Barclays v : Is self- interest commercially reasonable?

April 9, 2014

Summary Authors/Presenters

The Court of Appeal has recently considered the scope of an obligation to act in a commercially reasonable manner, in the context of determining whether and on what terms

to consent to the early termination of credit default Nick Pryor guarantees. The decision has implications for both finance Regional Innovation Solutions and general commercial agreements in which these types Director – EMEA & Asia of obligation are used. [email protected]

The Court of Appeal has recently considered the scope of an obligation to act in a commercially reasonable manner, in the context of determining whether and on what terms to consent to the early termination of credit default guarantees. The decision has implications for both finance and general commercial agreements in which these types of obligation are used. Introduction

It is commonplace in many commercial contracts to require that parties exercise any powers or discretions in a “commercially reasonable manner”; particularly so in finance documents. Often the phrase is resorted to in order to resolve an impasse in the negotiation of a contract, balancing one party's wish for freedom over how it deploys its rights and the other's desire not to see powers misused in ways not contemplated at the time of the agreement. The phrase is also embedded in standard documents such as the 2002 ISDA Master Agreement to strike the same sort of balance between buyer and seller.

Page 1 of 4 The recent Court of Appeal decision in Bank plc v Unicredit Bank AG has considered the meaning of the phrase and the limits of conduct that can be commercially reasonable.

In whose interest?

The case arose from credit default guarantees provided by Barclays to Unicredit during the financial crisis in 2008. At the time, Italian banking regulators allowed such instruments to give rise to favourable treatment when assessing a bank's tier one regulatory capital. A subsequent change of heart by the regulators prompted Unicredit to look for a way out of the guarantees in the summer of 2010.

The documentation permitted Unicredit to terminate early following a "Regulatory Change" but only with Barclays' prior consent. That consent was required to be determined "in a commercially reasonable manner". Unicredit sought consent to terminate the guarantees under this provision. Barclays accepted that a Regulatory Change had occurred but sought payment for giving its consent.

Barclays reasoned that when it entered into the guarantees it had anticipated that they would run for five years. It had taken this view because Unicredit had a right to terminate the contacts without Barclays' consent after a period roughly equal to the weighted average life of the reference obligations, which was expected to be about five years. At the inception of the guarantees Barclays had booked as a profit the discounted value of five years of fees under the contacts. It was not willing to book a corresponding loss on an early termination to reflect the fact that profit had not come to pass, and so it demanded the shortfall from Unicredit as the price of its consent.

Unicredit refused to pay, saying that it was unreasonable for Barclays to refuse consent except on these terms, when a Regulatory Change meant Unicredit was no longer receiving the capital relief it had sought to achieve. It treated the unreasonable refusal as a waiver of the consent requirement and purported to terminate the guarantees without payment. Proceedings ensued, centred on the question of whether Barclays' request for payment in return for its consent was commercially reasonable.

Page 2 of 4 In the High Court the judge sided with Barclays and decided that it was commercially reasonable for it to withhold its consent on the basis it did. In the Court of Appeal, Unicredit attacked that decision for allowing Barclays to give precedence to its own self-interest and exclude the interests of Unicredit. It also challenged the reasonableness of the sum sought.

There was much technical argument before the appeal court as to the most appropriate stand of case law to apply to this interpretative question. But in the leading judgment Lord Justice Longmore gave shrift to the debate, saying it was "ultimately unhelpful", as the words had to be construed in the particular context of these contacts.

That particular context was held to permit Barclays to take into account its own interests and disregard those of Unicredit. The court considered it impractical to ask Barclays to weigh the parties competing interests against one another and determine the overall commercially reasonable outcome. While the requirement of commercial reasonableness must exercise a control of some kind, it only prevented Barclays demanding a sum far in excess of the reasonably anticipated return from the contract.

Unicredit also argued that an entire agreement clause in the guarantees prevented Barclays from relying on its own understanding at the outset of the contracts as to their likely duration. But the court considered this a “non-point” as the clause was not intended to exclude admissible evidence about the way Barclays determined the conditions of its consent. BLP Perspective

The court’s succinct rebuttal of Unicredit’s arguments must be right. If upheld, they would have had potentially difficult implications for commercial reasonableness provisions, not least in the close out mechanism under the 2002 ISDA Master Agreement.

In essence Unicredit tried to convert Barclays’ contractual discretion into a quasi-fiduciary obligation to be an arbiter of fairness between the parties’ competing interests. The court wryly observed that while bankers may “have a keen instinct for where their own interests lie”, they cannot and should not be asked to assess and weigh the interests of other contracting parties.

Page 3 of 4 This is a straightforward application of principles of freedom of contract laid down in Victorian times, so perhaps the most noteworthy aspect of the case is that it was pursued as far as the Court of Appeal. This may demonstrate the determination of the defendant, or it may be seen as lending further weight to the view that the courts’ long standing approach to arm’s length commercial bargains, particularly in the finance sphere, is increasingly under attack.

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This document provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action.

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