Bank Reviews of IRHPs / Swaps (FCA / FSA Review)
In June 2012 the Financial Conduct Authority (FCA), formerly the Financial Services Authority (FSA), indicated it had found “serious failings” in the sale of swaps and other interest rate derivatives to small businesses which amounted to mis-selling. These derivatives, also referred to as Interest Rate Hedging Products or IRHPs, are sophisticated financial instruments which were sold to bank customers on the basis that they would provide protection from future adverse interest rate movements, although in many cases they did not in fact have this effect. The FCA came to a (confidential) agreement with four major banks (RBS, Barclays, Lloyds, HSBC) under which they agreed to review their past sales of IRHPs since December 2001. Subsequently a number of other banks that engaged in the sale of IRHPs to SMEs entered into similar confidential agreements with the FCA. We are the leading law firm advising and representing hundreds of bank customers through litigation and the FCA/FSA Review process.
The Bank Review of Past Derivatives Sales (IRHPs)
In a pilot study the FCA found “serious failings” in the sale of IRHPs to small businesses including: poor disclosure of exit costs, failure to establish customers’ attitude to risk, advice being dispensed from persons who were not authorised to advise on the sale of IRHPs and over-hedging (where there is a mismatch between the amount and/or term of the IRHP with that of the underlying loan). In over 90% of the cases included in the pilot study, these practices were found by the FCA to have amounted to mis-selling, as a result of which the customer should be entitled to “appropriate redress”. The FCA has stated that its agreement with the banks requires them to:
- Provide appropriate redress to non-sophisticated customers who were sold structured collars;
- Review and provide redress to non-sophisticated customers who were sold other IRHPs (except caps and structured collars); and
- Review and provide redress to non-sophisticated customers that complain about being sold caps.
Whilst in total 11 banks have agreed to review the sale of around 40,000 IRHPs, this is no more than an internal review (under the aegis of the FCA) and does not prevent customers from taking legal action against the banks. Such action may increase the pressure on the banks to provide fair and reasonable redress to their customers. It is important to note from the outset that the review is conducted by the bank not by the FCA. The FCA has agreed the terms of the review with the banks, but these terms have not been made public.
Qualifying for the FSA Review: Sophisticated and Non-Sophisticated?
The question of who is eligible for inclusion within the review has given rise to some confusion. There are in effect a number of different hurdles which a customer has to jump in order to qualify. Firstly, the customer must have been classified as either a “private customer” or a “retail client” at the date of the transaction in question. These two classifications (private customer and retail client) were applicable during different periods. Before 1st November 2007, the relevant classification was “private customer” and after this date it was “retail client”, a change which came about because of the Markets in Financial Instruments Directive (“MiFID”). Classification as either a private customer or retail client should have entitled the customer to the highest level of regulatory protection. Even if a customer was classified as a private customer or retail client, they will only be included in the review if the product in question was sold after 1st December 2001 and if they are considered to be “non-sophisticated”. In order to determine this, the banks apply a “sophistication test” agreed with the FCA. The original sophistication test as announced by the FCA prior to the pilot study, in June 2012, was that a customer would be considered sophisticated if they met any two of the following conditions:
- A turnover of over £6.5m; or
- A balance sheet of over £3.26m; or
- Over 50 employees.
In addition, a customer would be classified as sophisticated if, not withstanding the above tests, they had the knowledge and experience to understand the transaction. This might apply, for example, where the customer had experience of trading in financial markets. After the conclusion of a pilot review (further information below), the original sophistication test was modified and the criteria were amended to ensure that:
- Those who only meet the balance sheet test and employee criteria will be part of the review if the total value of their IRHPs is equal to or less than £10m;
- Subsidiaries and Special Purpose Vehicles (SPVs) of large group companies are likely to be excluded from the review;
- Company groups unable to take advantage of the lighter reporting requirements under the Companies Act 2006 are likely to be excluded from the review; and
- SPVs that fall outside the definition of a group under the Companies Act 2006 but are connected entities are likely to be excluded from the review where the total value of the connected entities’ IRHPs is more than £10m.
