Consulting case studies

EXECUTIVE SUMMARY The range of derivatives known collectively as ‘interest rate swaps’ have proved to be highly effective weapons in the armoury of corporate treasurers in combating the business threat posed by significant hikes in interest rates. It was, therefore, inevitable that this type of increasingly common derivative should also become available for smaller enterprises seeking to similarly mitigate interest rate risk. Few corporate treasurers, if any, anticipated the recent prolonged period of extremely low base rates in the UK although they would have been aware of the repercussions for swaps in terms of penalty charges in such an eventuality. Sadly, it appears from a new FSA review that many small businesses in the UK may not have been informed at the outset of the counterparty risks. A swap must, of course, have seemed the ideal low cost solution for both bank and client fearing a return of the high interest rates of the latter part of the twentieth century. It does, however, highlight the need to consider all possible outcomes during an advice process for the sale of a regulated product. The FSA believes 40,000 interest rate swaps could have been mis-sold to small businesses since the end of 2001. The scale of the problem is a major issue for UK banks as they will face significant claims for compensation even before the dust on PPI has settled. In regulatory terms, swaps are CFDs (Contracts for Difference) and bank personnel were obliged to have conducted a full KYC process, ensured suitability, provided a clear, fair and not misleading explanation of the product and raised the potential risks. A current court case is focusing on customer awareness of the ‘breakage costs’ and the disclosure information that the FSA/FCA believes should have been provided by the bank. Interest rate swaps, like many guaranteed investment products, have a legitimate place in the marketplace but their limitations have been dramatically exposed by the unusual conditions existing in the UK economy. The UK banks are currently undertaking case by case reviews as a priority to establish the facts. The FCA will, undoubtedly, vigorously pursue the companies and executive wrong-doers responsible for any widespread customer detriment. The clear message to all financial organisations is to fully review their current product range and to test the effectiveness of their advice and sales processes on the appropriate target audience. HOW INTEREST RATE SWAPS WORK The term ‘interest rate swap’ is used for several types of products used by businesses with outstanding bank loans to reduce their exposure to rising interest rates. In essence, a bank customer who purchases a swap buys a contract that pays them money if interest rates go up from a fixed point. This will, of course, offset the higher interest costs on their loan. However, if rates go down they will be required to pay money to the bank although there will be lower interest charges on their loan. The overall effect should be to fix the interest rate for the customer. A ‘collar’ is a product that limits the range within which the interest rate on a loan can move. Normally, the benefits of such an arrangement are obvious; alas, interest rates have fallen to historic lows in the wake of the 2008 banking crisis (from 5.25% in February 2008 falling to 0.5% in March 2009) resulting in purchasers of such products facing unexpected costs for a prolonged period. Many businesses that purchased interest rate swaps have been left facing high monthly repayments or breakage costs to terminate the contract. The FSA/FCA believes that many smaller businesses did not fully understand the risks associated with such derivatives. TYPES OF INTEREST RATE SWAPS Plain vanilla: The simplest and most common swap is a ‘plain vanilla’ interest rate swap. This involves an exchange of payment obligations by two parties in which the customer “swaps” the obligation to pay a variable rate of interest with a receiver. The latter takes on the variable interest obligation and agrees that the customer should pay a fixed amount of interest over a specified period of time. With a typical bank customer example, there are two contracts with one for the loan facility and another for the swap. These contracts are completely separate to each other. Compensation is paid if interest rates fall below an agreed fixed rate. Bank network staff will deal with the loan facility whilst the swap will be handled by the bank’s investment or treasury department. Cap and Collar agreements: This is another common type of swap. The agreement provides for a maximum rate (cap rate) and a minimum rate (collar rate). This enables the customer to cap interest rate rises by limiting rate fluctuations to within a simple range. Structured collars enable a customer to cap interest rate rises by limiting rate fluctuations to within a range (with a lower ceiling than a simple collar) but involves more complex arrangements if base rate falls below the floor limit. ‘Enhanced collars’ work in the same way but with additional restrictions and cost implications. Cap and Double Floor agreements: These are similar to cap and collar agreements but an interest rate cap with double floor allows the customer to pay a maximum and minimum rate. Please note if interest rates fall below the floor rate, the customer must pay the floor rate and is also penalised for this decrease (eg if the floor rate was 6% and UK base rate was 5.25%, the customer must pay an extra 0.75% plus a further 0.75% under the double floor = 6.75%). BACKGROUND & RECENT HISTORY The FSA originally highlighted ‘serious failings’ in the sale of interest rate swaps to small business customers in June 2012. ‘We found that when properly sold, in the right circumstances to the right customers, these products can protect customers against the risk of interest rate changes. However, when sold to ‘non-sophisticated’ customers, likely to be smaller business which wouldn’t necessarily have specific expertise and understanding in this area, some products may not have been appropriate for their needs.’ The review identified: • Poor disclosure of exit costs • Failure to ascertain the customers’ understanding of risk • Non-advised sales straying into advice • “Over-hedging” (the amounts and/or duration did not match the underlying loans; and • Rewards and incentives being a driver of these practices In a pilot, the FSA has looked at 173 sales to ‘non-sophisticated’ customers and found that over 90% did not comply with one or more regulatory requirements. A report called ‘Interest Rate Hedging Products Pilot Findings’ was published in March 2013 (see  http://www.fsa.gov.uk/pubs/other/interest-rate-swaps-2013.pdf ). Barclays, HSBC, Lloyds and RBS have subsequently agreed to conduct a past business review and proactive redress exercise in relation to their sales of Interest Rate Hedging Products (IRHPs) to ‘non-sophisticated’ customers on or after 1 December 2001. The banks agreed to: • Automatically provide fair and reasonable redress to non-sophisticated customers who were sold structured collars • Review the sales of other IRHPs (except caps or structured collars) to non-sophisticated customers to determine whether redress is due • Review the sale of caps to non-sophisticated customers to determine whether redress is due if a complaint is made by the customer during the review. Under the FSA’s original sophistication test, a customer was deemed to be sophisticated if at least two of the following applied at the time of sale:  – Turnover of £6.5m+ – Balance sheet total of £3.26m+ – 50+ employees This has now been amended to help ensure that customers who meet only the balance sheet and employee number criteria are included in the review where the total value of their ‘live’ IRHPs is £10m or under. The FSA has commented that the pilot demonstrated the value of independent reviewers in ensuring the outcomes for customers are fair and reasonable. In July 2012, it was announced that Santander, Allied Irish Bank, Bank of Ireland, the Co-operative Bank and Clydesdale & Yorkshire banks would also start the process of compensating small businesses. In addition, the FSA stated: ‘some of the more complex products, particularly structured collars, speculate on interest rates and can result in customers paying more if the interest base rate falls below an agreed level. It, therefore, requires a finely balanced judgment on the part of the customer’. It has accordingly been agreed by Barclays, HSBC, Lloyds and RBS that they will stop marketing ‘structured collars’. The FSA expects all case reviews to be completed by March 2014 and banks should prioritise cases where customers are in financial difficulty. The scale and impact of this latest mis-selling scandal cannot be underestimated especially as PPI abuses are still fresh in everyone’s memory and refunds continue. The FSA states that 40,000 interest rate swaps could have been mis-sold to small businesses since the end of 2001. Barclays announced in February 2013 that it had in total sold some 4,000 interest rate swaps of which it expected around 3,000 to be subject to mis-selling claims. The bank increased its mis-selling provisions to £850M. Santander has now allocated a provision of £232M relating to Alliance and Leicester small business customers whilst RBS has already allocated £50M. It is clear that the new FCA will focus on interest rate swaps and penalise any offenders. UK REGULATORY RULES Interest rate protection products or ‘swaps’ are financial derivatives. In terms of UK regulation, they are CFDs (Contracts for Differences) falling within Part III Specified Investments article 85 of FSMA (Financial Services and Markets Act 2000 (Regulated Activities) Order 2001). Most importantly, those advising on CFDs have a duty to comply with the statutory rules at the time of the transaction and must conduct ‘Know your Customer’ requirements, provide a `clear, fair and not misleading` explanation of the product, take reasonable steps to ensure that the client understands the product and potential risks, and ensure the product is suitable for the client/customer. Many legal firms believe that interest swaps have been sold by banks as a condition of a business loan. Such bundling is, of course, unlawful when sold with a regulated product. Many complaints have stated that the bank official in highlighting the benefits failed to provide the customer with a `clear, fair and not misleading` explanation of the risks associated with the products. It is important to stress that entering into a transaction which does not prove beneficial does not, of itself, give rise to mis-selling and/or a claim for damages. Such an outcome can only be decided on a case by case assessment. More specifically the FSA/FCA has stated in the sale of IRHPs to ‘non-sophisticated’ customers it would expect that: • The bank 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 were 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. B) The bank has taken reasonable steps to ensure that the personal recommendation is suitable for the customer. TERMINATION OF SWAPS An interest rate swap is completely separate to the underlying loan facility and the amount ‘protected’ is, therefore, calculated on a notional amount for a specified term. This arrangement can cause difficulties for customers seeking to repay their loan facilities early as the notional amount will remain in force as will the interest rate for the remainder of the term. The customer will, of course, be paying interest on borrowings that do not exist! The only way to terminate swaps early is to pay the “breakage cost” (ie exit cost) which is determined by ‘mark to market’ valuations at the time and can be very substantial. As the FSA/FCA recognises: ‘The nature of IRHPs means the scale of any break costs is inherently uncertain as, depending on market conditions, the customer may have to make a payment to the bank or the bank may have to make a payment to the customer’. In the pilot conducted by the FSA, it was found that in a high proportion of sales customers were not given sufficient information to enable them to understand the potential size of the break cost despite the possibility of such costs exceeding 40% of the value of the underlying loan. The FSA has stated that to comply with the regulatory requirements on the disclosure of break costs the bank should be able to demonstrate that: “In good time before the sale, the bank provided the customer with an appropriate, comprehensible and fair, clear and not misleading disclosure of any potential break costs. To determine whether a sale complied with our regulatory requirements, the banks will need to take account of the individual circumstances of the customer and the circumstances of the sale to determine whether it is