Banks face conflict of interest

Banks are being short-changed when it comes to their interests by a system that favours lowest fees

Charles Kerrigan

With financial institutions scaling back their legal panels in the news, attention is being turned to how the work will be done.

Once law firms have a place on a bank panel there remains the question of the link between the work they do for banks and how they are paid for this.

After a transaction, firms should be prepared to ask bank clients what they think they have bought for the price paid, and should feel confident that they will get a quick answer related to bank’s interests. This is starting to happen more openly, but the subject still deserves careful attention.

The general principle of debt finance work is that the legal fees of the firm acting for the bank are paid by the borrower. The borrower therefore covers two sets of lawyers’ fees: its own and the bank’s. Naturally, borrowers will consider this a significant additional cost to their debt and be rightly keen to keep fees down.

Usually, when a bank has a new piece of debt finance on which it wishes to instruct external counsel, it will liaise with its borrower, identify three firms on the bank’s panel that are acceptable to the borrower, ask each of them for an estimate of their fees and share these with the borrower. The borrower then directs the bank to instruct the firm with the lowest estimate, the rationale being to keep fees as low as possible.

It is interesting to consider, however, whether this is a rational choice from the bank’s perspective. If it is considered that, broadly, in agreeing a fee with a firm, the bank is purchasing an amount of time to be spent by that firm in protecting the bank’s interests, then it seems perverse that the bank allows the borrower to direct it to instruct the firm putting forward the lowest quote. If you assume that you get what you pay for, this is an odd result indeed for the bank because the firm providing the lowest quote may be preparing to spend the least amount of time acting for the bank’s interests.

A debt finance transaction involves the production and negotiation of documents and management of the process to get to signing with conditions precedent satisfied. But there is also a less visible element to it, which involves legal analysis, risk assessment and provision of advice to the bank. Banks should incentivise firms to concentrate on those less visible, but often more valuable, parts of the process.

Law firms will bear in mind that in debt finance, freedom of contract prevails and valid loan and security documentation is easily achieved. Besides, market practice on documentation is relatively well-settled. Banks are confronted with two significant issues of their own. Mature businesses are facing unprecedented challenges and changes. Many new businesses are being established and the point at which they may be able to raise debt is more open to question than previously. In this context, law firms and banks should ensure that an appropriate portion of their transaction budgets are applied to a thorough joint investigation of which businesses may take on secured or unsecured debt and how they should do so.