Variable interest rate clauses come in many different forms. Tracker rates, for example, are a type of variable interest rate. Many variable interest rates are only subject to alteration in accordance with certain conditions, while others provide banks with complete discretion in determining the rate of interest. A mortgage is a contract like any other, and the ordinary rules relating to contractual interpretation and compliance apply.
Two types of variable interest rate clauses will be con-sidered in this article, one with an express limitation and another without any limitation. The first is a variable interest rate that may be altered in response to ‘market conditions’, and the second is a variable interest rate, which may be altered by the bank unilaterally without express restriction.
Market conditions
Many variable-interest-rate clauses provide that the interest payable under the mortgage may or shall be altered in response to ‘market conditions’ or similar terminology. In order to legitimately raise the variable interest rate, the bank can only do so in response to market conditions. The meaning of ‘market conditions’ was considered in 2015 in Millar v Financial Services Ombudsman.
The case began as a complaint by the Millars to the Financial Services Ombudsman that Danske Bank had wrongly increased the variable interest rate on their seven mortgages. The Millars argued that the bank was only entitled to alter the rate of interest “in line with general market interest rates”, and that an increase in the rate of interest when European Central Bank (ECB) rates declined amounted to a breach of contract.
Clause 3 of the special conditions of the loan agreements provided that: “Our rate of interest and APR are variable. Rates of interest are altered in response to market conditions and may change at any time without prior notice and with immediate effect.”
The ombudsman determined that Danske Bank was entitled to alter the interest rate in response to ‘market conditions’ and was not restricted by reference to the ECB rate when determining the rate of variable interest. The ombudsman accepted the bank’s submission that the ‘cost of funding’ was a market condition.
Complaint dismissed
The ombudsman further accepted that the bank was not funded through the ECB and that its cost of funding had, in fact, increased. Accordingly, the Millars’ complaint was dismissed.
By way of statutory appeal, the Millars successfully appealed the decision to the High Court, but ultimately failed in the Court of Appeal. The Court of Appeal held that, as the construction of the relevant contractual term was a mixed question of law and fact, the ombudsman was entitled to deference in interpretation of the terms of the mortgage. The Millars failed to discharge the burden of proof necessary to set the ombudsman’s decision aside.
It is noteworthy that McKechnie J, in the 2018 Supreme Court decision in Attorney General v Davis, held that a conclusion based on an incorrect interpretation of documents may be regarded as a point of law in a statutory appeal on a point of law, and therefore is reviewable.
The decision would suggest that it is now possible to appeal a decision of the ombudsman on the basis of an incorrect interpretation of a mortgage.
Cost of funding
Despite the fact that the Court of Appeal did not rule on the interpretation of the variable-interest-rate clause, Kelly J agreed with the ombudsman that ‘in response to market conditions’ was not an ambiguous term. The court further held that the Millars had not established that the ombudsman was in serious error in his determination that an increase in cost of funding was a market condition.
Though not directly determined, it seems likely that a court would agree that a bank is entitled to raise its market-condition-based variable interest rate if its cost of funding increases.
It is also noteworthy that Kelly J did not agree with Hogan J in the High Court that ‘market conditions’ equated with ‘market conditions generally’. This small difference in terminology caused the judges to come to radically different conclusions when interpreting the variable-interest-rate clause, and serves to highlight the importance of careful review of such clauses.
Justification
A bank that has been increasing a market-condition-based variable interest rate, that has not experienced an increase in its cost of funding, must use another market condition to justify the increase.
It is interesting to note that, in response to queries raised by the ombudsman in Millar, Danske Bank stated that the cost of funding was the primary driver in deciding to increase its variable interest rate, and did not offer another market condition as justification.
In addition, a fund that purchases a mortgage from a bank may have different market conditions to contend with, and cost of funding may not be a consideration (see Baker J’s observations in Re: Hayes, a debtor).
Better part of valour
A discretionary variable interest rate is an interest rate that is set unilaterally by a bank at its discretion. The lawfulness of discretionary variable interest-rate-clauses was considered in 1989 by the English Court of Appeal in Lombard Tricity Finance v Paton.
The court held that the appellant could vary the interest rate at its absolute discretion, and that a loan agreement containing such a clause was lawful.
The prospect of banks having the power to increase discretionary variable interest rates seemingly without limit may justifiably give borrowers cause for concern.
Paragon of virtue
In Paragon Finance Plc v Nash and Staunton, Dyson LJ held that the power of a lender to set a discretionary variable interest rate could not be completely unfettered, as it would allow a lender to set interest rates at “the most exorbitant level”.
In Paragon, the defendants argued that the interest charged had become extortionate when Paragon failed to adjust rates in line with the Bank of England or prevailing market rates.
The defendants submitted, among other things, that the discretion given to Paragon in the mortgage agreements to vary the interest rate was subject to an implied term that it was bound to exercise that discretion fairly “as between both parties to the contract, and not arbitrarily, capriciously or unreasonably”.
The court did not go as far as the defendants requested, but held that it was necessary to imply a term in order to give effect to the reasonable expectations of the parties. The implied term imposed two limitations on the lender’s discretion. The first was that rates of interest would not be set “dishonestly, for an improper purpose, capriciously or arbitrarily”.
Reasoning
The second was that Paragon would not set rates of interest unreasonably, in the Wednesbury sense (essentially irrationally), but not that it would not set unreasonable rates. The second limitation was to the effect that Paragon could not exercise its discretion in a way that no reasonable lender acting reasonably would.
Dyson LJ stated that an increase in the interest rate by the lender if “commercially necessary” would be reasonable, even if from the borrowers’ perspective it seemed unreasonable. Dyson LJ was of the view that, if Paragon had increased the interest rate because it was in financial difficulty, brought about by other borrowers defaulting and consequently having to pay higher interest rates on the money market (cost of funding increases), that would not be in breach of the implied term.
It was held that there was no evidence to suggest that the decision to widen the gap between the rate being charged and the prevailing market rate was motivated by anything other than commercial considerations. Consequently, the court found against the borrowers. Paragon was cited by McGovern J in Cheldon Property Finance DAC v Hale.
Financial difficulty
The extent to which a bank’s financial difficulty can justify increasing a discretionary variable interest rate is not clear. In Paragon, it was stated that financial difficulty brought about by an increase in the cost of funding, due to other borrowers defaulting, would not breach the implied term. It is noteworthy that this type of financial difficulty is connected to the mortgage, and Paragon was not at fault.
A court may take a different view if the financial difficulty being experienced by a bank was from an entirely separate enterprise, or if it was as a result of the negligence or wrongdoing of the bank. It is also clear that financial difficulty would not justify a completely exorbitant increase in the interest rate. In addition, the discretion of a bank may be curtailed by the European Communities (Unfair Terms in Consumer Contracts) Regulations 1995.
Lip service
A mortgage with a variable interest rate which is subject to alteration in accordance with certain conditions can only be altered in accordance with those conditions. A bank cannot simply pay lip service to a contractual requirement. An Irish bank that is funded through the ECB, for example, may have difficulty justifying an increase in a market-condition-based variable interest rate. There may be considerable scope to challenge increases in these rates.
Banks are in a better position in relation to discretionary variable interest rates. Increases in the cost of funding or financial difficulty as a result of the crash would almost certainly justify increases in the variable interest rate, but – as outlined above – banks do not have carte blanche.
A bank cannot set a discretionary variable interest rate dishonestly, for an improper purpose, capriciously or arbitrarily. A bank can also not exercise its discretion in a way that no reasonable lender acting reasonably would, but can set rates a borrower may consider unreasonable.