reasonable to conclude that the customer could have understood the features and risks of the product. This will be a case-by-case assessment which may involve a consideration of: • the customer’s knowledge and understanding of these types of products generally; • the customer’s interaction during the sales process; • the complexity of the product; and • the quality and nature of the information provided during the sales process and when and how it was provided.” RISKS ASSOCIATED WITH INTEREST RATE SWAPS Interest-rate swaps involve two primary risks- interest rate risk and credit risk – known together as counterparty risk. When a swap contract is put into place, it is normally considered ‘at the money’ (ie the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows) but over time, the interest rates may change and the credit spreads fluctuate. Interest rate movements may not match expectations and swaps, therefore, entail interest-rate risk. A receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer profits if rates rise and loses if rates fall. If a counterparty wishes to shed the interest rate risk of the swap, or if a swap becomes unprofitable, the counterparty can set up a “countervailing” swap. This is essentially a mirror image of the original swap but has a different counterparty to cancel out the impact of the original swap (eg a receiver could set up a countervailing swap in which he pays the fixed rate). Swaps are also subject to the counterparty’s credit risk. There is a chance that the other party in the contract will default on its responsibility (eg Lehman Brothers). Although this risk is normally considered low (banks that deal in interest rate swaps generally have credit ratings of AA or above) the recent banking crisis has highlighted that this risk is real and must always be considered. CUSTOMER REDRESS Firstly, if it is believed that mis-selling has taken place, a formal complaint should be made directly to the bank in order to give it an adequate opportunity to deny the allegations or to make redress at an early stage. If matters remain unresolved and if eligible, the business or individual must have an average turnover of less than €2 million and have no more than 10 employees, a complaint can be made to the FOS (Financial Ombudsman Service). The FOS is able to award compensation up to £150,000 and also has the power to make a non-binding award for a higher payment. You cannot obtain £150,000 via the FOS and then sue for the remaining balance in the UK Courts. If an award from the FOS has been accepted no subsequent claim can then be made to the Court regarding that complaint. As an alternative and for larger enterprises, compensation can be claimed for the entire loss through the Courts and costs can also be retrieved from the defendant, if successful. Some customers may have suffered additional losses above the normal losses that may have been caused by the breach of regulatory requirements during the sale of the interest rate swap. This ‘consequential loss’ could include overdraft charges and additional borrowing costs. LATEST NEWS The FCA decided in late April 2013 to intervene in the appeal hearing of the interest rate swap case of Messrs Green & Rowley v The Royal Bank of Scotland plc due to be held at the Court of Appeal in October 2013. The FCA is to make written and oral submissions concerning the interpretation of its rules. The earlier Court decision in Green & Rowley appears to be at odds with the FSA over the information that the regulator says it would expect to see to comply with its regulatory requirements. The appeal is likely to focus on the risk warning provided by RBS to its clients in relation to the break costs of the swap product. The outcome of the appeal will, of course, be of great significance to the banks and relevant small businesses. eacg COMMENTARY The interest rate swaps market started decades ago as a means for large corporations to manage their debt. It has since grown into one of the most useful and liquid derivative markets in the world. Swaps are, of course, highly liquid. The most common, vanilla swaps, involve the exchange of floating-rate LIBOR for a fixed interest rate and are used extensively across the fixed-income markets to manage risks, speculate, manage duration and lock in interest rates. As recognised by the FSA (FCA), interest rate swaps have a legitimate role in a modern economy. It is very unfortunate that UK banks, with a pivotal role in economic recovery, are now facing the prospect of yet more adverse media exposure concerning a ‘mis-selling scandal’. Bank executives must be cursing the low base rate environment for this unexpected chain of events. Although there will be grey areas there can, of course, be no defence for the non-disclosure of key information particularly concerning the breakage costs. Small business customers will be greatly alarmed. Irrespective of the amount to be paid in customer compensation and the possibility of fines imposed by the regulatory authority, it is the nature of the long term relationship between banker and small business customer based on trust that is again placed in jeopardy. In our opinion it is crucial at this stage, that all financial organisations revisit their product range and advice processes to minimise the risk of any future consumer detriment and to ensure optimal and appropriate disclosure. The banking industry cannot afford another mis-selling scandal in advance of the implementation of the Vickers reforms from 2018. With politicians seeing restrictions on the banking sector as an election winning strategy, the industry must be seen to be putting its own house in order. The rewards are considerable and any impartial observer must be able to recognise across UK banking a clear ethos based on treating the customer fairly and a real focus on customer service. Roger Davies, Principal Consultant, ea CONSULTING GROUP.       1st May 2013 DISCLAIMER: All the information contained in this briefing is believed accurate as at date of publication but the ea Consulting Group cannot be held responsible for any errors or omissions.  This document is a briefing only and in summarising information does not cover all aspects of IRHPs. Interpretation can change over time and any opinions expressed by the author should be treated as such. Further action should not be considered without prior reference to your own legal advisors.