Hedges: a financial plague

Many practitioners are unaware that their clients may have toxic financial products hidden in their financial director’s or accountant’s file cabinet. If this cabinet were to be examined, they might see an innocuous “confirmation acknowledgment”, a generic PowerPoint presentation on “interest rate management”, or a bulky “ISDA Master Agreement”, amongst bank statements and facility agreements.

The practitioner would very likely be none the wiser that these documents are the telltale symptoms that their client has been infected with a toxic financial product known as an interest rate hedging product (IRHP). The severity of the financial consequences will depend on which type of IRHP was sold to the client.

What is an IRHP?

The most common type of IRHP is an interest rate swap. It is important to note that the swap is an entirely separate contract from a customer’s borrowing arrangements. A swap operates by the bank and customer entering into a contract to agree to exchange one set of cashflows for another, typically floating and fixed interest payments. The bank invariably agreed to pay the customer the floating variable interest rate (base or LIBOR), and the customer agreed to pay a fixed interest rate and the bank’s commercial loan margin.

Swaps were intended to provide a hedge against movements in interest rates by fixing the customer’s interest payments. The customer effectively “swaps” the uncertainty of a floating interest rate for the certainty of a fixed rate. One could be forgiven for thinking that the IRHP swap sounds perfect for the prudent risk-averse borrower. However, all is not as it seems.

Insurance or gamble?

The banks reassured their customers that the IRHPs were akin to insurance and would protect them from rising interest rates. It is perhaps more accurate to say that the IRHP is a gamble. The customer bets that interest rates will rise and the bank bets that rates will fall. There can be only one winner. If the floating interest rate falls below the customer’s fixed rate, the customer is “out of the money” and must pay the difference between the floating rate and the fixed rate to the bank. Likewise, if the floating rate is the higher, the customer is “in the money” and the bank must pay the difference to the customer.

Unfortunately for many bank customers, following the Lehman Brothers collapse in October 2008, interest rates plummeted and never recovered. The low interest rate environment proved crippling for many businesses, as their payments under the swap increased and they were unable to benefit from the low floating interest rate. Customers who tried to pay off their loan early were told they would need to pay breakage costs; some breakage costs were equivalent to 40% of the underlying loan value and unaffordable.

This left many businesses trapped with toxic financial products whose breakage costs were a contingent liability that might impact on their loan-to-value ratios and make it difficult to refinance with another bank. Some IRHPs are not amortising and the customer was “over-hedged” by the bank, the duration of the swap being greater than the loan so that even when the loan term ended, the customer was left making payments under the separate swap contract. How did it come to pass that so many SMEs gambled on the future interest rate with an inherently unsuitable IRHP?

Undue pressure to hedge

The banks decided that a way of maximising profits would be to sell IRHPs aggressively to SMEs. It was undoubtedly a bit of a “hard sell” to push customers into taking these products, so many relationship managers resorted to more strong-arm tactics to meet their sales targets if their fear-mongering mantra of future high interest rates failed to work. Often, near the conclusion of a new loan agreement or renewal of a loan, the bank would insist on an IRHP being entered into as a condition precedent or subsequent of the loan agreement. SME customers anxious to draw down their loan, reluctant to go through the negotiation process again with another bank and knowing little about the consequences of hedging, agreed to these last minute amendments. For many, this seemingly harmless decision was to prove costly.

The FCA review scheme

The mis-selling of IRHPs hit the headlines in June 2012 when the Financial Services Authority (now Financial Conduct Authority) set up a redress scheme to provide non-sophisticated businesses with compensation if they were deemed to have been mis-sold an IRHP. An independent reviewer is appointed who decides whether the banks have complied with their regulatory obligations imposed by the FCA’s Conduct of Business Rules. SMEs, often referred to as the lifeblood of the UK economy, were the primary victims of this financial plague and it was hoped that the FCA scheme would provide fair and reasonable redress to mis-sold businesses.

Regrettably, the FCA scheme (currently due to complete in May 2014) has been beset by delays, and has been criticised by leaving customers outside the scheme if deemed “sophisticated”. A customer will be deemed sophisticated if they had a turnover of more than £6.5 million when the IRHP was taken out. If the customer is a special purpose vehicle or part of a group of companies, they will be deemed sophisticated if the total value of the swap is more than £10 million. It should also be noted that a customer may be deemed sophisticated by the bank if it can shown that they had the necessary knowledge and experience to understand the IRHP sold to them.

