The Supreme Court of Mexico is reviewing a controversy, Contradiccion de tesis 2/98 y 11/98, that challenges the enforceability of arrangements under which Mexican banks have imposed charges for interest on unpaid interest. The resolution of this matter will affect the many legal disputes which arose in 1995 after the Mexican peso devaluation and the ensuing spike in interest rates (up to 100%) and could have serious financial consequences for an already troubled banking sector.
The legal question before the Supreme Court turns on the reconciliation of apparently contradictory laws in the Commercial Code, which applies to commercial activities such as loan transactions, and in the Civil Code, which applies to transactions between private parties. A general prohibition on the charging of interest on interest (or anatocismo) exists under both codes. Article 363 of the Commercial Code provides:
"Interest past due and unpaid shall not generate interest. The parties, however, may agree to capitalize the interest."
The Civil Code, however, is more stringent and provides: "Under penalty of nullity of the agreement, the parties may not agree in advance that interest will be capitalized to produce interest on interest."
Since 1992, the banks have used a contractual scheme for mortgage loans under which two loans are provided to the borrower: a primary loan for repayment of the debt, secured by a mortgage; and an additional loan for repayment of unpaid interest due on the primary loan. When the borrower fails to pay interest due under the primary loan, the bank lends funds to the borrower under the additional loan to pay the interest. The economic effect of this structure is to permit the banks to capitalize unpaid interest and to charge interest on that amount. Similar schemes are used for other credits, such as credit card and consumer loans.
The financial effects of this arrangement became ruinous for many mortgage borrowers in 1995 when interest rates and unemployment increased dramatically in the wake of the Mexican peso devaluation, leaving many home-owners with debts that grew to exceed the value of their properties. El Barzon, a debtors' advocacy group, led a movement to sue the banks to invalidate the charges incurred under the additional loans, claiming that this legal structure was an evasion of the legal prohibition of anatocismo.
The controversy before the Supreme Court initially focused on the results of decisions by the lower circuit court in five different cases decided in 1997. In May 1998, the Supreme Court requested all circuit courts to provide it with copies of judgments or notification of pending cases involving similar claims of anatocismo. The federal attorney general's office initially supported the position of the lenders in the proceeding before the Supreme Court. However, as a result of the Supreme Court's request to the circuit courts, it has now received a list of 207 cases in which lower tribunals issued contradictory rulings, and has been requested to present its views by August 1998.
In general, Mexican judicial decisions apply only to the parties involved in the controversy and do not have the controlling status of precedent, familiar to common law jurisdictions. However, because the ruling of the Supreme Court resolves contradictory decisions by the circuit courts, it will be a legally binding precedent (or jurisprudencia) applying to all similar pending controversies. As such, it will have a big impact on the future operations of banks in Mexico.
The lower court decisions in favour of the banks relied on the Commercial Code provisions permitting the parties to agree on the capitalization of interest. They concluded that the additional loan established to guarantee the mortgage was an agreement between the parties for the payment of interest due, when and if necessary, and did not constitute an example of compound interest (or anatocismo). These courts took the view that the Commercial Code only prohibited a loan agreement in which the parties expressly agreed to the charging of interest on interest. The courts emphasized the contractual freedom of the borrower to enter into the two different loan agreements and to prevent the draw-down on the additional loan by making its interest payments on the primary loan in a timely manner.
By contrast, the argument in favour of the borrowers emphasized the economic substance, as opposed to the legal form, of the two loan agreements. The entire purpose of the structure was to permit the charging of interest on unpaid interest due on the primary loan. This interpretation held that the additional loan does not constitute a new loan aimed at the payment of interest due, because no money is delivered to cover the payment of interest. The payments are made by direct transfers by the bank to the bank. The additional loans are documented only in accounting documents and involve no transfer of funds to the debtors. The conclusion of the circuit courts ruling for the borrowers was that the additional loan agreement simply amounted to a legal evasion (or acto simulado) which was illegal and unenforceable.
Although the borrowers are correct that the economic substance of this legal structure is to permit the charging of compound interest, it is also true that Article 363 of the Commercial Code establishes an exception to the general prohibition against anatocismo by permitting the parties to agree on capitalization of interest. Thus, the banks have considerable support in arguing that there is no acto simulado because the two loan agreements serve this purpose.
Although the court's decision will be focused on the settlement of the legal dispute over mortgage loans (estimated at some 800,000 mortgage loans granted by commercial banks), it will have a direct effect on other bank transactions, such as credit card loans. The borrowers are pressing the court for a ban on compound interest, while the banks claim that a decision against them would require a re-structuring of the entire Mexican financial system.
This matter is expected to be decided before the end of this year. Because of the importance of this case, it will be handled by all 11 members of the Supreme Court, and not by the more typical chamber of five judges. The Supreme Court has publicly pledged to make its decision based on a strict legal interpretation of the conflicting circuit court cases, rather than the financial impact on borrowers or lenders.
Curtis, Mallet-Prevost, Colt & Mosle
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