Bank charges and the Unfair Terms Regulations

In the last few years, an unprecedented wave of mass litigation has swept the UK. Thousands of UK bank customers have made sheriff court or county court claims against their banks to reclaim charges for unauthorised overdrafts, bounced cheques or failed direct debits. However because settlements are typically reached at the eleventh hour, no legal precedent on the issue has yet been set.

The customers have argued that bank charges are unfair because the actual administration cost of exceeding the banks' credit limit is estimated to be £2, yet the majority of banks charge consumers £39. The banks have retorted that these charges are justified to offset the cost of bad debts incurred by customers, and that the future of free banking may be threatened if charges are found to be unlawful. It is estimated that UK banks make £3.5bn of fees each year from charges.

From a legal perspective, bank charges for unauthorised overdrafts and bounced cheques are a charge for breach of contract, known as liquidated damages. It was established in Dunlop Pneumatic Tyre Co v New Garage and Motor Co that liquidated damages clauses should be a genuine pre-estimate of loss. Otherwise a liquidated damages clause becomes a penalty clause, which is in theory unenforceable by the courts. A penalty clause, where the financial recovery to the innocent party would exceed any accurate pre-estimate of loss, is void. Both clauses provide for agreed payments to be made by the party in breach and both serve the same function of avoiding disputes and reducing uncertainty. Furthermore both may also serve as an incentive to performance. In practice, there are many payments that are not genuine pre-estimates of loss but are forced into the category of liquidated damages in order to make them enforceable.

The OFT test case

The legality of bank charges has not yet been ruled on by a senior court in Scotland or England & Wales. On 5 April 2006 the Office of Fair Trading ("OFT") announced that default charges which are set at more than £12 would be presumed to be unfair and unenforceable in terms of the Unfair Terms in Consumer Contracts Regulations 1999 ("the UTCCR"). Charges above this sum will be subject to legal action by the OFT. On 12 September 2006, the OFT began a factfinding inquiry into the issue. However, due to the number of claims, the OFT decided that it was undesirable to await the outcome of the inquiry. The banks and the OFT therefore agreed that a test case be brought. They agreed to raise an action in the Commercial Division of the High Court in London seeking to determine the legal basis of the claims. The action was raised on 27 July 2007. It is anticipated that a decision will be reached by the end of February 2008.

The first part of the case will consider whether the Unfair Terms in Consumer Contracts Regulations 1999, a set of rules governing contracts between individuals and businesses, apply to the unauthorised overdraft charges. If a penalty clause exists within a consumer contract it will normally be subject to the UTCCR, which implemented Council Directive 93/13/EEC on Unfair Terms in Consumer Contracts. The UTCCR can apply to almost any type of term that was not individually negotiated, and will invalidate the term if it is unfair. The burden of establishing that a clause is unfair falls on the consumer.

The upcoming test case will be the first time the regulations have been seriously tested in relation to the banking industry. The OFT must persuade the judge that the regulations apply; it will then have to prove at another hearing that the banks' contractual terms are unfair. However the defendants – Abbey, Barclays, Clydesdale, HSBC, HBOS, Lloyds TSB, Royal Bank of Scotland and the Nationwide Building Society – have lined up some of the City's biggest law firms and leading Queen's Counsel to represent them. If the court agrees with the banks that the charges do not fall within the scope of the regulations, the case will fall at the first hurdle.

The case will affect tens of thousands of existing claims before the county courts that have been frozen pending the outcome. It is estimated that the banks have paid up to £1 billion in total to settle claims from individual customers out of court, but they stand to lose billions more if they are defeated in court. This is bad news for English consumers because the OFT test case could be appealed all the way to the House of Lords and in the meantime all cases will remain frozen.

Frozen cases thaw in Scotland

However cases are proceeding in Scotland. In Coleman v Clydesdale Bank, Sheriff Pyle refused the bank's motion to sist the claim on the basis that it was unsatisfactory to compel a pursuer to be delayed merely for a decision of a foreign court, which would guarantee no certainty in defining the law which ought to be applied. The Coleman case was recently followed by Morrison v Bank of Scotland, in which Sheriff Douglas refused the motion to sist, observing that the onus lay on the defenders seeking to sist the action and the OFT decision would not necessarily address Scots common law.

If any of the proceeding Scottish cases reaches a hearing it is likely the banks will lose, as the pursuers can found upon the Scottish case of Castaneda and Others v Clydebank Engineering and Shipbuilding Co, Ltd. In this case, the House of Lords held that a contractual party can only recover damages for actual or liquidated losses incurred from a breach of contract. Alternatively Scottish litigants can of course rely upon the UTCCR. English consumers wishing to proceed with their cases may raise proceedings in Scotland if their bank has its registered office there.

The impact of the UTCCR

The UTCCR can have significant effects on a business should such a business be found to be in breach of the regulations. The negative publicity an OFT-led investigation attracts can have serious consequences for a business. This was illustrated relatively recently when the OFT announced in 2002 that My Travel Group's contractual clauses were unfair to consumers. Soon after the OFT announcement, the shares in My Travel Group plummeted. Although the announcement was not the only reason for the slump, the decision certainly contributed greatly to the company's demise.

Unfair terms in consumer contracts are found in many sale contracts, insurance contracts and financial contracts. The regulations apply to non-negotiated contracts between suppliers and consumers. The core terms of the contract should be clear. If there is ambiguity then the regulations may apply.

The underlying themes of the regulations are fair dealing and consumer protection. An unfair contractual term shall be void. Fairness requires the supplier to act in good faith towards the consumer. The supplier should not be able to obtain an advantage over consumers by using complex or ambiguous contractual clauses. The parties must act in good faith to ensure there is a balance between the interests of both supplier and consumer. The clauses favouring either party should cancel each other out to ensure that neither party has a more favourable bargaining position.

A contract containing void terms will continue to bind the parties should the other contractual terms be able to do so. Furthermore the contractual clauses must be free of legal jargon, written in plain English and legible type, have important terms highlighted and have no hidden terms. Thus terms such as "delict", "without prejudice" and "indemnify" may all be in breach of the UTCCR.

A consumer contract falls within the ambit of regulation 5 of the UTCCR. The banks' charges constitute an unfair penalty under reference to paragraph 1(e) of schedule 2 to the regulations:

"Indicative and non-exhaustive list of terms which may be regarded as unfair

"1. Terms which have the object or effect of -...

(e) requiring any consumer who fails his obligation to pay a disproportionately high sum in compensation".

Reform movement

Penalty charges are generally imposed by banks throughout the world, but are subject to different limitations in each country. In the United States, for example, banks are generally allowed to charge whatever they see fit; such charges are often a source of considerable revenue. However there is proposed reform in light of the UK experience. There is also support for reform in Australia. A report on bank charges by the Consumer Law Centre in Victoria, Australia concluded that consumers, especially low income consumers, were unable to oppose penalty fees on their bank accounts and that regulators should step in to protect them from being punished by their banks.

The much-anticipated OFT test case on bank charges will settle once and for all whether bank charges are unlawful in the United Kingdom. If the result falls in favour of the consumers then consumers should expect banking to become more expensive in the years ahead as banks seek to recoup their losses by charging customers for services that are mostly free at the moment, such as cash machine withdrawals, direct debits or standing orders, which is common practice in some other countries.

In the aftermath of the test case many industries such as the retail warranty industry or payment protection insurance will be hoping the OFT (utilising the UTCCR) does not turn its attention on them.