Effects of Illegality on a Loan

Effects of Illegality on a Loan

There remain some other matters which merit clauses in the loan agreement but which do not fit neatly into the above categories. These matters are dealt with in this section and concern the effects of illegality on the loan, and the need to provide protection against market disaster and increased costs for the lender.


It is usual for a clause to be included in the loan contract dealing with how the borrower uses the funds. This will state that the borrower will use the funds for specified purposes which may be general in nature. The effect of a breach of this clause is that an event of default has occurred with the usual consequences. The clause is primarily aimed, however, at a potential illegal use of the funds by the borrower.

A lender who knowingly advances funds for an illegal purpose finds himself with a void loan contract in English law. This can include not only criminal purposes but also ultra vires activities by the borrower. The risk in English law of lending to a company which uses the money for an ultra vires purpose is effectively removed by the Companies Act 1985 .

In the case of a borrower who uses the loan proceeds for an illegal purpose, it will be no defence for the lender to claim that he did not know that the purpose was illegal as he is presumed to know the law that governs his contract. This represents a further reason for him to choose a law with which he is familiar . It will be a defence, however, for him to claim that he did not know the true use to which the borrower was putting the funds, thus the reason for including the clause which will state purposes which are legal. Besides emphasising the lender's ignorance of the illegal use, the clause may also succeed in raising an estoppel against a defence that the borrower runs based on the illegality rendering the contract void .

It has been seen that where the contract is illegal under the contract's governing law at the time the contract is made, this will render the contract void, assuming the lender knows the facts. Under English law a contract can also be rendered void by its performance becoming illegal due to a change in the law during the life of the contract. This is an example of the doctrine of frustration of contracts. As well as subsequent illegality, subsequent impossibility also frustrates a contract. The result of this is that if the governing law of a contract is English law, the contract becomes unenforceable if the only way to perform it will involve one or both parties committing an illegal act in this or another jurisdiction . In other words if repayment of the loan will itself be an illegal act, the lender will have no remedy in English common law. This is so even if the repayment would have been legal at the beginning of the loan. The most obvious examples of this scenario are the outbreak of war between the United Kingdom and the borrower's country and the introduction of exchange controls by the borrower's country.

To address the potential unfairness of this rule to a party who has performed much more of the contract than has the other, and a loan agreement is a perfect example of this, the Law Reform (Frustrated Contracts) Act 1943 was passed. It provides that where a contract has been frustrated under English law, all sums paid to a party before the frustrating event occurred are recoverable from him. The court may permit the party to retain some or all of the sum paid if that party has incurred expenses and the court considers it just and equitable to permit him to do so.

The frustrating event may in any case not be a permanent one, and when it is caused by illegality it will almost certainly cease to exist at some future time and the contract will once again be legal and possible to perform. For this reason the doctrine of frustration is capable of suspending the validity of a contract instead of rendering it permanently void .

The introduction of exchange controls can have the effect where the borrower is contractually obliged to repay in a currency foreign to him, his law prevents him from obtaining that currency. The effect of the Bretton Woods Agreement of 1944 is that a forum may also decline to uphold the lender's right to recover even if there is no obstacle from illegality under the contract's governing law. Thus the Law Reform (Frustrated Contracts) Act would not assist a lender in the English courts when the Bretton Woods rule applied.

It is usual for a lender to include an illegality clause in the loan contract. This will state that if it becomes illegal anywhere in the world to service the loan, then the lender will be entitled to cancel his commitments and immediately recover any sums outstanding. This of course merely repeats the English law of frustration as amended by the 1943 Act but a lender may extend the scope of the provision to matters which make it difficult but not impossible to service the loan, e.g. funding from a particular favoured market becomes illegal but he would be physically able to fund it from another. It is also desirable to make it clear that changes in a law external to the governing law of the contract will have the frustrating effect as any sliver of a possibility of performing the contract without breaking that law can be recognised under the general law so that the contract does not become frustrated. This was well illustrated by the facts of Libyan Arab Foreign Bank v Bankers Trust .

Finally, it is also possible for a lender to include a force majeure clause excusing performance in the event of a variety of disturbances.

Market disaster and margin protection clauses

Term loan agreements invariably incorporate a clause which is drafted in contemplation of a market disaster. The eurodollar market has thrived since the 1960s on the basis that eurodollars can be confidently expected to be available on demand and other currencies are also often made available to borrowers. Even so, lenders require the comfort of knowing that they will not be contractually bound to lend what has become impossible to obtain. They also require the comfort of knowing that they will not become vulnerable to interest rate exposure as a result of market distortions.

The typical clause will provide that the lender (or the agent if it is a syndicated loan) may determine that market disturbance is such that fair means do not exist to settle what interest rate is payable under the agreement. This would for example happen because the LIBOR mechanism is in a state of flux and either no figure for LIBOR exists or a figure is available but the lender cannot in reality obtain funds at that figure. Once the lender has so determined, he will notify the borrower accordingly and the lender (or agent) and the borrower then attempt to agree on an appropriate rate of interest. Failing such an agreement, the lender (or agent) will be entitled to impose a rate of interest which accurately reflects the cost of funds. The borrower may be entitled to prepay without penalty if an interest rate is imposed in this way. It will also be provided that the borrower is prevented from drawing fresh funds under the agreement whilst the market is in turmoil.

Margin protection clauses will typically deal with two distinct possible eventualities. One concerns the risk that the capital adequacy requirements of the lender's regulator will be strengthened and that as a result the lender will require a greater margin in respect of the loan than has been agreed in the agreement. The clause will also contemplate any other regulatory type of matter which has the same effect of increasing costs. The borrower may be given the option to prepay if the clause is implemented .

The other margin protection clause concerns grossing-up of payments in the event of a withholding tax being imposed by the laws of any country, most significantly those of the borrower's jurisdiction. Withholding taxes on income payments are commonly imposed by revenue authorities, usually for the reason that the receiver of the income will not account to that country's revenue for the tax due on that income. There are many domestic examples of withholding tax, such as in the UK the deduction of tax at source on bank and building society interest payments to retail investors. When a borrower pays interest to a lender, the borrower's country may require tax at source to be deducted on the payment. Whilst this will typically be around 10%, it is payable on all the interest paid and not just on the margin. To a lender, with his cost of funds, this is clearly inappropriate even if he is liable to income tax in the borrower's jurisdiction, which he may not be.

The typical clause provides that the borrower must make payments without any deduction but that if he is compelled by law to deduct a withholding tax, then he must gross up his payments so that the lender receives a net sum which amounts to the contractual payment due. In round figures, if the borrower is obliged to pay interest in the sum of $100 and he is bound to deduct tax at 10%, the clause obliges him to gross up his payments to $111 so that 10% can be deducted and $100 will still remain. If such a provision is implemented, the borrower clearly suffers a significant increase in the cost of his loan. For this reason, most loan agreements are set up in such a way that no withholding tax will be payable in the country from where the payments are sourced. The clause protects the lender if a withholding tax is introduced during the life of the loan . The borrower usually has the right to prepay without penalty if the clause is triggered.

If withholding tax is deducted in the borrower's country, the lender may be able to claim a tax credit in his home country in respect of it. This follows from the fact that the payment of tax, whilst made by the borrower is in fact tax paid on account of the lender's liability to pay tax in the borrower's country. The availability of any tax credit will depend on any tax treaty which exists between the two countries. The usefulness of any tax credit which is available to the lender will depend on the extent to which the lender has tax liability in his own jurisdiction against which to off-set the credit .