By Patrick Selley, Financial Services Disputes Specialist, Keystone Law
The mis-selling of interest rate caps, swaps and collars to SMEs hit the headlines recently, and the leading banks have found themselves under the spotlight of the Financial Services Authority as it considers a full-scale investigation into the alleged mis-selling of complex financial packages.
Most businesses borrow at rates offered by their bank, which will typically be at a floating rate based on LIBOR (London Inter-Bank Offer Rate) plus a margin for the bank. Interest rate volatility can have a dramatic impact on financing costs and cash flow for business borrowers. The most common tools used to minimise exposure to interest rate fluctuations are swaps, caps and collars. These derivative products represent a highly specialised area of financial services requiring considerable understanding.
The problem is that the products banks offer to borrowers to reduce their exposure to interest rate fluctuations can themselves have hidden risks and costs which are at least as damaging to a borrower as the interest rate fluctuations they were designed to guard against. It is estimated that tens of thousands of these derivative products have been sold, mainly between 2005 and 2008. However, as interest rates have fallen to historic lows in the last few years borrowers can find themselves tied in to unsuitable products by the extortionate and unexpected costs involved in moving to a more appropriate product.
Types of derivative product
There are three main types of derivative product:
Base rate cap
This sets a ceiling on the borrower's interest rate costs. When the floating rate is above the cap rate, the bank agrees to pay the difference between the floating rate and the agreed cap rate. In return, the borrower pays the bank a premium which can be upfront or in instalments.
Base rate swap
This allows a borrower to convert a floating rate loan into a fixed rate debt. If the floating rate is higher than the agreed rate on the 'roll-over' date, the bank pays the borrower the difference. If the floating rate is lower than the agreed rate then the borrower pays the bank the difference.
Base rate collar
This is a combination of a cap and a minimum interest rate or 'floor'. The borrower limits exposure while benefitting from favourable rate movements within an agreed range.
These products offer savvy borrowers a valuable facility which can save them money and allows them to fix financing costs. However, these products are very lucrative for the banks which sell them and questions have been raised as to alleged mis-selling. Some typical concerns are as follows, where:
- the borrower did not understand what was being sold and the bank's promotional literature highlighted only the benefits of the product;
- the borrower never wanted to buy the product but it was made a condition of a loan or of continuation of a loan;
- the very substantial break costs were never explained;
- the bank was able to terminate the contract if rates moved against the bank; or
- the borrower did not understand that the product, and the need to continue paying for it, would continue even if the accompanying loan was paid off.
Mis-selling is essentially a breach of duty owed by the entity (typically a bank) selling the product to the purchaser (usually the borrower). It is often, if not invariably, characterised by the failure to inform fully or to mis-describe the attributes of a financial product resulting in the sale of a product that is unsuitable for the needs of the borrower. With sophisticated and complex products such as interest rate derivatives, it is easy to understand how the affected business can believe that it has been mis-sold a particular product.
The first thing to do is to make a complaint to your bank.
In light of the recent FSA review, your bank may provide you with satisfactory compensation particularly if your bank is Lloyds, HSBC, Barclays, RBS or NatWest. These banks have agreed to initiate their own internal review of their sales practices and to proactively compensate customers where mis-selling has occurred.
Lloyds, HSBC, Barclays, RBS and NatWest have agreed that they will:
- provide redress to non-sophisticated customers to whom they have sold structured collars after September 2001;
- review the sales of other hedge products (except caps and structured collars) to non-sophisticated customers after September 2001; and
- review the sale of caps if a complaint is made by a non-sophisticated customer during the review.
In this context “sophisticated customer” means, in the financial year during which the sale was concluded, a customer which is a company meeting at least two of the following criteria:
1. having a turnover of more than £6.5 million; or
2. having a balance sheet total of more than £3.26 million; or
3. having more than 50 employees.
Alternatively, a customer is sophisticated where the bank is able to demonstrate that, at the time of the sale of the relevant product, the customer had the necessary experience and knowledge to understand the service to be provided and the type of product or transaction envisaged, including their complexity and the risks involved.
It has been widely reported that the banks have allocated substantial sums to be used to settle deserving claims arising from this internal review and otherwise. It is somewhat unlikely that the banks would make this provision if they did not intend to use it and so one can, on this basis, assume that affected businesses will be offered payouts.
