UK: Swaps, Caps & Collars - The Redress Experience

Last Updated: 24 July 2013
Article by Peter Levaggi and Joe Edwards

Bank customers that were mis-sold 'swaps' and related products are finally starting to receive compensation.

Interest rate hedging products ("IRHPs")

IRHPs threatened to be the latest in a line of scandals against banks. The Financial Conduct Authority ("FCA") (the Financial Services Authority ("FSA") as it then was) carried out a review into the sale of IRHPs and found serious failings in the sale of many products to small businesses.

IRHPs are products that were sold to protect against interest rate movements. A variety of products were sold to purportedly protect customers including caps to limit interest rate rises, swaps to enable a customer to fix their interest rate, collars to place a cap on interest rate rises to within a range (i.e. a ceiling and a floor) and the complicated structured collars which are similar to a collar but include complex arrangements if the base rate falls below the floor limit.

IRHPs have created a raft of problems for property companies. A great number of products were sold without the bank explaining the risks and fees associated. As interest rates have fallen drastically in recent years, many companies and individuals were forced to pay much higher interest rates because of the IRHP than under the underlying loans. Some IRHPs required the customer to pay hundreds of thousands more than they would have been paying in interest payments if no product had been taken out. In certain situations, the customer has had to enter into insolvent administration due to the payments under the IRHP.

Many customers were unaware of, and often not properly informed about, the termination fees. IRHPs usually provide complex methods for calculating termination fees, which many customers were unable to decipher. These termination fees can be extremely high, and sometimes well into seven figures. Termination fees and consequently high redemption figures have led to a transactional paralysis with property owners being unable to sell, as they are unable to afford the cost of terminating the product and redeeming their commercial mortgage.

The review of IRHP's

In 2012, the FCA produced a pilot report highlighting the sale of IRHPs inappropriately to "non-sophisticated customers". These sales practices included, amongst others, poor disclosure of termination fees, failure to ascertain the customers understanding of risk and "over-hedging" where the amount and duration of the IRHP did not match the underlying loan.

As a consequence, the majority of major banks, including Barclays, HSBC, Lloyds, RBS and Clydesdale have been directed to automatically provide fair and reasonable redress to "non-sophisticated customers" who were sold structured collars. Banks have also been directed to review the sales of other IRHPs to "non-sophisticated customers" to determine whether redress is due.

Eligibility for the review

The review is aimed at products that were entered into on or after 1 December 2001.

The review is aimed at "non-sophisticated customers", and the initial test for such customer was based on the test of a small company under Section 382 of the Companies Act 2006. Under this test a customer was deemed to be "non-sophisticated" if the customer did NOT meet two of the following points:

  • turnover of more than £6.5 million;
  • a balance sheet total valuation of more than £3.26 million; or
  • more than 50 employees.

In addition, customers who meet only the balance sheet and employee number criteria are included in the review where the total value of their live IRHPs is equal to or less than £10 million. This provision is to ensure certain types of customer are included in the review, such as farmers and bed and breakfast owners who have large balance sheet valuations and also a high seasonal work force.

A point of confusion which has arisen is whether the £10 million limit only applies where the customer exceeded both the balance sheet and employee number, or whether the £10 million cap on the aggregate notional IRHP value applies to all case (regardless of the other tests). A satisfactory response to this point has not yet been provided by the FCA.

If a customer is deemed sophisticated by the process it is often worth challenging this determination. The concepts of "sophistication" and "mis-selling" ultimately depend on the facts of the particular case.

The banks fact finding meetings

Many customers who bought IRHPs have now been contacted by the bank to explain that they can opt in to the review. The Customers are asked to attend a fact finding meeting with the bank.

The banks promote these meetings as a way of discussing the product in a friendly and open manner, with a view to ascertaining whether it was likely to have been mis-sold. However, the experience of these fact finding meetings is very different.

The intention of the banks is to reduce their liability and they will often have legally trained representatives in attendance. Therefore, customers need to exercise extreme care in answering questions which are posed to them by the bank. Amongst other things, the banks are looking to structure the meetings in such a way as to detrimentally impact the customer's case by, for example, casting doubt over the customer's recollection of events or proving that the customer's previous banking habits mean that they would purchase the IRHP as a way to avoid fluctuating interest rates, notwithstanding how it was sold.

We strongly suggest that customers prepare a detailed submission to the bank before the fact finding meeting. This will ensure that relevant information is provided to the bank. Also, submissions improve clarity and consistency of arguments which will result in a greater likelihood of any claim by the customer against the bank succeeding. Further, to ensure the customer's interests are protected in these meetings, given the bank's agenda to reduce liability to the fullest extent, we advise having an experienced professional adviser attend these meetings.

Factors the bank will look at as to whether the IRHP was mis-sold

The factors the bank will look at as to whether the IRHP was mis-sold include, amongst others, whether the bank provided the customer with appropriate comprehensible, fair, clear and not misleading information on the features, benefits and risks associated with the IRHP in good time before the sale.

The bank will also look at whether the IRHP exceeds the term or value of any lending arrangements, and if so, whether the potential consequences that were disclosed to the customer were comprehensible, fair, clear and not misleading in any way. Further, in relation to an advised sale, whether the bank has obtained sufficient personal financial information about the customer and that the bank has taken steps to ensure that the personal recommendation is suitable for the customer.

