by Stevie Loughrey
"Interest Rate Swap Scandal"
The misselling of interest rate hedging products, particularly swaps, collars and enhanced collars, by high street banks to individuals and small and medium sized enterprises has become big news in recent months and led to many media commentators labelling it the latest financial misselling scandal. The Telegraph in particular has done a commendable job in bringing a previously niche issue to wider public attention.
It is estimated that tens of thousands of these complex derivative products have been sold by high street banks to individuals and small and medium size limited companies, mainly in the period 2005 to 2008. The purpose of the products was to provide interest rate protection for the customer, but the focus during the sales process was on what would happen if rates went up and little if any attention was given to what would happen if rates went down. Equally, the banks almost never provided their customers with any indication as to the likely magnitude of termination fees if they wished to exit the product early.
As interest rates have tumbled to their current historic lows of 0.5%, many businesses and individuals who purchased these products have been left facing crippling monthly repayments and exorbitant costs to extricate themselves from the products.
This has led to a slew of complaints with many of those complaints now finding their way into the High Court. The common thread of the misselling claims is that the bank told the customer all about the benefits but neglected to explain properly the potential dangers. Indeed in many cases the bank made the purchase of a hedging instrument a condition of new or continued lending, therefore the customer had little or no choice but to enter into the product.
Interest rate hedging products are forms of "derivatives"; financial products that are derived from some other underlying asset. Rather than the underlying asset being traded there is an exchange of cash over an agreed period based on the underlying asset. So, for instance, interest rate swaps are contracts to exchange cash based on the underlying value of interest rates which may be aligned to Bank of England base rate or LIBOR. The hedging instrument is usually entirely separate to the underlying loan and the rate paid by the customer under the hedging agreement is in addition to the lending margin under the loan.
Under a standard "swap" agreement, the customer exchanges a variable rate of interest for a fixed rate of interest - say, for example, base rate plus lending margin, for 5.5% plus lending margin.
The "collar" is a mixture of a maximum rate (a cap) and a minimum rate (a floor). By way of example, a cap may be agreed at 6% and a floor at 4%. The customer will pay the prevailing rate (plus margin) if base rate sits between the permitted range. If it sits below the floor rate, the customer pays 4% plus margin.
An "enhanced collar" is a version of the collar but with a "digital floor" or "knock-in rate", set below the floor. Let's assume the same scenario as above, namely a cap at 6% and a floor at 4%. The knock-in rate may be set at 3%. Under such an agreement if base rate sits below the knock-in rate, the customer pays the difference between base and the floor plus the floor rate, up to a maximum of 6%. So, if the current base rate was 2.5%, the customer would pay the bank 5.5% i.e. 4% plus 1.5%. This is in addition to lending margin.
The above examples are only broad categories of interest rate hedging products, there are many variations within these groups, for example there are callable products which give the bank the right to terminate at a fixed point and monthly/quarterly thereafter. These are particularly iniquitous as when the prevailing rate works against the bank it has the right to terminate, thus depriving the customer of the protection they thought they had purchased. There are also extendable products, where the bank has the right to increase the length of the agreement after a fixed period of time. If the current rate and yield curve are in the bank's favour, it is of course likely to extend. If it is not, it will terminate.
Although it is standard that interest rate products are calculated on a "notional principal", the concept is not always fully understood and can lead to disputes. A basic example of how the notional principal works is that a customer borrows £5m for 5 years with the notional principal of the hedge fixed at £5m for the same period. This means that if the customer repays, say, £2.5m, the notional principal of the hedging product still remains at £5m and so the interest rate product continues to be calculated on this amount for the remainder of the five years. This can cause particular problems for customers who repay loans early (for instance, a house builder that is contractually obliged to pay the proceeds of each house sale to the bank as sales take place).
Products such as those referred to immediately above, where the notional principal remains the same throughout the duration of the product, are known as "bullet" products. There are other products which include an amortisation schedule, where the notional principal decreases throughout the duration of the product. These products can also lead to disputes where the amortisation schedule is not properly aligned with the underlying debt.
The majority of the complaints we are handling centre around the following issues:
- The customer did not understand the product it was sold. Often the customer did not appreciate that the hedging product was entirely separate to the underlying loan and did not understand the lending margin was additional to the hedge rate. Further, they did not understand, because it was not explained to them, what would happen if rates fell to the levels they are currently at. Most of the graphs provided in the sales pitch presentation documents the banks used, do not show interest rates below 3.5%, hence creating the impression that it was inconceivable that rates would fall below that level. This is despite the fact that in other developed countries such as the U.S. and Japan, rates had fallen much lower than that (in Japan they had been 0.1% for many years).
- The customer was not aware of the magnitude of the break cost (this is common to every complaint we have seen). If a hedging product is broken before the end of its term then a substantial break cost may be payable. This is known as the "mark to market" figure - that is the market value (reflecting in part the value the product might have had to the bank if it had not been broken.) The banks often say that it was not possible to provide customers with indicative breakage costs prior to entering into the products. However, we now know from having consulted various financial experts (many of them ex investment bankers with experience of selling derivatives) that with the modelling software the banks had at their disposal it would have taken the salesperson a matter of minutes to provide the customer with indicative termination costs if the customer wished to terminate at say the 5 year point of a 10 year hedge and rates were say 2%, 5% or 10% at that point.
