A pilot study by the Financial Services Authority (FSA), which concluded last June, found that over 90% of the sales of interest rate hedging products (IRHP) sold to small to medium sized businesses were non-compliant. The FSA has now reached agreement with the banks to begin work on reviewing their sales of IRHPs and provide redress where due. Under the regulator’s principles of redress banks ‘should aim to put customers back in the position they would have been in, had the breach of regulatory requirements not occurred’. In addition to the cost of the IRHP, some customers may be entitled to consequential losses (for example, overdraft charges or additional borrowing costs), so it is important that businesses consider the full extent of their losses before making a claim.
What is an Interest Rate Hedging Product?
If properly sold, IRHPs can protect bank customers against the risk of interest rate movements. Products range in complexity from simple ‘caps’ that fix an upper limit to the interest rate on the loan to more complex derivatives such as ‘structured collars’ which, in addition to fixing interest rates within a band, also introduce a degree of interest rate speculation.
However, in recent years interest rates have fallen to record levels leaving many businesses paying excessive levels of interest on their loans or facing expensive fees to get out of the deals.
The FSA Review
Last June, the FSA announced that it had found serious failings by banks in the sale of IRHP to small and medium sized businesses.
The FSA identified 4 categories of IRHP which they consider were mis-sold by banks:
- Swaps; which enable customers to ‘fix’ their interest rate;
- Caps; which place a limit on any interest rate rises;
- Collars; which enable customers to limit interest rate fluctuations to within a simple range;
- Structured collars; which enable customers to limit interest rate fluctuations to within a specified range, but involve arrangements where, if the reference interest rate falls below the bottom of the range, the interest rate payable by the customer may increase above the bottom of the range.
The FSA found that complex IRHPs were sold to non-sophisticated customers and that banks engaged in a range of poor sales practices, including:
- Poor disclosure of exit or break costs;
- Failure to ascertain customers understanding of risk;
- Non advised sales straying into advice;
- “Over-hedging”, ie. where the amounts and/or duration did not match the underlying loans); and
- Rewards and incentives being a driver of these practices.
In relation to the exit costs, the FSA found that in a high proportion of cases the customer was not given sufficient information to understand what the exit costs would be. In some instances, the exit costs exceeded 40% of the value of the underlying loan.
The FSA recently reached agreement with 11 banks to review their sales of approximately 40,000 IRHPs sold on or after 1 December 2001. It expects the banks to complete their reviews within 6 months, although some banks will be given up to 12 months.
The basis for assessing sales of IRHPs
The FSA requires the banks and the independent reviewers to determine whether:
- the customer was ‘non-sophisticated’ or ‘sophisticated’;
- the sale of the IRHP complied with the FSA’s regulatory requirements; and
- it is appropriate for the customer to receive any redress and, if so, what redress would be fair and reasonable.
The sophistication test
The FSA review focused on the sale of IRHPs to “non-sophisticated” customers on the basis that these customers would be unlikely to have possessed the specific expertise to understand the products and associated risks. The FSA has created a test to enable banks to differentiate between sophisticated and non-sophisticated businesses (“the sophistication test”).
Under the FSA’s original sophistication test, a customer was deemed to be sophisticated, and therefore not eligible for redress, if at the time of the sale the customer had at least two of the following:
- A turnover of more than £6.5m;
- A balance sheet total of more than £3.6m;
- More than 50 employees.
However, and notwithstanding that a customer may be deemed to be non-sophisticated in terms of the test, a customer could also be deemed to be sophisticated if the bank is able to demonstrate that, at the time of the sale, the customer had the necessary experience and knowledge to understand the product, including its complexity and the risks involved.
The FSA has since controversially sought to amend the customer sophistication test, although it should be noted though that the second element of the original test (the experience and knowledge of the customer) has not changed. The FSA have produced a flow chart at www.fsa.gov.uk/static/pubs/other/irs-flowchart-2013.pdf which sets out the reformulated sophistication test.
Specifically, the FSA has amended the way in which the 3 criteria referred to above are applied to the different types of businesses so as to ensure that subsidiaries of large groups and special purpose vehicles are excluded. In addition, customers who meet only the balance sheet and employee numbers criteria are included in the review where the total value of their live interest rate hedging product is equal to or less than £10m.
The upshot of the amended sophistication test is that customers that took out IRHPs with a value of more than £10m will lose out on the chance to claim compensation as they will be deemed by the banks to be sophisticated.
Assessing compliance with regulatory requirements
The banks will need to establish whether it is reasonable to conclude that the customer could have understood the features and risks of the product. The FSA has not provided a precise test of what constitutes a compliant or a non-compliant sale that can be applied in the same way in every case.
The FSA already has in place rules governing the sale of IRHPs to non-sophisticated customers, based on these rules, they would expect:
- The bank to have provided the customer with appropriate, comprehensible and fair, clear and not misleading information on the features, benefits and risks associated with the IRHP in good time before the sale;
- If the IRHP exceeds the term or value of any lending arrangements, the potential consequences should have been disclosed to the customer in a comprehensible and fair, clear and not misleading way;
- In relation to an advised sale: (a) The bank has obtained sufficient personal and financial information about the customer, including the customer’s investment objectives, level of education, profession or former profession and relevant past experience of IRHPs, and (b) The bank took reasonable steps to ensure that the personal recommendation was suitable for the customer.
All non-compliant sales to non-sophisticated customers will be considered for redress, with the aim of putting the customer back in the position that it would have been had the breach of the statutory regulations not occurred.
The FSA consider that there are 3 potential outcomes for non-compliant sales:
- Full redress – Exit from the IRHP at no charge and a refund of all payments, including, where appropriate, any break costs previously paid.
- Alternative products being provided to customers and/or a different profile (e.g. amount, duration or structure of IRHP). A refund of any difference in payments between the alternative product and the product actually purchased, including, where appropriate, the difference in any break costs previously paid.
- No redress – if it is reasonable to conclude that, had the sale complied with the regulatory requirements, the customer would still have bought the same product, or the customer suffered no loss.
Some customers may also be entitled to consequential losses, being additional losses suffered over and above the normal losses covered by the breaches of the statutory regulations. These may include, for example, overdraft charges or additional borrowing costs. In order to successfully claim such losses the customer will need to show that they were caused by the breaches and were reasonably foreseeable.
What if my company is in financial difficulty, administration or is dissolved?
The FSA report specifically states that customers must continue to meet their contractual obligations in relation to the products. However, the banks have agreed to prioritise cases where customers are in financial difficulties. In certain instances, the banks may suspend payments for customers in financial distress.
Companies in administration may also qualify for review. In these circumstances, the banks will contact the administrators of the company. Similarly, if a company has been dissolved, it may still be eligible for a review. However, before any redress can be paid by the bank, an application will have to be made to the Court to restore the company to the Companies House register.
The basis for reviewing sales and any potential redress is complicated, in particular given the absence of a precise ‘complaint sale’ test that can be universally applied. Therefore we urge businesses who think they may be affected to seek independent professional advice.