On this basis, the banks are required to consider whether it is reasonable to conclude that the customer could have understood the features and risks of the product. If the bank has failed in relation to these guidelines, then it has an obligation to provide redress, the aim of which is to put the customers back in the position they would have been in had the breach of the regulatory requirement(s) not occurred.

The FCA has set out various potential outcomes for customers including:

  • Full redress - if it is reasonable to conclude that had the sale complied with the regulatory requirements, the customer would not have bought any IRHP, redress will be the exit from the product at no charge and a refund of all payments paid.
  • Alternative product including a different product and/or a different profile - if it is reasonable to conclude that, had the sale complied with the regulatory requirements, the customer would have purchased a different IRHP, then redress will be the alternative product and the refund of any difference in payments paid.
  • No redress - if it is reasonable to conclude that had the sale complied with the regulatory requirements the customer would have bought the same product or the customer suffered no loss.

It should also be possible to recover foreseeable consequential losses which flowed from any mis-selling activities. There are established legal principles in respect of consequential losses.

Other action against the banks, notwithstanding the redress scheme

Notwithstanding the provisions of the redress system, customers who either do not come within the ambit of the review or who have failed to achieve the outcome they expected from the review, have a number of options. These can include, where applicable, raising a complaint through the Financial Ombudsman. The maximum compensation that the Ombudsman can make is £150,000 (providing the complaint was made after 31 December 2011).

Customers also have the ability to bring action through the Courts. Most IRHPs sold are subject to a limitation period of six years (although we are involved with a number of cases which have longer limitation periods). If limitation on a particular IRHP is six years, then there would be great difficulty in bringing a case which falls outside this time period. Therefore, many of the IRHPs sold before the end of 2006 might now be time barred. It should be noted that these time limits do not affect the FCA review and redress Scheme.

Relevant cases before the courts

The Court option does not appear to be an easy route as there is no automatic system of compensation. Each customer will have to show on the facts of their particular case that the product was mis-sold. The first notable case was Grant Estates Limited v Royal Bank of Scotland [2012].

Grant Estates Limited ("GEL") were property developers. In 2007, RBS offered funding on the condition that the bank was satisfied with GEL's interest rate hedging arrangements. The directors of GEL were adamant that RBS had forced them into this decision. However, there were a number of discussions between the bank and the directors about the issue and the product was selected and put in place. Interest rates then fell sharply and GEL was required to pay a far higher interest rate because of the product and were unable to fund the termination fee. The directors argued that as a direct consequence of this the company went into administration in 2011. The directors claimed that GEL would not have defaulted on its obligations if it had not been the subject of the product. The contractual documentation between GEL and RBS contained clauses explaining that RBS was not providing advice and that GEL was making its own decisions on its own account. The directors also claimed that there had been a breach of the FSA's Conduct of Business Source Book.

The Court rejected the directors' arguments. The product had not been mis-sold or misrepresented. In addition to this, the Court held that a breach of the rules contained within the FSA's Conduct of Business Source Book was not actionable by a company through the Courts. The only remedy for a company was with the FSA (now FCA) on this basis. Two individuals brought a similar case in Green and Rowley v RBS [2012]. Once again the Court decided that there had not been mis-selling (and in this personal case that the FSA's Conduct of Business Source Book had not been breached). There is a further case which looks like it will be tried in October 2013 (Guardian Care Homes v Barclays). This case will bring together the complaint of mis-selling of IRHPs with LIBOR rigging. It is possible that this case will reverse the fortunes of those complaining about IRHPs through the Courts.

In addition to these cases, there has been another case before the Courts which is of relevance to litigation in relation to IRHPs. This is the case of Rubenstein v HSBC [2012]. The background to this case is that Mr & Mrs Rubenstein sold their matrimonial home and Mr Rubenstein took HSBC's advice as to where the sale proceeds should be deposited. A financial adviser employed by HSBC recommended that the money be put into an AIG Premier Access Bond and selected a certain fund available within the bond. Mr Rubenstein had concerns as to how secure this might be and sent an e-mail to the adviser requesting details of the risks associated with the product. The adviser replied that this investment carries the same risk as cash deposited in one of HSBC's accounts. In actual fact the fund was not a cash fund at all, but was a money market fund which contained a risk. This fund had closed after a run on it in 2008. This caused significant loss to Mr Rubenstein.

The Court of Appeal found that the adviser had been negligent and in breach of the FSA's Conduct of Business rules by recommending an unsuitable product to Mr Rubenstein. In addition, it was found that the adviser had misled Mr Rubenstein by telling him that the investment was the same as a cash deposit. The Court held that it was the bank's duty to protect it's customer from exposure to market forces when the customer made it clear that he wanted an investment which was without risk. The bank failed to explain the nature of the risk appropriately to Mr Rubenstein and therefore he was awarded damages of over £110,000 plus costs.

This case, whilst not specifically in relation to IRHPs, shows that the banks do have a duty to explain risk in an appropriate manner and action can be taken against banks if there has been a breach of this obligation. However, the Court route obviously poses significant difficulties. It is hardly surprising that all the emphasis has therefore been on the FSA (now FCA) programme.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Joe Edwards
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