Interest Rate Hedging Products ("IRHPs")
IRHPs threaten to be the latest in a string of scandals against the major banks. Almost every medium sized property portfolio backed by mortgage finance has now been drawn into the review carried out by the Financial Services Authority ("FSA").
In 2012 the FSA carried out commenced its review and declared that there had been serious failings in the sale of Interest Rate Hedging Products to small businesses. So what is an IRHP?
Interest Rate Hedging Products were sold by the banks as vehicles to protect against the risk of interest rate movements including:
- SWAPS – these enable the customer to fix their interest rate.
- CAPS – these place a limit on any interest rate rises.
- COLLARS – these enable the customer to cap interest rises by limiting rate fluctuations to within a simple range (i.e. a ceiling and floor).
- STRUCTURED COLLARS – these enable the customer to cap interest rate rises to within a range, but involve more complex arrangements if the base rate falls below the floor limit (often very complicated devices where the floor varies subject to a range of conditions).
IRHPs created major problems for property companies. Not only have interest rates fallen dramatically, leaving the customer with artificially high interest rates as a consequence of the SWAPs, the real issue for many property companies is that the effect of the IRHP is often to create an artificially high break/termination fee. Termination fees can often amount to 20% of the capital value of the debt and this has led to a major obstacle in redeeming the subject loans. Property companies are often based on the ability to re-sell property on the open market. Termination fees and consequentially 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 break.
In 2012 the FSA produced a pilot report highlighting the sale of IRHPs inappropriately to non-sophisticated customers. The sales practices outlined by the FSA included:
- Poor disclosure of termination fees.
- Failure to ascertain the customers understanding of risk.
- Non-advice sales straying into advice.
- "Over Hedging", i.e. where the amounts and/or duration did not match the underlying loans.
- Rewards and incentives being a driver of these practices.
As a consequence of this the majority of the major banks including Barclays, HSBC, Lloyds, RBS and Clysdale have been directed to automatically provide fair and reasonable redress to non-sophisticated customers who were sold structured collars. In addition to this, banks have been directed to review the sales of all other Interest Rate Hedging Products to non-sophisticated customers to determine whether redress is due.
The FSA direction is primarily aimed at non-sophisticated customers. Initially the test for a non sophisticated customer was based on the test for a small company under Section 382 of the Companies Act 2006. Under this test a customer was deemed to be nonsophisticated if the customer did NOT meet two of the following points:
- Turnover of more than £6.5 million or
- A balance sheet total valuation of more than £3.26 million or
- More than fifty employees.
There was a saving provision for the banks in that a customer could be deemed sophisticated if the bank was able to demonstrate that at the time of the sale and irrespective of the size of the business, the customer had the necessary experience and knowledge to understand the service to be provided for the type of product or transaction envisaged.
In 2012 the FSA ordered Barclays, HSBC, Lloyds and RBS/Nat West to carry out an initial pilot review of sales of IRHPs to small businesses. The results of this pilot were published in December 2012 and further directions given by the FSA in January 2013.
One of the findings was that the "sophistication test" should be changed so that if a customer failed both the balance sheet and the employee numbers test, it could still be classed as non-sophisticated. This was designed to assist businesses such as farmers and bed and breakfast owners who might have large balance sheet valuations (due to owning property) whilst also having a large seasonal workforce. It was thought that some farming businesses and small hotels/bed and breakfasts, despite failing these two tests could be classified as non-sophisticated. The intention was to bring those businesses into the scheme.
However, the test was also amended so that subsidiaries of large group companies were to be excluded from the review.
The pilot findings stated that:
"customers who meet (only) the balance sheet and employee number criteria are included in the review where the total value of their live interest rate hedging products is equal to or less than £10 million".
At first glance this suggested that the new £10 million limit only applied where the customer exceeded the balance sheet and employee number criteria. Notwithstanding this stated intention this caused confusion which the FSA tried to resolve through the production of a flow chart. Unfortunately the flow chart states that if a customer has an aggregate notional IRHP value of greater than £10 million, it will automatically be classified as sophisticated (regardless of the other tests).
It is of course open to any small or medium sized business to argue that (in actual fact) it has no understanding or sophistication in relation to this kind of bank lending and is therefore justifiably entitled to redress.
On this basis the banks have been directed to assess whether the FSA's Conduct of Business Source Book has been complied with in relation to the subject sales. The FSA have not provided a precise test to illustrate what would constitute a compliant or non-compliant sale. However the FSA have stated that for sales within the review they would expect that:
- The bank provided the customer with appropriate comprehensible, fair, clear and not misleading information on the features, benefits and risks associated with the Interest Rate Hedging Product in good time for the sale.
- If the Interest Rate Hedging Product exceeds the term or value of any lending arrangements the potential consequences should have been disclosed to the customer in a comprehensible fair, clear and not misleading way.
- In relation to an "advise sale", 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 put customers back in the position they would have been in had the breach of the regulatory requirements not occurred.
The FSA have set out various potential outcomes including:
- Full redress – if it reasonable to conclude that had the sale complied with the regulatory requirements, the customer would not have bought any Interest Rate Hedging Product, redress would 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 interest rate hedging product – then redress would 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 still 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.
The banks have now been directed to consider redress every non-sophisticated customer on this basis. However other options are available.
Financial Ombudsman and Court Action in Relation to IRHPs
Redress through the FSA does not necessarily require the assistance of solicitors. However in many cases the banks have been resistant to accepting certain customers on the basis of non-sophistication. In those cases the customer can still actively complain through the FSA and through the Financial Ombudsman. The maximum binding money aware that the Ombudsman can make is £150000 (providing the complaint was made after 31 December 2011) Customers are also deciding whether or not to bring action through the Courts. Most of the interest rate hedging products 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 interest rate hedging product is six years, then there would be great difficulty in bringing a case which falls outside this time period (therefore many of the interest rate hedging products sold before the end of 2006 might now be time barred). It should be noted these time limits do not affect the FSA review and redress scheme.
The Court option does not appear to be an easy route for any customer 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 has not been mis-sold or mis-represented. In addition to this, the Court held that a breach of the rules contained within the FSA's Conduct of Business Source Book were not actionable by a company through the Courts. The only remedy for a company was with the FSA 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 Interest Rate Hedging Products with LIBOR rigging. It is possible that this case will reverse the fortunes of those complaining about IRHPs through the Courts.
The Court route obviously poses significant difficulties. It is hardly surprising that all the emphasis has therefore been on the FSA programme. The banks have been given a period of six months to make their first determination and we should be seeing the results of that review by the summer.
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.