As before, a customer would be classified as sophisticated, regardless of the above criteria, if they had the necessary knowledge and experience to understand the transaction. Furthermore (and contrary to what we suggested should be the case), it appears that in practice the banks are applying an additional test to exclude any customer with IRHPs whose total notional value exceeds £10 million. To summarise, in order to be included in the review:
- The IRHP must have been sold on or after 1st December 2001; and
- The customer must have been classified at the time as a private customer (for trades before 1st November 2007) or a retail client (for trades on or after 1st November 2007); and
- The customer must have lacked the necessary knowledge and experience to understand the transaction; and
- The customer must be non-sophisticated according to the criteria set out above (and if part of the group, the group as a whole must be non-sophisticated by these criteria); and
- The customer’s live IRHPs at the date of sale must have an aggregate notional value of no more than £10 million.
Further information on the sophistication criteria can be found here. Customers that fail the sophistication test (i.e. that are classified as sophisticated) will not be able to participate in the review and are therefore only likely to be able to obtain satisfactory redress if they issue legal proceedings against their bank(s).
FCA Review – “Independent” Reviewers / Skilled Persons
The banks involved in selling IRHPs have appointed independent reviewers (also known as “skilled persons”) who may be present during any meetings or calls with the bank during the course of the review. The role of the independent reviewers is to ensure that the outcomes of the review are fair and reasonable. The independent reviewers have been “approved” by the FCA who have, we understand, vetted them to ensure that they have the necessary skills, expertise and independence to understand the nature of IRHPs and the needs of those who were sold these products including scrutinising any potential conflicts of interest. Where a potential conflict of interest has been identified, a second independent reviewer will be appointed to review those cases. Each bank has appointed its own independent reviewers, for example, Barclays have appointed either KPMG or Deloitte LLP and HSBC have also appointed Deloitte LLP. It is important to note that the independent reviewer will not actually conduct the review. The review will be conducted by the banks themselves (although in some cases they have outsourced at least some of this work). The reviewer will, in effect, review the bank’s review to ensure that it is achieving satisfactory outcomes. It may also be questioned whether a reviewer appointed by the bank can be truly independent. It could therefore be said that the “independent reviewer” is neither independent nor a reviewer.
FSA Review Pilot Scheme
Before conducting a review of IRHPs the banks, in particular Barclays Bank Plc, HSBC Bank Plc, Lloyds Banking Group Plc and The Royal Bank of Scotland and National Westminster Bank Plc, were told to carry out a pilot review in which 173 sales to non-sophisticated customers were considered. The purpose of the pilot review was to assess each bank’s approach to reviewing the sales of IRHPs and the potential outcomes i.e. whether the bank correctly determined whether these customers were entitled to redress and if so whether the redress offered is fair and reasonable. The pilot review also considered the application of the sophistication test (see above). Following the pilot review it was found that in aggregate over 90% of the cases reviewed contained breaches of one of more regulatory requirements. However the cases selected for the pilots were atypical and involved the sale of the most complex products. It remains unexplained and surprising that the FSA and the banks did not choose a fair or typical sample of the customers and products they sold. Cynical observers of the pilot review have suggested that by choosing to review the most complex products (which the banks had already agreed not to sell in future to unsophisticated SMEs) the likelihood of findings of regulatory breaches was much higher; and the impact of statistical findings of regulatory breaches much greater in the eyes of the media and the public, thereby creating false faith in the prowess of the regulator.
Is the lengthy FCA Review Process Fair?
Whilst the review is being overseen by the FCA and the independent reviewer, the review itself is being conducted by the banks themselves and therefore we do not consider it to be an entirely independent process. We also do not consider, contrary to what we have seen banks argue, that this review amounts to a form of Alternative Dispute Resolution (“ADR”). An ADR process involves the parties each making representations, usually with the involvement of a neutral third party. A review by one party of its own conduct cannot properly be considered as ADR. Each bank will be conducting its review in a slightly different manner. Generally speaking, the review will involve some level of customer engagement and an opportunity for customers to: (i) give their version of the sales process; and (ii) provide any documentation in support.
