Posted on Feb 06, 2013 by | 0 Comments
When a new television show is tried out on the public it is called a pilot so the Financial Services Authority (FSA) thought since the banks are about to launch a review scheme of mis-selling of swaps to thousands of SMEs, it would be prudent to do a pilot too.
The FSA issued an eagerly awaited press release, paper, and flowchart last week on the findings of their pilot review scheme. The ‘pilot’ was a small sample of the more complex cases from each bank with the goal of ensuring that the banks’ approach to reviewing the sales of interest rate swaps are consistent and will deliver a fair and reasonable outcome.
THE GOOD NEWS
The FSA found that over 90% of the sales to ‘non-sophisticated’ customers in their pilot did not comply with one or more regulatory requirements (i.e. the COBS Rules found in the FSA Handbook). Moreover, the FSA is of the view that a significant proportion of these sales are likely to result in redress being due to the customer.
Many people who are not at the ‘coalface’ in the interest rate swap mis-selling scandal will find the high number of regulatory failures in this pilot remarkable but it is unsurprising to us as the banks have not complied with FSA regulations in almost every case we have seen so far.
INDEPENDENT REVIEWER’S DECISION WILL PREVAIL
The role of the independent reviewer is of vital importance to ensure customers receive fair and reasonable redress. This was borne out in the pilot where the FSA saw evidence of the independent reviewers challenging the banks’ decisions both on whether sales complied with regulatory requirements and on redress.
This will be heartening to hear for many customers who rightly were concerned that the bank appointed independent reviewers may simply go through the motions allowing the banks’ to largely decide whether they had complied with the FSA regulations and if the redress offered was fair and reasonable. It remains to be seen whether the independent reviewers will maintain their gusto for challenging the banks’ decisions once the full review is underway.
However an independent reviewer’s role will be especially critical in the assessment of the difficult judgement calls which will need to be made as to what a customer would have done if the bank had complied with the regulatory requirements to determine what amounts to fair and reasonable redress.
HAVE YOUR SAY
The FSA is encouraging customers to provide their recollection of the sales process and any written material that they consider relevant to the review of the sale. Clearly it should be of great assistance to the customer to give their version of events to clarify evidence held on file, support contemporaneous meeting notes, put an email in context and give a more detailed account of a call or meeting.
The FSA give reassuring examples of how a customer’s input can prove decisive, when taken with other evidence, that mis-selling occurred. However the bank will get an opportunity to ask the customer to clarify issues that may be unclear from their file.
It is not clear the manner in which these questions will be asked; if a customer is ‘grilled’ by the bank then they may say something which may then be taken out of context by the bank and used against the customer.
THE SOPHISTICATION TEST – WHAT’S CHANGED?
This element of the review has already been analysed by Liana Park in “FSA Pilot Findings – Are you sophisticated?” so this blog post intends to only skim the surface but in essence the FSA have tweaked their original test which means some businesses previously excluded now fall within the review and vice-versa.
The original sophistication test was that a customer was deemed sophisticated if they had at least two of the following:
* A turnover of more than £6.5 m; or
* A balance sheet total of more than £3.26m; or
* More than 50 employees.
The changes are:
* if a business ticks both the balance sheet and employee elements above (previously sophisticated and outside review) but not the turnover then it will be non-sophisticated and fall within the review. What’s the catch? The catch is that the total value of the live swaps must be no more than £10 million.
* If a business is part of a group, for example Apple Ltd is part of Fruit Group Ltd, then previously Apple Ltd would have fallen within the review as it didn’t tick two of the above elements but now because Fruit Group Ltd is sophisticated (as ticks two or more elements) then Apple Ltd is deemed to be sophisticated too.
*If a busineSs is a Special Purpose Vehicle (SPV) and it is connected to a group structure of companies deemed sophisticated under the test (albeit not formally part of the group) with a total live swap value above £10 million; for example, a director of the SPV is the director in the group companies then it will be deemed to be sophisticated so long as the total live swap value is above £10 million.
