The FSA finally takes action on interest rate swap arrangements
Many years ago I prepared a complaint by a business to the Financial Ombudsman Service (FOS) – which deals with complaints against FSA authorised firms. The complaint arose out of the bank's requirement for the business to enter into an interest rate swap arrangement (IRSA) in support of a loan facility the bank was offering. Interest rates subsequently dropped and the client became liable for increasing large monthly payments. The client questioned whether it had been miss-sold.
The key facts of the case are set out below:
- the requirement to take the interest rate swap was raised at the 11th hour – at which point the client's options were limited as it was too late to find alternative funding
- the customer classification process was not compliant with the bank's own internal procedures and also it was not compliant with the FSA's rules in place at that time
- there was evidence (in the form of emails) which suggested that the bank had in fact provided advice and as such a greater duty of care should have been imposed
- a letter which purported to provide information relating to the maximum exposure was misleading as the total final exposure was 200% greater than the potential maximum exposure which was communicated to the client
- when explaining the product to the client, the bank said it was essentially an insurance product to protect against the possibility of rising interest rates. No explanation was provided in relation to the downside of the product and as such, the client was not aware of the potential risks of the product until interest rates fell and liability under the terms of the IRSA significantly increased
- correspondence from the bank provided misleading information as to the cost of unwinding the arrangement on more than one occasion.
As the business the client was intending to buy, and hence the reason for the loan facility fell through, the loan facility was never used. However, the IRSA remained in place and the client was committed to increasing monthly payments.
Sadly, my tale did not have a happy ending, as the FOS took a strict line when determining the complaint and found against the client. At the time it felt like a huge injustice had been done and I wondered whether other businesses had encountered a similar experience to my client?
Roll the clock on a few years and the spotlight is now being cast on these arrangements brought to the forefront of business news by an investigation by the Sunday Telegraph. As a result of increasing pressure, the FSA undertook a review of the sales of this product to SME's. On Friday 29 June FSA announced that it had reached an agreement with Barclays, HSBC, Lloyds and RBS to provide appropriate redress where mis-selling has occurred which is likely to result in the banks having to pay out significant sums of money in compensation. The FSA reported that it had found serious failings in the sales process and in particular:
- exit costs was not properly disclosed
- there was a failure to ascertain the customer's understanding of risk
- where the sale was non-advised, there was clear evidence that advice had been given
- the amounts and / or the term of the hedging agreement did not match the underlying loan, and
- banks were offering financial incentives for selling the product to customers.
The four banks have agreed to carry out past business reviews of the sales of the interest rate hedging products since December 2001 and pay compensation where it is found that the product was mis-sold. The past business review will focus on the sale of the more complex interest rate hedging agreements to "non-sophisticated" customers. The past business review will be scruntinised by an independent reviewer and overseen by the FSA .
So why has it taken such a long time for the FSA to sit up and take notice of the interest rate swap mis-selling scandal? Apparently the FSA first looked into the issue two years ago and banks were asked to ensure that they had in place tighter controls in relation to the sales of these products. However, nothing appears to have been done about products which had already been sold. It is the historic sales where there is a higher likelihood of mis-selling.
The fact that the entities which were mis-sold were small and medium business enterprises (SME's) is an important factor. SME's were likely to be classified as either Intermediate (under the FSA's old Conduct of Business Rules) or Elective Professional (under the FSA's new Conduct of Business Rules). Accordingly, the banks did not have the same requirements to provide information as it would have done if it were dealing with a retail customer where there would have been an obligation on the bank to explain the risks of the product. However, it is clear that all large proportion of the SME's were not financially experienced and were unlikely to have had an understanding of the hedging product that they entered into and the banks failed to act responsibly in ensuring that adequate information was provided to customers even in circumstances where the sale was non-advised.
Whilst the FSA's current actions are somewhat late in the day – it is good to that perhaps this story will have a happy ending.
What is an IRSA?
An IRSA is a derivative financial product being cash based on the underlying value of interest rates such as LIBOR or the Bank of England base rate. It is a hedging product often used to offset the potential risk of rising interest rates.
