year rate. The complexity of these curves makes them difficult to predict for the uninitiated.
- The currency barrier products Interest rate swaps: Particularly risky, these loans are generally indexed to the parity between several currencies, such as the euro and the Swiss franc (CHF) or the Japanese yen (JPY). The interest rate, initially attractive, can explode if the foreign currency appreciates sharply against the euro, leading to an exponential increase in repayments.
Specific issues for local authorities and private individuals
Structured loans were widely marketed to local authorities, hospitals and social housing bodies. Attracted by favourable starting conditions to finance their investments, these public players found themselves trapped by financial charges that placed a heavy burden on their budgets, to the detriment of public services. The outstanding amount of these loans, carried in particular by institutions such as Dexia, represented several billion euros and required State intervention to avoid a financial disaster.
Individuals and entrepreneurs were not left out. Mortgages, often intended for tax-relief purposes, have been offered with indexation to foreign currencies. For the borrower, the risk is twofold: not only can the interest cost soar, but the outstanding capital, denominated in a foreign currency, can also increase considerably if the exchange rate develops unfavourably, directly threatening personal assets.
Litigation concerning the classification and validity of structured loans
Faced with an exploding debt burden, many borrowers have gone to court to try to challenge these contracts. Legal action is taken in a number of ways, with the aim of challenging the very nature of the contract, its validity or the conditions under which it was granted.
Classification as a speculative product or forward financial instrument
A fundamental question is whether a structured loan should be treated as a simple loan or as a complex, speculative financial instrument. The distinction is a major one. If it is a financial instrument, the bank is bound by much stricter obligations in terms of information and advice, as set out in the French Monetary and Financial Code. Case law defines a product as speculative when it exposes the borrower to disproportionate or even unlimited risks, based on variables unrelated to the borrower's own economic activity. The inclusion of a swap or complex options in the structure of the loan is a strong indication of its speculative nature, although the courts examine each case individually.
The validity of the indexation clause (monetary, monetary and financial code)
French law strictly regulates indexation clauses. Under articles L. 112-1 et seq. of the French Monetary and Financial Code, an indexation clause is only valid if the index chosen is directly related to the purpose of the contract or the activity of one of the parties. A clause that indexes an internal loan to a foreign currency parity may be deemed unlawful, as it has no direct link with the borrower's business. The Court of Cassation has taken differing positions on this point, with the Commercial Chamber being more flexible than the Civil Chamber. The penalty for an unlawful clause is nullity, which may be absolute if it is considered to contravene a public monetary order.
Cancellation on grounds of lack of consent (violence, fraud, error)
The borrowers also sought to have the loans cancelled on the basis of the defects in consent provided for in the Civil Code. Arguments put forward include error as to the speculative nature of the product, fraud resulting from misleading presentation by the bank, or economic violence exerted on a local authority in difficulty. However, these actions have often failed, as judges consider that borrowers, particularly local authorities with financial services, are "informed borrowers", capable of understanding the scope of their commitment, even if the mathematical formula is complex.
Actions based on misleading commercial practices (Consumer Code)
Action based on misleading commercial practicesThe "misleading practice" rule, set out in article L. 121-1 of the French Consumer Code, offers another angle of attack. A practice is considered misleading if it is based on false allegations or presentations, or is likely to mislead the borrower. This may involve a presentation that highlights an advantage (a low rate) while concealing or minimising a major risk (exposure to unlimited exchange rate fluctuations). Demonstration of such a practice can lead to criminal penalties for the bank and compensation for the loss suffered by the customer.
The bank's responsibility with regard to structured loans
In addition to the validity of the contract itself, banks may be held liable for breaches of their professional obligations. These duties, defined by case law, vary in intensity depending on the status of the borrower and the complexity of the product.
Breach of the duty to warn
The duty to warn requires the bank to alert an "uninformed" borrower to the specific risks of a transaction. This duty is particularly relevant in two situations: when the loan finances a speculative transaction or when it presents a risk of excessive debt for the borrower. In the case of structured loans, the speculative nature of the transaction is often obvious. The main difficulty for the borrower is proving that he or she is "uninformed". While private individuals are more easily considered to be 'laymen', local authorities or companies with a financial department find it difficult to obtain this qualification, which weakens their chances of success on this basis.
