Thematic mis-selling is a feature of the UK financial services landscape. Past scandals include the misselling of personal pension plans, which is estimated to have cost the industry c£12b in compensation; the systematic mis-selling of payment protection insurance, which is now reported as likely to give rise to c£5b of payouts in redress. The sale of interest rate swaps and hedging products in 2007 and 2008 by a number of major high street banks look set to be the next such scandal. Estimates as to the number of swaps sold vary but may well run into hundreds of thousands. The Bristol Mercantile Court is to hear this year one of the fi rst cases that will analyse the issues surrounding the sale of these products. In this article, I highlight some of the main areas of concern arising from rate swap sales.
The principal targets for the sale of swaps and hedging instruments have proved to be small and medium sized enterprises with reasonably substantial commercial borrowing. At a funding review banks took the opportunity to suggest that if the cost of borrowing were to rise then the borrower may have diffi culty in servicing their repayment obligation. To ‘protect’ the borrower against that risk a swap contract was recommended under which interest rates could be fi xed at an affordable level. So far, so good. Unfortunately, that is pretty much all that was explained. Offered an apparently fi xed rate described as ‘protection’ many SMEs signed up.
A swap is a form of fi nancial derivative – specifi cally a ‘contract for differences’ within Article 85 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001: accordingly, any advice and arranging of the product is regulated and must comply with the Conduct of Business Rules. As interest rates began to fall from 5.75% in July 2007 to 0.5% from March 2009 borrowers began to realize the hidden costs and features of the product they had acquired – and that the swap contract had rarely been sold in a manner compliant with the Conduct of Business Rules. The latter Rules require that in recommending such a product the bank takes reasonable steps to ensure that the decision to trade is suitable for its client (COBS 9.2.1 R (1)) and that it has obtained such information as is necessary to have a reasonable basis for believing that the recommended transaction meets the client’s objectives (COBS 9.2.2 R); further, the bank must explain the risks of the specifi c type of investment being recommended including the risks particular to that type of investment and in suffi cient detail to allow the client to make an informed decision (COBS 14.3.2 R).
Risks routinely not explained in selling these often long dated instruments (many were written for 10, 15 or 20 years) include the following:
- If base rates fall the product would cease to be ‘in the money’ and leave the hedger with a fi nancial obligation to the bank for the term of the hedge;
- Any repayment of the commercial borrowing leaves the financial obligation in place under the hedge for its term;
- Exiting the hedges prematurely may involve a substantial cost which could be unaffordable;
- The bank may be able to terminate the hedges and claim the breakage costs because of an event of default in any event under a ‘cross default’ clause;
- The fi xed rate applies only to f x base rate and leaves the bank free to increase its margin charges;
- There may be ‘over-hedging’ on the basis that (i) the value of the hedge exceeds the commercial borrowing and (ii) if the hedge does not amortise so the degree of ‘over-hedging’ would simply increase with time;
- The contingent liability for the breakage costs may impact on Loan to Value ratios in respect of borrowings and/or make the loan ‘non-transportable’; and
- Often no proper comparison was undertaken with a fixed rate mortgage.
So far the banks have tried to hide behind ‘disclaimers of liability’ and an insistence that the swap was acquired as part of an ‘execution only’ piece of business. These issues will be considered by the Bristol Mercantile Court this year. The judgment should throw welcome light on this area of claim.