Progress on Interest Rate Swap Mis-selling Claims – the aftermath of Titan Steel Wheels.
Over the past year an increasing number of small and medium size enterprises (SMEs) have been emerging with potential claims for mis-selling against the UK’s four largest banks. At lot of these SMEs believe they were missold highly complex derivatives (often known as “interest rate swaps”) which they purchased in order to protect themselves against the rise in interest rates.
So what are interest rate swaps? Swaps are usually based on term borrowings (facilities which have a definite duration, i.e. not overdrafts) which banks may have asked their commercial and corporate borrowers to “hedge” . Term facilities are often structured to charge a “floating” rate of interest plus a margin – this means interest costs can move as rates go up and down. A “hedge” is a financial instrument which – if used correctly – can provide some level of protection or insurance against adverse movements (e.g. upwards) in interest rates. Hedges or swaps can take a number of different forms:
• Swaps: as their name suggest, they “simply” swap a floating rate of interest for a defined fixed rate of interest – the borrower then knows their interest costs for the duration of the hedge. This clearly benefits the borrower if rates rise; but, conversely, if rates fall, the borrower continues to pay the fixed “hedged” rate.
• Collars: these allow the rate to continue to float but provide upper and lower limits so that the borrower knows that the rate can’t rise above a maximum level but, conversely, if rates fall to the bottom end of the collar, they will not benefit from further interest rate reductions.
• Caps: these allow the interest rate to float as long as it stays below the cap level. If rates rise above the cap level, the borrower only pays the capped interest rate.
Banks will generally charge an additional “credit spread” which represents their own capital cost in providing the hedge to the borrower, plus a profit margin. It is worth noting that the profit margin on these products can be very important to the bank: in some cases, the hedges can be a significant contributor to the total profit on a lending transaction.
The bank’s justification for asking a customer to hedge is that the hedge can reduce the financial risk of the borrower, and in some circumstances and for specific clients interest swap agreements can be useful products. But – and it is a big but - a huge number of swaps were sold to SMEs for whom they were not appropriate. In many cases no consideration was given to the instrument which might be most appropriate to that client; no information was given about the alternative methods by which financial risk could be reduced; nothing was said to the customer about commission which the bank might expect to generate by selling the swap; and no steps were taken to ascertain that the instrument being sold by the bank was appropriate for the customer (all of which are obligations imposed on the banks under the FSA’s Conduct of Business Rules). The majority of these businesses relied entirely on the bank’s “advice”, never thinking to request further information about potential risks and downsides of signing up to such an arrangement, such as huge breakage charges on early cancellation.
While misselling claims have been advanced against banks for the past couple of years, it has not been until about six months ago that the public, via the media, have become aware of the enormity of the potential amount of claims against the big banks. At the start of May the Financial Services Authority (FSA) completed their initial review into allegations that the major banks, including Barclays, Lloyds Banking Group, HSBC and RBS, systematically missold interest rate derivatives to SMEs. The FSA is expected to make their final decision on whether to pursue enforcement action against the banks at the end of June. Several broadsheet newspapers have started to heavily publicise the misselling of interest rates to SMEs and the catastrophic effect that has had on the businesses. Additionally, over 40 MPs from the major parties are currently urging the Treasury Select Committee to hold hearings on the issue. As a result, the public awareness and interest in the banks being found legally accountable for their actions has drastically increased.
The major issue so far for most SMEs who find them in a situation where they think they may have a claim against a bank is funding. While most of these businesses are struggling, the banks have almost endless pockets to fight any claim to the end. However, what may have appeared as a ‘no access to justice’ situation is now improving, as after-the-event (ATE) insurance premiums have fallen and litigation funders, such as Restitution, are willing to back claims with good prospects of success and recovery rates. South of the border there are also several claims funders, Norton Accord notably one of the biggest, prepared to back mis-selling claims.
2 years ago a major organisation (Titan Steel Wheels) took on RBS, arguing that they had been mis-sold two currency swap products. Unfortunately Titan Steel Wheels lost on a number of grounds: Titan was considered by the court to be equally as sophisticated as RBS for the purpose of the transactions and therefore there was an equality of arms; and s150 of the Financial Services and Markets Act 2000 (Rights of Action) Regulations prevents any body other than a “private person” from bringing a claim in respect of any breach of the FSA Conduct of Business Rules.
Several cases since Titan Steel Wheels have attempted to find ways round both of these points but most have settled. As a result, there is at present no precedent which holds a bank liable for the misselling of complicated financial products. Indeed, as the law currently stands, experienced businessmen are not taken to have relied on any advice they have been given by the banks. Instead, those customers are expected to reach a decision based on their own knowledge and experience on whether to sign up to a financial arrangement. While such a position may have made sense fifteen or twenty years ago, it does not appear as appropriate any more. The financial products in question at the moment are so complicated that only a very experienced financial consultant would know what information to look out for and which potential risks to enquire further about. It would appear far fetched to expect a person owning a property development company or a small gift shop, for example, to have sufficient knowledge and understanding of such financial products and arrangements.
However – watch this space: in less than a fortnight the first Scottish case on interest rate swap mis-selling, currently being pursued by Grant Estates against RBS, is due to proceed to a 4 day hearing in the Court of Session. A number of different arguments are being advanced to defeat the s150 argument and it seems likely that both sides are approaching the door of the court with some trepidation. Will the bank run the case exposing itself to the risk of an unfavourable outcome which may just open the floodgates? The answer will become clear on the 29th May.