1. Definition and types of structured loans
The three main categories of structured loans
Structured loans are complex financial products whose interest rate varies according to a mathematical formula linked to changes in financial indices. They fall into three main categories:
Deactivating barrier products operate on a conditional mechanism: as long as a benchmark index remains below a certain threshold (the barrier), the borrower benefits from an advantageous interest rate. If the index breaches this barrier, the subsidised rate is deactivated in favour of an alternative formula that is generally unfavourable.
Slope products index the interest rate on the spread (or 'slope') between two indices, typically short- and long-term rates. The risk lies in the inversion or flattening of this yield curve, which can trigger a sharp rise in interest rates.
Currency barrier products are indexed to currency fluctuations. If the exchange rate crosses a certain threshold, the interest rate may rise significantly, exposing the borrower to an exchange rate risk that is beyond their control.
Derivatives used
These loans incorporate various derivative instruments:
Swaps are used to exchange financial flows according to predefined terms and conditions, in particular to convert a fixed rate into a variable rate indexed to complex benchmarks.
Options give the lending institution the right to activate certain conditions at specific times, generally to the detriment of the borrower.
Forwards are forward contracts that stipulate the terms of exchange at a future date. They are incorporated into loans to modify their characteristics according to market trends.
The characteristics of a "toxic" loan
A structured loan becomes "toxic" when it has several characteristics:
- Excessive leverage, amplifying fluctuations in the underlying indices
- Potentially high interest rate volatility
- No cap on rates
- Complexity that makes it difficult for borrowers to assess risk
- A clear imbalance in the distribution of risk between lender and borrower
2. The development of structured loans and their target audience
The development history of these products
The development of structured loans accelerated in France in the early 2000s, against a backdrop of low interest rates and the search for higher yields. Banking institutions massively marketed these products, presenting them as innovative debt management solutions.
The period 2005-2008 marked the peak of this commercialisation, before the financial crisis revealed their latent risks. Market turbulence triggered the activation of numerous unfavourable clauses, turning seemingly advantageous loans into unsustainable financial charges.
Local authorities as prime targets
Local authorities have been the prime target for these products for a number of reasons:
- Their constant need for funding for public investment
- The relative sophistication of their financial services compared to retail customers
- The political attraction of initially low interest rates reducing the apparent cost of debt
- Less protective regulations than those applicable to private individuals
Municipalities, départements and regions have subscribed to these products on a massive scale, often without fully understanding the associated risks.
The scale of the phenomenon and its financial consequences
In 2013, the outstanding amount of structured loans held by local authorities was estimated at around €13 billion, of which almost €4 billion was classified as "toxic". Some local authorities have seen their interest rates rise from 3-4% to more than 20%, or even 50% in the most extreme cases.
The consequences have been disastrous for many local authorities, who have been forced to cut back on investment or raise local taxes. The government had to intervene by creating a €3 billion support fund to help those hardest hit.
3. The legal status of structured loans
The debate on the speculative nature of structured loans
The legal nature of structured loans has been the subject of considerable debate in case law. The central question was whether these products constituted simple loans or disguised speculative transactions.
Several courts considered that the incorporation of complex derivative instruments fundamentally transformed the nature of the contract, bringing it closer to a speculative investment than to traditional financing. This classification paved the way for their validity to be called into question, particularly for local authorities whose ability to speculate is strictly regulated.
The validity of indexation clauses
The validity of indexation clauses was another major point of contention. French law requires indexation to be based on a direct relationship with the subject matter of the contract or the activity of one of the parties.
The courts have frequently questioned the validity of indexations based on currency parities unrelated to the activity of local authorities (such as the Swiss franc/dollar exchange rate) or on rate differentials unrelated to the local economy.
The right of local authorities to take out such loans
The legal capacity of local authorities to take out structured loans was questioned in the light of the principle of speciality and the limitations on their financial powers.
Administrative jurisprudence has gradually established that local authorities cannot legally contract speculative loans, as these exceed their statutory purpose, which is limited to satisfying the local public interest. This position has led to increased recourse against lending institutions.
4. Principles applicable to structured loans
The rules of the Monetary and Financial Code
The Monetary and Financial Code sets out a number of provisions governing structured loans:
- Increased pre-contractual information requirements for complex products
- Banking institutions' duty to advise and warn
- Rules for classifying customers according to their level of financial sophistication
Case law has gradually strengthened these obligations, requiring banks to demonstrate that they have provided full, clear and appropriate information on the specific risks of the products on offer.
Application of regulations on sliding scale clauses
The indexation clauses in structured loans were examined in the light of the provisions on sliding scale clauses, in particular article L.112-2 of the French Monetary and Financial Code, which prohibits certain forms of indexation.
The courts have often invalidated clauses based on indices that have no direct connection with the subject of the contract or the activity of the parties, paving the way for the reclassification of contracts and the application of a substitute legal rate.
The boundary between credit and financial instruments
The hybrid classification of structured loans, on the borderline between traditional credit and financial instruments, has raised complex regulatory issues.
This dual nature has led to the cumulative application of traditional banking regulations and those relating to investment services, particularly in terms of information, advice and assessment of the suitability of the product for the customer's profile.
5. The emergence of specific litigation
Major court cases
Litigation over structured loans has focused on a number of emblematic cases:
The Dexia affair was the epicentre of the scandal, having been the main distributor of these products before its bankruptcy. Numerous local authorities took legal action against the bank, resulting in a variety of rulings that were often favourable to borrowers.
The SFIL dispute (Société de Financement Local), which took over part of Dexia's portfolio, also generated a large volume of litigation. However, legislative intervention in 2014 limited the number of claims against this public institution.
The different litigation strategies employed
Borrowers have deployed various legal strategies:
- Contesting consent on the grounds of a defect in consent (fraud, error)
- Questioning the validity of indexation clauses
- Invoking the breach of the duty to advise and inform
- Challenging legal capacity to contract (for local authorities)
- Reclassification of the contract as a financial instrument subject to more protective rules
These strategies have met with varying degrees of success depending on the jurisdiction and specific circumstances.
Financial and legal issues
This dispute has raised considerable issues:
- Systemic risk linked to the scale of the sums involved (several billion euros)
- Striking a balance between protecting borrowers and ensuring the legal certainty of contracts
- Sharing the cost of the crisis between banks, local authorities and taxpayers
- Changes to the regulatory framework with the adoption of the Act of 29 July 2014 on securing structured loan contracts.
These issues prompted the legislator to intervene and set up a support fund, implicitly recognising the shortcomings of the pre-existing legal framework for these innovative but risky financial products.
Sources
- Cour des Comptes, "Local authorities and structured loans", Thematic public report, 2018
- Court of Cassation, Commercial Division, 28 March 2018, no. 16-26.210
- Council of State, 28 December 2016, no. 397146
- Law 2014-844 of 29 July 2014 on securing structured loan contracts.
- Information report No. 4030 of the French National Assembly on toxic loans taken out by local authorities, 2011
- Bartolone report, "Mission d'information relative aux produits financiers à risque souscrits par les acteurs publics locaux", 2011
- Decree no. 2014-444 of 29 April 2014 on the support fund for local authorities
- Gaudemet, Y., "Les emprunts toxiques des collectivités territoriales", Revue française de finances publiques, 2014
- Klopfer, M., "La gestion de la dette locale", LGDJ, 2016
- Revue Banque, "Feature: Structured loans to local authorities", No. 768, 2014
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