Many banks required SME's to enter into an IRSA in support of a loan facility to provide the business with protection from rising interest rates. As such, it was not the businesses decision to hedge the risk of rising interest rates, but more often than not a requirement of the loan. Additionally, the break costs are often a significant proportion of the loan or loan facility and are not easily quantifiable. IRSA's were sold on the basis that they would protect the business in the event that interest rates rose, but no one explained the downside, ie what would happen in the event that interest rates went down.
What should you be looking for?
There are a number of questions that you should ask yourself which will help you understand whether you may have a case:
- Was the IRSA a condition of a loan facility? When was the condition raised – early on in the discussions or at the last minute? Were you a hostage to fortune, ie were you in a position where you had no choice but to enter into the IRSA as it would have been too late to seek alternative funding, and was the bank aware that this was the case?
- Did the term of the IRSA match the term of the loan or did the IRSA last longer? If the IRSA exceeded the term of the loan, was the reason for this explained to you? It is difficult to find any logic in having the term of the hedge longer than the term of the loan.
- Was the amount of the IRSA for the same or a greater amount than the loan you took out? If it is for a greater amount did the bank explain the reason for this?
- What customer classification were you given? Did the bank explain the basis of the customer classification and what the customer classification meant?
- When did you enter into the IRSA? Was it pre or post November 2007? The customer classification process, particularly under the old Conduct of Business Rules (where a customer could be classified as Intermediate on the basis of a financial assessment rather than any experience or understanding) enabled the banks to wriggle out of providing detailed information about the potential risks of the product. If you entered into the arrangement post November 2007 the bank would have had a greater obligation to assess your understanding before being able to categorise you as a professional customer – indeed it is likely that an SME with no relevant experience would be classified as a retail customer – but could have been asked to consider electing up to professional.
- Does the IRSA documentation enable the bank to unwind the arrangement at certain trigger points at no cost, eg where the IRSA becomes particularly disadvantageous due to a significant increase in interest rates?
- Were you informed that you had a right to unwind the arrangement? Were you informed of how the cost of unwinding the arrangement would be calculated?
- Were you advised by the bank to enter into the product? (see below for more information on the relevance of whether you received advice from the bank). The majority of the sales were non-advised and as such the bank will say that it was not the responsibility of the bank to provide information about the associated risks of the product.
- If you were advised, did the bank explain the risks of the product to you? Were you provided with any information / literature which explained the nature and the risks of the product to you?
- Did you have any relevant financial services experience at the point you entered into the IRSA? Did you understand the IRSA and the potential downside risks?
What can you do?
In the first instance you should contact the business directly which sold you the IRSA and make a formal written complaint. The business you are complaining to is required to deal with any complaints it receives in accordance with the FSA's rules.
To be able to make a complaint you will need the following:
- a copy of the customer classification letter detailing the customer classification you were given which should include the reason for the classification
- a copy of any documentation making the IRSA is a condition of a loan or loan facility – this could be in the form of an e mail – preparing a timeline of the discussions / negotiations with the bank will be useful
- a copy of any documentation which indicates the basis upon which the IRSA was sold to you, ie did the bank advise you that it was suitable, or as is most likely, did the bank state that it was a non-advised sale?
- a copy of the IRSA and any associated documentation.
Advised versus non-advised
The difference between an advised and a non-advised sale is the extent to which the bank owed a duty of care at the point the business entered into the arrangement. Where the business has been advised, the bank will need to demonstrate the basis upon which the product has been deemed to be suitable for the client and will need to demonstrate that it has taken the following into account:
a) the knowledge and experience of the client in relation to interest rate swap products
b) the client's financial situation, and
c) the investment objectives of the client
and on the basis of the information obtained the bank is satisfied that the product is suitable.
However, in reality, very few of these types of arrangements are likely to be advised sales. Even where the business believed it was being advised, there is likely to be a clause buried in a document which states that the sale is non-advised and as such, there is no obligation on the bank to assess the customer's understanding of the product and whether it is suitable for their needs.
Once a complaint has been submitted the bank must provide you with a response to the complaint within 56 days (or notify you in that time why it is unable to respond in full). In the event, that the bank rejects your complaint you may have the right to refer the matter to the Financial Ombudsman Service (FOS).
The Financial Ombudsman Service
The FOS is an independent body set up to deal with complaints, amongst other, about FSA authorised firms. It is free to refer a complaint to the FOS and the FOS is designed to be consumer friendly i.e you do not need to employ solicitors to assist you in preparing the complaint. The firm being complained about is required to respond to any requests for information by the FOS and is not permitted to recoup any legal costs in defending a FOS complaint.
