The European Union's Court of Justice has handed down a preliminary ruling this month in a Spanish case that sheds light on the transparency requirement for variable interest rates under mortgage loan agreements.
The court's judgment sets out general rules that will be of particular interest to residential mortgage lenders in the UK who are considering how to replace any LIBOR-linked loan products with products based on another reference rate, such as SONIA, ahead of LIBOR's demise at the end of 2021.
The issues at hand
The case of Marc Gómez del Moral Guasch v Bankia SA (C 125/18) concerned a mortgage loan agreement entered into in Spain between a consumer and a banking institution to finance the acquisition of a residential property.
Interest on the mortgage loan was linked to an official reference index, which was based on the average rate of mortgage loans granted by Spanish savings banks – índice de referencia de préstamos hipotecarios (IRPH). The borrower, Mr Gómez del Moral Guasch, brought a court action in Spain to challenge the fairness of the interest rate provision in his mortgage loan agreement.
As the question of fairness was governed by the EU's Unfair Contract Terms Directive (93/13/EEC), the Spanish court referred the matter to the Court of Justice of the European Union (ECJ) for a preliminary ruling on the Directive.
The ECJ considered two key issues. Firstly, what information must be provided to a consumer about a variable interest rate in order to meet the plain and intelligible language test under the Unfair Contract Terms Directive? Secondly, does the use of a regulated index take an interest rate provision in a mortgage loan agreement outside the Directive's scope?
Although the case did not concern the implications arising from the impending discontinuance of the London Interbank Offered Rate (LIBOR), both of the issues addressed in the ECJ's ruling are of direct relevance to UK mortgage lenders considering the feasibility of new products linked to an external reference rate, such as the Sterling Overnight Index Average (SONIA), as part of their LIBOR transition plans.
Plain and intelligible
The protection for consumers under the Unfair Contract Terms Directive is based on the idea that consumers are in an inherently weaker position as regards their bargaining power and their level of knowledge, so the Directive requires that written terms in consumer contracts must be drafted in plain, intelligible language.
The requirement that contract terms must be in plain, intelligible language does not simply mean that each term must be formally and grammatically intelligible, but rather that contract terms must be "transparent" in a broad sense.
In the Bankia case, the ECJ clarified what "transparency" means in the context of an interest rate provision. In order to be transparent, the ECJ said, an interest rate provision must put an average consumer, who is reasonably well informed and reasonably observant and circumspect, in a position to understand the specific functioning of the method used to calculate the interest rate.
It must also enable the consumer to evaluate, on the basis of clear, intelligible criteria, the consequences of the interest rate provision for their financial obligations.
The ECJ indicated that an interest rate provision in a mortgage loan agreement that is linked to an external index or reference rate is more likely to be transparent if essential information about the method by which the index or rate is calculated is easily accessible to the public and if the lender has provided the borrower with historic data relating to fluctuations in the index or rate, as well as the latest available value for the index or rate.
Historic and current data can give the consumer an objective indication of the consequences of their interest obligations being linked to that index or rate. It is also a useful point of comparison for assessing the cost of different products.
Making SONIA transparent for consumers
One challenge for any mortgage lender seeking to offer SONIA-linked loans is the requirement under the Unfair Contract Terms Directive to draft its mortgage documentation in such a way that the interest rate provision is expressed in plain and intelligible language and is transparent in a broad sense.
The legal requirement for transparency was implemented into UK law by section 68 of the Consumer Rights Act 2015 and continues to apply post-Brexit.
SONIA reflects the average rate of interest that banks pay on any given day to borrow cash in Sterling, overnight and on an unsecured basis. When it is used as a reference rate for interest on financial market transactions over a longer period, the interest is generally calculated using a "compounded average" of SONIA during an "observation period" that is a given "lag time" prior to the interest period in question.
Those concepts are more at home in the financial markets than in the world of retail banking and are likely to be overly complex for many borrowers – even reasonably well informed and reasonably observant and circumspect ones.
In the Bankia case, the ECJ said that, in order to be transparent, an interest rate provision would need to be drafted in such a way that an average consumer understood the specific functioning of the method used for calculating the interest rate. Though not impossible, achieving that level of transparency for a rate as complex as SONIA is clearly challenging.
When it comes to transparency, the head of the Financial Conduct Authority (FCA), Andrew Bailey, in a speech last summer questioned the suitability of financial market benchmarks for use in residential mortgage lending and pointed towards the Bank of England Base Rate as having "the advantage of being easily understood by a wide range of borrowers".
For variable interest rates linked to an external reference rate, the rules of the FCA in its Mortgages and Home Finance: Conduct of Business sourcebook (MCOB) require lenders, before entering into a mortgage contract, to warn consumers about historic fluctuations in the reference rate and to give them the latest available value for the rate. This pre-contractual information must be provided in the form of a European Standardised Information Sheet (ESIS).
Those ESIS disclosures would help a prospective borrower evaluate the financial consequences of their interest obligations being linked to SONIA, but would not necessarily help the borrower to understand how SONIA functions.
The protection under the Unfair Contract Terms Directive does not apply to written terms in consumer contracts that reflect mandatory statutory or regulatory provisions. In other words, if a contract term has to be included in order to comply with national legislation or the rules of a regulator, then that term is outside the scope of the Directive and is not subject to the transparency requirement.
In the Bankia case, the ECJ was asked to consider whether the interest rate provision in the mortgage loan agreement was outside the scope of the Directive on the basis that it provided for the interest rate to be linked to IRHP – an official reference index provided for by Spanish legislation that may be applied by banking institutions to mortgage loans.
The ECJ determined that an interest rate provision is only outside the scope of the Directive if there is a mandatory requirement under national law or regulation for the relevant index or rate to be used, or if national law or regulation provides for the relevant index or rate to apply by default if a borrower and lender do not agree other arrangements in a mortgage loan agreement.
For lenders considering SONIA-linked mortgage products, the judgment clarifies that a contract term in a mortgage loan agreement that provides for a variable interest rate to be linked to an external reference rate will still be subject to the transparency requirement, even if the reference rate has been recommended by a regulatory authority as a successor to LIBOR. It is only where the use of the rate is mandated by statute or becomes the subject of a binding regulation that the transparency requirement does not apply.
Public statements by UK regulatory authorities to date do not suggest that there will be any mandatory statutory or regulatory provisions requiring the use of SONIA or another reference rate as a replacement for LIBOR-linked mortgage loans, so it will be important for mortgage lenders to ensure interest rate provisions for any new products are drafted with the transparency requirement in mind.
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