It should also be remembered that any business which survives the sophistication test may yet be deemed sophisticated by the banks’ “catch-all” test which is if the relevant bank can show that the customer had the necessary experience and knowledge to understand the service to be provided and the type of product envisaged including its complexity and the risks involved.
It should be stressed the 10 million total live swap value threshold is only in relevant to:
* customers who tick the balance sheet & employee number elements.
* SPV customers.
All non-sophisticated customers with one element of the test (or none) who are not an SPV will have no need to concern themselves with the £10 million threshold device.
ASSESSMENT OF REGULATORY BREACHES
Whether an interest rate swap was mis-sold is plainly fact-sensitive and this is confirmed by the FSA who confirm that ‘a case-by-case assessment’ of all relevant evidence is necessary. As a result there is no “one size fits all” test that will determine whether a sale of a swap complied or did not comply with the regulatory requirements.
The FSA give examples of what they would expect banks to do pre-sale. One example given is that the bank will provide the customer with appropriate, comprehensible, fair and clear information which is not misleading. Moreover the information would include the features, benefits, and risks associated with the swap in good time before the sale.
The customers were not aware of the magnitude of the break costs (it should be noted that this is common to every customer that has approached us). These costs arise when a swap is terminated early before the termination date. The FSA noted in their Pilot Paper that the scale of any break costs is uncertain as it depends on market conditions.
However a salesperson could have used modelling software to give customers an indicative figure which would have made them aware of the potential size of the break cost.
Many of our clients were of the view that break costs would be similar to the modest fees that apply to fixed rate mortgages rather than the eye-watering break costs that result from swaps. The FSA saw one example of break costs exceeding 40% of the value of the customer’s underlying loan.
It seems to us from the FSA Pilot Paper that the banks are only too aware that in almost every case they did not provide (in good time before the sale) customers with appropriate, comprehensible and fair, clear and not misleading disclosure of any potential break costs.
So how will the bank overcome this hurdle? We think the banks will focus their efforts on showing that customers did not need to know the break costs as they understood the features and risks of the product. It goes without saying that the factual position in each case will be critical.
It is encouraging that the FSA say all ‘non-compliant’ sales will be considered for redress. Of course that does not mean automatic redress; it simply means that it must be taken into account and that the banks cannot ignore redress when making their decision.
Redress must be fair and reasonable. This would suggest that the redress must be objectively fair in the particular circumstances of each case. Whether redress is fair and reasonable may well turn out to be one of the most hotly contested battlegrounds between customers and banks in the Review Scheme.
The Scheme follows the approach taken in law which is that the Pursuer (or Claimant in England) is entitled to recover compensation which will put him or her back in the position in which he or she would have been in if the Defenders (Defendants in England) had fulfilled their obligations.
THREE POTENTIAL OUTCOMES
There are three potential outcomes for customers:
(1) If it is reasonable to conclude that, had the sale of the swap complied with the regulatory requirements, the customer would not have purchased the swap then:
FULL REDRESS – Exit from the swap at no charge, refund of all payments and any break costs previously paid.
(2) If it is reasonable to conclude that, had the sale complied with the regulatory requirements, the customer would have purchased a different swap:
ALTERNATIVE PRODUCT – An alternative swap product (which will be simple e.g. a cap, vanilla swap etc), refund of any difference in payments between the alternative product and the product actually purchased including any difference in break costs where appropriate (i.e. difference between 7.5% of the swap value and the break costs of original swap product).
(3) If it is reasonable to conclude that, had the sale complied with the regulatory requirements, the customer would still have bought the same swap or suffered no loss:
NO REDRESS – no redress is offered whatsoever, not even for inconvenience or distress.
THE CAUSATION HURDLE
A striking statement from the FSA is that “redress will not be owed to the customer in all cases where the sale did not comply with the regulatory requirements”.
What the FSA is emphasising here is that the usual rules of causation apply so that the loss suffered by the customer must be caused by the bank’s breach of contract. While it may seem unfair to a customer that a bank can breach the regulations and get off with it, in reality, if a customer were to sue the bank in a Court then the same causation rules would apply.