To refer a complaint to the FOS the complainant needs to be an eligible claimant within the FSA's Rules. In summary, you must either be:
- an individual, or
- a micro-enterprise.
A micro-enterprise is defined as one which has a turnover or annual balance sheet which does not exceed €2 million and employs fewer than ten employees. Additionally the term enterprise means any person engaged in an economic activity, irrespective of legal form, ie it will include self employed persons, partnerships and associations.
The FOS will consider the complaint and may request further information from you and the business to enable it to make its determination. The FOS is only able to enforce awards of up to £150,000, although it may make higher awards if it considers it appropriate to do so.
However, as a result of the decision by the High Court in Andrews v SBJ Benefit Consultants  EWHC 2875 (Ch) you will precluded from bringing civil proceedings to recover any amounts in excess of the £150,000 FOS limit. Accordingly, the amount that you are seeking is a factor which should be taken into account when determining whether the FOS or the civil route is the best route for you.
The civil route
In the event that:
- the complainant is not an eligible claimant, or
- the FOS has determined the complaint and has rejected it, or
- the FOS has determined the complaint but the amount being claimed exceeds the £150,000 threshold and you have rejected the FOS award,
it may be possible to bring a civil case to try a recover any losses in circumstances where there has been:
- misrepresentation: you may be able to claim misrepresentation if you believe that the bank misrepresented the way the product worked or if the bank can be shown to have failed to disclose material or important facts. You would also need to establish that had all the relevant information been disclosed to you, you would not have entered into the arrangement
- negligent misstatement: this is harder to establish than misrepresentation. Negligent misstatement requires the bank to have made a false statement (whether intentionally or recklessly) of fact upon which you relied in entering into the IRSA
- breach of common law advisory duty: where you were advised by the bank, or possibly where you believed that you were being advised by the bank, and the standard of care owed by the bank fell below a reasonable standard, then you may have a claim for a breach of common law advisory duty.
The basis upon which proceedings could be brought will depend on the individual circumstances of the case. In each case, you would need to establish loss.
Alternatively, S.150 of the Financial Services and Markets Act 2000 (FSMA) enables private persons to bring a claim for breach of statutory duty. Broadly speaking, an entity in the course of carrying on a business is unlikely to qualify as a private person, Under s.150(3) of FSMA the FSA may prescribe breaches of certain rules as actionable by anyone, but the current exceptions are unlikely to be of any use in these circumstances. Additionally, for an action to be successfully brought on this basis it would need to be demonstrated that the bank had breached the Conduct of Business Rules or the New Conduct of Business Rules (COBS), eg relating to customer classification /suitability and appropriateness.
The civil route should not be entertained lightly. Whilst an unfavourable judgement could open the floodgates to billions of pounds' worth of claims, banks are likely to vigorously defend any actions in relation to the miss-selling of IRSA's, at least in the early stages of an action. A number of cases have been commenced against banks, but to date no judgement has not been given on an IRSA case. It is understood that a number of cases have settled on confidential terms; whilst the terms can only be a matter of speculation, it is likely that the confidentiality is at the insistence of banks wishing to resolve claims out of the spotlight of public proceedings.
In the event that you decide to make a complaint to the business and thereafter refer the matter to the FOS you should not need to employ the services of a solicitor.
In the event that you are considering legal action through the courts you should seek legal advice from a solicitor who has experience of this type of product. Some firms may not be able to act for you if they act for the banks. You could also consider contacting one of the action groups e.g the Norton Accord, which may be able to provide assistance with funding the legal costs of civil action.
However, if you have an interest rate hedging agreement with Barclays, HSBC, Lloyds or RBS then you should shortly receive a letter from your bank explaining whether the sale of your interest rate hedging product will be included within the past business review.
- Sophisticated customer’ has been defined as : in the financial year during which the sale was concluded, a customer who met at least two of the following: (i) a turnover of more than £6.5 million; or (ii) a balance sheet total of more than £3.26 million; or (iii) more than 50 employees. Alternatively, the firm is able to demonstrate that, at the time of the sale, 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 of the sale, 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.