FSA Review Process – “Fact Find” to Decision
The first step of the review and is being called a “fact find” however it could also be called a cross-examination of the customer with no right to question the bank sales persons. The fact find should be treated with caution. Any information given to the bank during the fact find is “with prejudice” which means that it can be used against the customer in subsequent legal proceedings. Furthermore, the fact find is a one way process which means that whilst the bank will be provided with the information that you give them, they will not be providing you with any information from their end.
Businesses with cases in the review may consider it prudent to instruct an experienced law firm to prepare written responses for the purpose of the FSA review fact find rather than the person who entered into the swap trades being subjected to a one sided inquiry. This is the approach we often adopt and we are able to put forward to the bank and present our client’s cases succinctly in order to seek to secure redress at a maximal level. For further information, see our legal news article: ‘FCA Review’ of Interest Rate Hedging (IRHP) Sales: Written Statement or ‘Fact Find’ Interview? Customers should receive a letter from their bank explaining what the review process is to going entail and details on the next steps.
An overview of the review process is outlined below:
Step 1 – Notification The bank will write to all customers that have been classified as non-sophisticated. If the customer has purchased a structured collar, they will be advised that they have automatically been included in the review. If the customer has purchased an IRHP that is not a structured collar (not including caps) then the customer will be asked to choose whether it would like to participate in the review.
Step 2 – The Fact Find Some of the banks have appointed third parties, typically city law firms, to carry out fact finds on their behalf, for example, Barclays have appointed Eversheds LLP to assist them. As part of the fact find these law firms are writing to bank customers to invite them to take part in the fact find by way of a recorded interview, either a telephone call or meeting. Customers will be asked whether they would like the independent reviewer to listen in to the telephone call as a silent observer. In its Report, ‘Interest Rate Hedging Products – Pilot Findings’, the FSA stated that it would encourage all customers to take advantage of the opportunity to engage in the review. Crucially, a customer’s account of the sale in correspondence by way of a written statement is permitted by the review but is generally discouraged by the bank’s review teams and lawyers [see: ‘FCA Review’ of Interest Rate Hedging (IRHP) Sales: Written Statement or ‘Fact Find’ Interview?].
Step 3 – The Decision A member of the banks Customer Review Team will review the information provided to them following the fact find and will reach an initial decision on what redress to offer. The independent reviewer then reviews and approves the decision.
Step 4 – Customer Meeting Once the independent reviewer has approved the offer of redress it will be sent to the customer and a meeting to discuss the offer will be set up with the independent reviewer in attendance (if required).
Step 5 – Closure Customers will be given the choice to accept or reject the offer. We note that the banks and the FCA are saying that legal representation is not required during the review process. We find this to be disingenuous as the banks themselves are instructing large national and city law firms such as Eversheds LLP. We remain cautious about the review process. We wrote to Eversheds LLP (who are conducting the fact find on behalf of Barclays) asking for confirmation that Eversheds will be acting impartially and to confirm that they will not be acting for Barclays in any litigation involving IRHPs. They refused to confirm that they would not act for Barclays in any IRHP litigation after the conclusion of the review. In January 2013 it was anticipated that the review process would between six to twelve months with priority going to customers that are in financial difficulty. It is clear to us, from the progress that has been made to date that twelve months may not be sufficient time to conclude the review and provide redress, whilst during this time many customers will find that they are out of time to bring a legal claim in the absence of satisfactory redress proposals as more than six years will have passed from the date of the sale / first contact with the derivative sales person.
FSA Review: What Redress may be offered?