In addition, any customers with a hidden swap loan (an IRHP embedded within a commercial loan), such as a “Tailored Business Loan” from Clydesdale Bank, are also outside the FCA review.

Many customers who do come within the FCA review process have lost confidence in it, due to a one-sided disclosure process, bank-appointed independent reviewers, and no formal appeal procedure should the reviewer refuse to award redress.

It is not all doom and gloom. Some SMEs have persuaded their independent reviewer that the bank breached the FCA’s regulatory rules, and have had their IRHP ripped up, breakage costs waived and interest payments returned. However, it is fair to say there will be a large majority of disgruntled customers who will be left with two rather unalluring redress avenues: a complaint to the Financial Ombudsman Service (FOS) if eligible, or court proceedings if their claim has not time barred and they have sufficient fighting funds or ATE insurance.

FOS route

Customers who have been able to complain to FOS have met with a mixed response, although some notable complaints have been upheld. It should be borne in mind that FOS can award a maximum of £150,000, which for many customers will not cover the losses suffered due to the IRHP. It may also take up to two years to obtain an Ombudsman’s decision, by which time a business may have run out of time and ceased trading. The last resort for a customer is to raise court proceedings against the bank, but recent decisions in Scotland and England do not bode well for such a course.

First blood to the banks

The first mis-selling case before the Court of Session was Grant Estates Ltd v The Royal Bank of Scotland plc [2012] CSOH 133. Grant Estates Ltd, a property company, entered into an IRHP swap agreement with RBS that fixed the interest rate on the company’s borrowings of £777,000. If rates had increased, the swap agreement would have protected the company and saved it thousands of pounds, but unfortunately it was entered into just before a significant fall in rates. The burden of paying the IRHP rates ultimately pushed the company into administration.

However, Grant Estates Ltd’s arguments, which mainly focused on seeking to have limited companies fall within the FSA’s Conduct of Business Rules, were thrown out at an early stage. The outcome was a blow to SMEs, as it closed off the less arduous statutory claim route (via the Financial Services and Markets Act 2000) for limited companies. To rub salt into the wounds, Lord Hodge upheld contractual estoppel, so the bank’s non-reliance/non-advisory small print disclaimers effectively torpedoed the common law routes of negligent advice and misrepresentation.

SME rout in England

In Green & Rowley v The Royal Bank of Scotland plc [2012] EWHC 3661 (QB), a small commercial property partnership took on the bank in Manchester Mercantile Court, arguing that its IRHP swap had been mis-sold by negligent misrepresentation. The judge preferred the evidence of the bank and reached the view that no advice had been given.

Moreover, the judge reached the conclusion that the swap was “entirely suitable” for an SME such as Green & Rowley. Furthermore, the bank’s information on break costs, “that there could be a cost or benefit depending on market conditions [if swap terminated early]”, was sufficient.

The decision was appealed, but this was brought to an abrupt end early on as the Court of Appeal held that since no advice had in fact been given, no duty of care arose.

In short, the bank’s victory was so convincing that there was no need to advance its formidable defence of contractual estoppel – the “small print” argument that no advice was given.

Hope for the borrower?

Until the UK’s SMEs have been cured of their toxic IRHPs, the wider economic recovery is going to take longer than anticipated. It is imperative that the FCA review provides fair and reasonable redress without delay to all those customers mis-sold an IRHP by their bank. It is important that SMEs take legal and financial advice to ensure that regulatory failures by the bank are highlighted and are not overlooked by the independent reviewer.

Many IRHPs were taken out between 2005 and 2009, so SMEs and their advisers should seek to preserve all their claims immediately (by standstill agreement or protective court proceedings) to ensure that their potential IRHP mis-selling claim is not time barred. Despite the unfavourable court decisions, SMEs should not lose heart, as there will be many businesses with more favourable facts, reliable witness evidence and perhaps contemporaneous supporting documentation who will be in a better position to take on the banks in court or negotiate a satisfactory settlement.

The IRHP mis-selling scandal has taken a heavy toll on many businesses, and it can only be hoped that lessons will be learned and SMEs recover fair redress through the FCA review, FOS or the courts so they can once again return to being one of the main drivers of economic growth.