While it remains to be seen how ready banks will be to settle claims voluntarily, it would not seem unreasonable to assume that there will be a certain amount of reticence amongst banks to settle the larger claims.
It should be noted that the banks have agreed that they will not foreclose on any loans where there is an outstanding complaint or where their internal review has identified unresolved potential mis-selling.
Right of appeal
Customers who are not satisfied with the banks’ response will have a right to bring a claim through the relevant independent government appointed ombudsman, the Financial Ombudsman Service (FOS). Banks are regulated by the FSA and in particular must comply with the FSA's Conduct of Business Rules (COBs). COB 9 requires the seller of a financial product to have obtained sufficient information from the purchaser of that product so as to ensure recommendation of only a product that is suitable for that customer's needs. Also the seller must assess the expertise, experience and knowledge of the customer to establish that it was capable of making an informed decision and that it did in fact understand the risks involved. The customer must also be capable of bearing the risks should those risks materialise.
If a complaint is brought before the FOS and the customer can show that the seller failed to comply with the relevant rules, then the Ombudsman will make an award.
Problems facing customers with substantial claims
However, there are two major problems with the ability of the FOS to provide effective and universal redress.
First, access to the FOS is not universal. The FOS was designed mainly for members of the public and not corporate customers. The FOS is open to micro-enterprises, namely businesses having a turnover or an annual balance sheet not exceeding €2 million and employing fewer than ten persons, but of course, and by definition, that serves to exclude the customers who are likely to have suffered the greatest loss as a result of mis-selling.
Second, the maximum award the FOS can make is capped at £150,000.
It therefore seems inevitable that a significant number of dissatisfied customers will need to go to the expense of instructing lawyers who specialise in financial services litigation in order to win the compensation they are due through the courts.
Claims can be brought in the courts where damages are likely to be greater than £150,000 or where the claimant is not a micro-enterprise. Claims can be founded on a breach of the relevant laws and in particular the two set out below. Court action is quite separate from an application to the FOS and it is possible to apply to the courts if a customer is not satisfied with the decision of the FOS.
Section 150 Financial Services and Markets Act (FSMA)
This allows individuals and sole traders (defined in the FSMA as "private persons") to claim for loss suffered as a result of contravention of the applicable COB (see re COB 9 above) in the courts. The action is essentially an action for breach of statutory duty.
Breach of duty to advise
If the borrower is not a 'private person', and accordingly section 150 FSMA does not provide a remedy, then a remedy will be available through the courts, if it can be established that the conduct of the bank constituted a breach of its contractual duty or its general duty of care to advise the customer, or if it can be established that the bank made an incorrect representation about the product to the detriment of the customer.
The essential issues in most such claims are
- did the bank have a duty to advise the borrower?; and
- do the terms of the contract between the bank and the borrower lawfully exclude liability?
If a bank can be said to have acted as an adviser, then it will have much higher duties to a business than if it did not. Invariably banks will say that the nature of the relationship between the bank and its customer was such that no duty to advise arose and that it was an 'execution only' relationship. Each case will be determined on its facts and the primary method of establishing the nature of the relationship will be to look at and to interpret the contract between the parties. Other factors, such as the size and sophistication of the business or whether it had the chance to enter into a similar contract with other banks but without similarly onerous terms, will be relevant but are unlikely to displace a very clearly worded contract.
Exclusion clauses are one of the most fought over and written about areas of contract law. The courts and Parliament do apply certain limits on the use of exclusion clauses and further rules as to their interpretation, for example that, in the event of ambiguity, they are construed against the party seeking to rely on them (i.e. the bank). The limits that apply to exclusion clauses are specific rather than general and the role of the borrower's lawyer is to persuade the court that one or more limits should govern the exclusion clause in question and as such it should not be given legal effect.
If you think you have been mis-sold a swap the first thing to do is to find all the relevant documentation. This will include correspondence and emails with the bank at the time, and before, the swap was put in place. The second thing to do is to complain to the bank which sold the swap.
Where a customer is not happy with the bank’s response then the customer will have to take further action. To the extent the FOS is able to assist then the customer should apply to the FOS. Applying to the FOS is a simple process and full details are available on its website, www.financial-ombudsman.org.uk.
If in doubt as to what to do next, and where the FOS cannot help or did not help, the customers will need expert advice from solicitors specialising in resolving disputes between banks and their customers to give them the best chance of avoiding the costs and restrictions involved with unsuitable financial products.