Any redress offered by the banks should be fair and reasonable and put the customer back in the position they would have been in had they not been mis-sold the IRHP. Customers should note from the outset that the FSA/FCA Review process does not necessarily provide legal redress rather regulatory redress which may well provide lesser compensation than available at law. the redress in the FSA review may not be as full and fair as legal redress via litigation which is designed to put parties into the position that would today exist as if an IHRP had never been entered into. The potential outcomes under the FSA review are stated by the FCA as:
- Full Redress – exit from the IRHP (at no charge) and a refund of all payments including a refund of the break fee where this has already been paid by the customer.
- Replacement Redress – Where the review shows that, had the regulatory requirements been complied with the customer would have purchased a different IRHP, customers will be offered an alternative simple product (such as a cap, vanilla swap or vanilla collar) and/or a different profile such as a change in the amount, duration, or structure of the IHRP. This form of redress will also include a refund of any difference in payments including the difference in any break costs where the same has been paid.
- No Redress – this is the likely outcome where the review identifies that (i) had the bank complied with its regulatory requirements the customer would have bought the same product; or (ii) the customer suffered no loss.
As far as we are aware and at the time of writing, no offers of redress have been made. We are concerned that in many cases, even where the review finds the product has been mis-sold, the redress offered may be substantially less than the customer would be entitled to through the courts. This is because the redress is not as good as legal redress which rips up the derivatives contract. A replacement for a cancellable swap may be argued by the bank to be a base rate swap under the notion of “Regulatory Redress”; such a product switch might result in close to nil financial redress.
FCA Review: Consequential Loss
Many customers will have consequential loss, which is loss that has flowed as a direct result of having been mis-sold the IRHP. Examples of consequential loss include overdraft charges and additional borrowing costs and potentially legal costs. Under the review, consequential loss will be assessed in accordance with pre-existing legal principles; we can help establish your entitlement. Consequential loss is a vital element to be determined by reference to legal principles and is another aspect which ought to be professionally advanced by a specialist legal team.
Swaps Mis-selling Banks Spending £Millions to Save £Billions?
Barclays and RBS are said to have 500-550 person strong Interest Rate Derivative review teams which are staffed by experienced individuals including derivatives sales people and experts. In addition the banks are instructing City and National law firms such as Eversheds and TLT Solicitors to aid them in the FCA/FSA Review. We understand some of the IRD review teams contain staff who used to cross- sell OTC derivatives in the period in which the FSA found clear evidence of mis-selling. Bank customers may question why major banks are spending tens if not hundreds of millions of pounds on the review process? No doubt the FSA/FCA Review is designed to save the banks tens of billions of pounds. Spending millions to save billions is economically sensible for the bank and for the Treasury as it may mean there are no further taxpayer bailouts of banks as a direct consequence. However it means many businesses may not achieve the true redress they are entitled to at law. Those bank customers that attend ‘fact finds’ and meet the banks without taking suitable legal advice and representation are likely to find themselves in a disadvantageous position (as they will not be advised as to the issues that require highlighting in their individual case in the FCA Review process and what pointers for redress the banks are looking for) than those who have instructed experienced law firms to represent them.
FSA Review: News Updates
International Business Times interviews LEXLAW Principal, M Ali Akram on the flaws in Barclays Banks FSA Review process (4 March 2013): ‘Mis-Selling Derivatives Exclusive: Barclays’ Lawyers Accused of Breaching Code of Conduct’
International Business Times’ interview of M Ali Akram, Principal of City Law Firm, LEXLAW, results in a Derivatives Mis-selling Exclusive and a subsequent question raised in the United Kingdom Parliament by The Rt. Hon. Tessa Munt MP for Wells (PPS to The Rt. Hon. Vince Cable MP). Response by The Rt. Hon. Andrew Lansley MP, Leader of the House (7 March 2013): Article featuring LEXLAW leads to Parliamentary Question on Interest Rate Swap Mis-selling:
International Business Times reports that earlier interview of LEXLAW Principal, M Ali Akram on the flaws in FSA Review process has lead to a Business Statement in Parliament (7 March 2013): ‘Mis-Selling Derivatives Scandal: Tessa Munt MP Questions Independence Over Barclays’ ‘Fact-Finders’’
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