- The customer was not aware of the implications of the bank's ability to terminate the hedging product, if it was a callable product. These products are designed to greatly favour the bank. A typical scenario may be a swap for 10 years with the right for the bank to end it at the end of the fifth year and then at quarterly intervals after that. In effect, the customer is selling options to the bank. The attraction to the bank is that if the swap begins to work against it (e.g. when interest rates are rising) it can simply terminate the swap without having to pay any compensation to the customer. So, the bank has it both ways - putting it simply, if interest rates fall the customer pays; if the rates go up the bank can end the swap.
- The FSA Conduct of Business Rules have not been complied with (of which more below).
What do the FSA Rules say
The FSA requires that banks provide full and clear information to their customers before undertaking investment type business. This must include guidance on the risks associated with different investment strategies and full disclosure of all the costs and charges.
- A firm must provide appropriate information in a comprehensible form to a Client about:
(a) the firm and its services;
(b) designated investments and proposed investment strategies; including appropriate guidance on and warnings of the risks associated with investments in those designated investments or in respect of particular investment strategies;
(c) execution venues; and
(d) costs and associated charges; so that the Client is reasonably able to understand the nature and risks of the service and of the specific type of designated investment that is being offered and, consequently, to take investment decisions on an informed basis.
- That information may be provided in a standardised format.
- This rule applies in relation to MiFID or equivalent third country business.
- The requirement to provide information about designated investments and proposed investment strategies also applies to a firm in relation to designated investment business other than MiFID or equivalent third country business carried on for a retail Client in relation to a derivative, a warrant or stock lending activity.
Banks are required to ensure that the information they provide to their customers in presentation documents etc is 'clear, fair and not misleading':
- A firm must ensure that a communication or a financial promotion is fair, clear and not misleading.
- This rule applies in relation to:
- (a) a communication by the firm to a client in relation to designated investment business other than a third party prospectus;
(b) a financial promotion communicated by the firm that is not:
(i) an excluded communication;
(ii) a non-retail communication;
(iii) a third party prospectus; and
(c) a financial promotion approved by the firm.
Similarly, banks must ensure that the benefits and risks are equally shown to their customers:
A firm must ensure that information:
- includes the name of the firm;
- is accurate and in particular does not emphasise any potential benefits of relevant business or a relevant investment without also giving a fair and prominent indication of any relevant risks;
- is sufficient for, and presented in a way that is likely to be understood by, the average member of the group to whom it is directed, or by whom it is likely to be received; and
- does not disguise, diminish or obscure important items, statements or warnings.
Banks have a duty to provide a clear description of the risks of the products, especially to Private / Retail Clients:
A firm must provide a client with a general description of the nature and risks of designated investments, taking into account, in particular, the client's categorisation as a retail client or a professional client. That description must:
- explain the nature of the specific type of designated investment concerned, as well as the risks particular to that specific type of designated investment, in sufficient detail to enable the client to take investment decisions on an informed basis; and
- include, where relevant to the specific type of designated investment concerned and the status and level of knowledge of the client, the following elements:
(a) the risks associated with that type of designated investment including an explanation of leverage and its effects and the risk of losing the entire investment;
(b) the volatility of the price of designated investments and any limitations on the available market for such investments;
(c) the fact that an investor might assume, as a result of transactions in such designated investments, financial commitments and other additional obligations, including contingent liabilities, additional to the cost of acquiring the designated investments designated investments; and
(d) any margin requirements or similar obligations, applicable to designated investments of that type.
If a bank is in the position of recommending the interest rate product (i.e. 'advice' rather than 'execution'), then it has to comply with the suitability obligation of COBS 9 requiring it to take reasonable steps to ensure that any recommendation given was suitable for the customer.
- A firm must take reasonable steps to ensure that a personal recommendation, or a decision to trade, is suitable for its Client.
- When making the personal recommendation or managing his investments, the firm must obtain the necessary information regarding the Client's:
(a) knowledge and experience in the investment field relevant to the specific type of designated investment or service;
(b) financial situation; and
(c) investment objectives;
so as to enable the firm to make the recommendation, or take the decision, which is suitable for him.
- A firm must obtain from the Client such information as is necessary for the firm to understand the essential facts about him and have a reasonable basis for believing, giving due consideration to the nature and extent of the service provided, that the specific transaction to be recommended, or entered into in the course of managing:
(a) meets his investment objectives;
(b) is such that he is able financially to bear any related investment risks consistent with his investment objectives; and
(c) is such that he has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of his portfolio.
- The information regarding the investment objectives of a Client must include, where relevant, information on the length of time for which he wishes to hold the investment, his preferences regarding risk taking, his risk profile, and the purposes of the investment.
- The information regarding the financial situation of a Client must include, where relevant, information on the source and extent of his regular income, his assets, including liquid assets, investments and real property, and his regular financial commitments.