An example of a breach (specifically of FSA Guidance) which may not have affected the sale is where the bank did not disclose to the customer the commission they would receive on the sales transaction (COBS – 5.7.4 G(2)). The customer may very well have still proceeded to purchase the swap even if the commission had been revealed.
In the Review, the customer receives no compensation whatsoever which does seem unduly harsh when a Court would generally speaking award at least nominal compensation for inconvenience and trouble arising from a breach of contract.
A grey area is what will happen to cases where the customer was told that taking out a swap was a condition of the loan. This may be a significant issue in relation to the causation hurdle which could adversely affect customers.
We are aware of many clients who have suffered additional losses over and above the normal losses arising from the swap (such as swap payments and breakage costs). These additional losses are called consequential losses which as the FSA say will include overdraft charges and additional borrowing costs.
The banks have agreed to use the established legal approach to determine consequential losses. This will mean that customers will need to prove:
(1) that the breach caused the loss.
(2) that the loss was reasonably foreseeable at the time of the breach of the regulatory requirements. A lay person may find it helpful to consider ‘reasonably foreseeable’ to mean ‘serious possibility’ or ‘on the cards’.
KNOWLEDGE IS KEY
A critical factor in deciding whether a loss is foreseeable is the actual or presumed knowledge of the bank at the time it breached the regulatory requirements. The bank will know certain things about the customer, and some facts which are not known, it ought to have known.
The specific circumstances of each case at the time of the breach should assist in showing what the bank should be presumed to know and then whether the losses that are being sought are reasonably foreseeable.
OTHER REDRESS OPTIONS
The FSA Pilot Paper makes clear that those customers eligible to make a complaint to the Financial Ombudsman Service may do so if dissatisfied with the FSA Review decision. Customers with fewer than 10 employees and a turnover of less than £2 million Euros will therefore be able to lodge a complaint with FOS before, during or after the Review (assuming wrong occurred within 6 years).
The other option is to pursue the banks through the Courts but customers need to be extremely vigilant on timebar issues. If the swap sales discussions and swap trade were more than 6 years ago in England & Wales and 5 years in Scotland then the action may be time-barred (there are limited exceptions).
Scottish swap victims should be aware that they may be able to pursue an action in England depending upon the terms of the swap documentation (often the swap documentation stated English law and English Courts).
If your claim has not time-barred then it would be prudent to raise an action and then put it to sleep to preserve your legal right to pursue the bank in Court. If your FSA Review decision is disappointing, you may still be able to reasonable redress by settlement of a claim in Court as the bank will have to take into account the merits, litigation risk etc when making a settlement offer to you.
TAILORED BUSINESS LOANS
A notable omission from the FSA Review Process is the issue of Tailored Business Loans (TBL). The likely reason why the pilot paper did not mention TBLs is because Clydesdale Bank and Yorkshire Bank were the banks that mainly sold them to SMEs (and they were not the banks which the initial pilot was reviewing).
TBLs are essentially interest rate swaps embedded in loans whereby the bank entered into a swap with a third party and linked it to specific customer loans. Although these products have been excluded by the FSA Review Scheme, we have yet to hear a compelling reason why they should be excluded.
TBLs were, like stand-alone swaps, not properly explained in many instances so that the customers had no understanding of the risks they were taking and the onerous breakage costs they may need to pay to exit the TBLs. We note that widely respected derivative experts agree with our view on this issue and we hope the FSA will reconsider its position soon.
MBM Commercial's Dispute Resolution Partner, Cat MacLean, has been asked for her initial thoughts on the FSA Pilot Paper by the Herald newspaper.
The link to the newspaper article is set out below:
Do you have any queries about the FSA Pilot Scheme? Do you think you are eligible for the FSA Review Scheme but don’t know where to start?
If so, MBM Commercial LLP may be able to assist you. For more information, please contact Neil Morrison a Senior Solicitor in the Financial & Banking Disputes team, on 0131 226 8200 or firstname.lastname@example.org