Breach of duty to inform
The duty to inform, which is broader than the duty to warn, requires the bank to provide complete, accurate and non-misleading information on the characteristics of the loan. The commercial and contractual documentation must be clear and enable the borrower to understand the nature and extent of the risks. Banks have been condemned for failing to inform their customers on essential points, such as the valuation method for the underlying swaps or the consequences of an unfavourable trend in the indices. The bank must be able to prove that it has provided adequate and comprehensible documentation.
Breach of duty to advise
The duty to advise is the most demanding obligation. It is not limited to providing information, but requires the bank to actively guide its customers towards the solution best suited to their situation and objectives. In principle, the bank is bound by a duty not to interfere in its customer's affairs and is not required to express an opinion on the advisability of a transaction. However, this duty to advise may apply if the bank took the initiative in arranging the transaction, encouraged the customer to opt for a complex product or proposed a hedging solution that turned out to be unsuitable. In such cases, the bank's active role justifies increased liability.
The duty to inform (Grimaldi case law)
Inspired by a leading case (Grimaldi), the duty to inform is a more subtle obligation. It can be invoked even in respect of an "informed" borrower. It is based on the idea that in the presence of significant asymmetry of information, the professional (the bank) who holds information that his client cannot reasonably have, must communicate it to him. In the context of structured loans, this could involve information on the exceptional volatility of an index or on systemic risks that only the bank is in a position to anticipate. If this duty is breached, the bank will be liable for loss of opportunity for the borrower not to enter into the contract.
The legal treatment of toxic loans and crisis exit solutions
Faced with the scale of the dispute and the major financial risk to public finances, the legislator intervened to provide a framework for the situation and offer ways out, while regulating credit more strictly in the future.
Creation of the early repayment support fund (2014 Finance Act)
To help local authorities and certain public bodies strangled by these loans, the 2014 Finance Act established a support fund. Financed by the State and the banking sector, this fund is intended to cover part of the early repayment penalties. However, the granting of this aid is conditional on the conclusion of a settlement with the bank, which implies a waiver of any legal action. This scheme has therefore forced public borrowers to make a delicate choice between certain but partial assistance and lengthy litigation with an uncertain outcome.
Retroactive validation of loans granted (Act 2014-844 of 29 July 2014)
The most serious threat to the banks and to the State (via its guarantee to Dexia) came from nullity actions based on the absence or irregularity of the Total Effective Rate (TEG) in the contracts. Court rulings had begun to find in favour of borrowers on this very formal ground. To avoid a cost estimated at more than 17 billion euros, the legislator passed a retroactive validation law. This law "validated" loan contracts concluded with legal entities governed by public law against disputes based on the TEG, provided that other information on the cost of the credit was included in the contract. When the matter was referred to it, the Conseil Constitutionnel ruled that the law complied with the Constitution, finding that the major financial risk to public finances constituted an "overriding reason of general interest" justifying such retroactivity. This law closed an important avenue for litigation, but did not affect actions based on breaches of the duty to inform or advise.
The acpr's recommendations and the framework for future loans
Looking ahead, the authorities have stepped up protection for borrowers. The Autorité de Contrôle Prudentiel et de Résolution (ACPR) has issued best practice recommendations requiring banks to be more transparent. They must now provide clear simulations illustrating the effects of an unfavourable variation in the indices and issue a separate information document warning of the exchange rate risk. In addition, the law has tightened the rules applicable to loans to local authorities and individuals. Local authorities can no longer take out loans based on overly complex indices and must fully hedge their foreign exchange risk. For individuals, loans in foreign currencies are now highly restricted.
The issue of toxic structured loans illustrates the tension between financial innovation and the need to protect borrowers. The resulting disputes have highlighted the duties of banks and the remedies available to their customers. If you are faced with a structured loan that has become excessively burdensome, it is essential to analyse your contractual situation to identify possible courses of action. Our law firm can support you in this process and defend your interests against the bank.
Sources
- Monetary and Financial Code
- Commercial code
- Civil Code
- Consumer Code
- Law 2014-844 of 29 July 2014 on the validation of loan or borrowing contracts entered into by legal persons
- French Finance Act 2013-1278 of 29 December 2013 for 2014
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