This is a relatively new and untested area of the law - there has not yet been a single reported judgment in this jurisdiction regarding the sale of an interest rate swap to an individual or a small or medium sized enterprise - mainly because the banks continue to settle these cases outside of court with confidentiality agreements attached.
By way of over-view the legal position is as follows. Section 150 of the Financial Services and Markets Act provides:
- "Actions for damages
(1) A contravention by an authorised person of a rule is actionable at the suit of a private person who suffers loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty.
(6) "Private person" has such meaning as may be prescribed."
The FSMA (Rights of Action) Regulations define "private person" as follows:
- "3. - (1) In these Regulations, "private person" means -
(a) any individual, unless he suffers the loss in question in the course of carrying on -
(i)any regulated activity; or
(ii)any activity which would be a regulated activity apart from any exclusion made by article 72 of the Regulated Activities Order (overseas persons); and
(b) any person who is not an individual, unless he suffers the loss in question in the course of carrying on business of any kind; but does not include a government, a local authority (in the United Kingdom or elsewhere) or an international organisation."
The consequence of the above is that individuals can bring a statutory claim against the banks, however, under current law, companies find it more difficult to do so because of the underlined section above and the interpretation of this wording by David Steele J in Titan Steel Wheels Limited v Royal Bank of Scotland  EWHC 211. There is a strong school of thought that this case was decided on specific facts and is distinguishable from the vast majority of cases we have seen, where there is nothing in the history of the company's prior dealings to suggest that the hedging transaction was entered into "in the course of business" i.e. it was not part of their normal trading. Indeed, in the vast majority of cases we have seen the company has had no prior experience of hedging products.
If the bank acted as an adviser then it usually has higher duties to the customer (including possible fiduciary obligations). Whilst in practice banks often advise customers when selling interest rate products, if a dispute arises, the bank will commonly deny this and will seek to rely on exclusion of liability clauses. Banks are keen to avoid the potential tortious and contractual liability which can follow from the relationship of adviser.
In nearly every case we have seen the customer has been very clear they considered the bank's salesperson was providing them with what they believe to have been advice. In addition, we and they contend that the giving of advice is to be inferred from the evolution of the products on offer in the various presentation documents and emails sent to the customer. Normally the bank begins by setting out 3 or 4 options, which are whittled down in a process of selection carried out by the bank. We contend this constitutes recommendation by the bank, not least because in the vast majority of cases we have seen the customer themselves did not possess sufficient knowledge or expertise to be able to make such choices.
The typical response by the banks is that their customer, the intended claimant, is precluded from bringing a claim because of the waivers and disclaimers included in the hedge confirmation letters. It is important to note that these terms were first seen by the customers after the oral contract was entered into (the trades take place over the telephone on a recorded line because it is a live market). We contend that the bank should not be able to rely on terms which were first brought to the attention of the customer after the bank says it entered a valid and legally binding oral contract. In most of the cases we have seen, we consider there are grounds for contending that the banks owed their customers contractual and fiduciary duties not to mislead or provide inappropriate or incomplete information at the point of the transaction.
Irrespective of the statutory right of action, we consider that common law duties provide an alternative right of action for negligence and breach of fiduciary duty if the Court were to be satisfied that the bank acted as an advisor.
What can you do if you consider you have been missold one of these products
Carter-Ruck has been pursuing complaints for bank customers who have been missold these products for some time now and is acknowledged to be a leader in this area. We are currently conducting a large number of these claims and are receiving a huge volume of new case enquiries on a daily basis. Unlike many larger commercial litigation firms in the City, we only act against banks. Therefore we do not suffer from the conflict problems which prevent other firms from accepting instructions against banks.
It is important to realise that there is a six year limitation period in respect of claims for negligent financial advice. This ordinarily runs from the date the hedge was entered into i.e. the trade date, however there may be earlier trigger events which bring the limitation date forward. As the majority of the sales took place in the period 2005 - 2008, if you consider you have been missold one of these products, you ought to seek legal advice without delay.
If instructed, we will do whatever we can to try and resolve the issue without recourse to legal proceedings. We will seek waiver of the termination fee plus reimbursement of the monies the customer has paid towards the product (less the cost of what they would have paid had they not entered into the product), plus any consequential losses which can properly be attributed to the misselling of the product.
If the bank refuses to put forward sensible settlement options pre-action and we advise it to be in the customer's best interests to issue proceedings, we are prepared, in appropriate cases, to accept instructions on a full or partial Conditional Fee Agreement i.e. (a "No Win, No Fee" agreement). Given that many of the individuals and businesses consulting us have been brought to their knees trying to service the cost of the product they entered into, it is often a great comfort to know that if they do have to fight the case in court they have the ability to see it through to conclusion and are able to pursue the case on an equal footing to the bank. In such circumstances, we have delegated authority from one of the leading After the Event insurance providers, Temple Legal Protection Ltd, to provide our clients with insurance cover in respect of the bank's costs. Again, this offers great comfort to clients in that if the claim proves to be unsuccessful, there is cover in place to meet the bank's legal costs.