The Banking Commission’s Proposals relevant to Swaps Mis-selling

The Parliamentary Commission on Banking Standards today publishes its Final Report – ‘Changing banking for good’.  It outlines the radical reform required to improve standards across the banking industry. We examine how the Final Report deals with issues of LIBOR manipulation and derivatives mis-selling and suggest further steps that could be taken to deter bank misconduct.

An Inquiry into Banking Standards

The Commission was established in July 2012, in the wake of the Swaps mis-selling and LIBOR rate manipulation scandal, to conduct an inquiry into professional standards and culture in the UK banking sector and to make recommendations for legislative and other action.  The Chairman of the Parliamentary Commission on Banking Standards, Andrew Tyrie MP, said today:

Recent scandals, not least the fixing of the LIBOR rate that prompted Parliament to establish this Commission, have exposed shocking and widespread malpractice.  Prudential and conduct failings have many shared causes but there is no single solution that can restore trust in the industry.  The Final Report contains a package of recommendations that, together, change banking for good.  Given the misalignment of incentives, it should be no surprise that deep lapses in banking standards have been commonplace.

The Commission’s Proposals relevant to Swaps Mis-selling

The Final Report contains a number of proposals of which the headline suggestion is criminal liability and deferred pay for bankers guilty of reckless misconduct extending to senior executives in supervisory positions and top traders who should operate by a new set of banking standards set by regulators.  These proposals have five themes:

  1. making individual responsibility in banking a reality, especially at the most senior levels;
  2. reforming governance within banks to reinforce each bank’s responsibility for its own safety and soundness and for the maintenance of standards;
  3. creating better functioning and more diverse banking markets in order to empower consumers and provide greater discipline on banks to raise standards;
  4. reinforcing the responsibilities of regulators in the exercise of judgement in deploying their current and proposed new powers; and
  5. specifying the responsibilities of the Government and of future Governments and Parliaments.

The Report also makes recommendations relevant to swaps mis-selling which we highlight below:

1. Greater Access to the Financial Ombudsman Service (FOS)

The Final Report makes plain that “the evidence the Commission has received suggests that too often the banks have not taken customer complaints seriously” and that “large banks have a poor track record when it comes to complaints handling.”

It is considered that the narrow definition of an “unsophisticated customer” used to determine eligibility for access to the Financial Ombudsman Service (FOS) for redress has been highlighted as problematic by the wave of cases relating to interest rate swap mis-selling to small businesses.  Many small businesses have fewer than 10 employees.  Such businesses are particularly vulnerable to potential exploitation by the banks they rely upon for finance, particularly in the case of complex derivative products. (emphasis added)

The Commission recommends that the FCA consult on options for widening access to the FOS (Paragraph 523).  The suggestion is that the FOS might widen its criteria for eligible complainants which is currently restricted to private individuals or “micro-enterprises”.  Micro-enterprises is an EU term covering smaller businesses with an annual turnover of less than two million euros and fewer than ten employees.

It is noted that the FOS decisions on cases of swaps mis-selling (which are unpublished) have been historically predominantly in the favour of the banks and have wrongly excused the banks conduct in the sale of derivatives products to SMEs (save for two FOS published decisions of Ombudsman Boorman which came after the FSA report on the mis-selling of Interest Rate Hedging Products by the major banks).

In order to be of service to bank customers the FOS will need to ensure that it improves its own standards when considering complex legal disputes such as these.  The FOS ought to have no hesitation in taking legal and regulatory advice from specialists where necessary to avoid reliance on the bank’s viewpoint which has been carefully shaped by the bank’s legal advisers.

2. A Licensing Regime to Uphold Individual Standards

The Final Report proposes replacement of the current regulatory Approved Persons Regime (individuals approved by the FSA to perform one or more ‘controlled functions’ on behalf of an authorised firm).  The proposals are for the following:

  • A Senior Persons Regime to replace the Significant Influence Function element of the Approved Persons Regime. This should provide far greater precision about individual responsibilities than the system that it replaces, and would serve as the foundation for some of the changes to enforcement powers and approach that we recommend in Chapter 10;
  • A Licensing Regime to replace the Approved Persons Regime as the basis for upholding individuals’ standards of behaviour, centred on the application of a revised set of Banking Standards Rules to a broader group than those currently covered by the Statement of Principles for Approved Persons; and
  • Reform of the register to support the first two pillars and ensure that relevant information on individuals can be captured and used effectively (Paragraph 612).

The licensing regime proposal is intended to avoid the current situation where individual bankers involved in rate setting or the mis-selling or swaps can seek to claim a level of ignorance of the process they are a part of or claim they were only following orders.  The revised Banking Standards Rules ought to clearly set out what is and what is not acceptable individual conduct.

3. Financial Literacy, Transparency & Cross-selling

The Final Report urges there to be greater financial literacy for customers and greater transparency by the banks particularly when cross-selling products.

The Commission states that:

  • Waves of mis-selling and other forms of detriment suffered by consumers in the retail banking market reflect widespread financial illiteracy on the part of customers and a more financially literate population will be better capable of exerting meaningful choice, stimulating competition and exerting market discipline on banks, which, in turn, can drive up standards.
  • Industry, regulators and governments must avoid a situation where the banks design ever more complex products and then blame consumers for not being financially literate enough to understand them.
  • Alongside greater financial literacy, there is a need for a relentless drive towards the simplification of products and the introduction of clear, simple language.
  • Mis-selling and undesirable cross-selling are very unlikely to be eliminated through higher financial literacy, but improvements to such literacy will help bear down on those problems and be more effective, in many cases, than ever more detailed conduct regulation.
  • Cross-selling and a lack of price transparency are not restricted to retail banking.  Parts of investment banking are also characterised by opaque fee structures and some highly sophisticated companies [let alone small businesses] have entered into complex transactions that they have not fully understood.  This should not usually be an area for regulatory intervention: the principle of caveat emptor acts as an important force for market discipline. The regulator should not seek to shield sophisticated customers from the consequences of their poor decisions. However, it should be their duty, wherever possible, to ensure maximum price transparency at every level of banking (Paragraph 536).

These issues are prime features of cases of derivatives mis-selling (largely to small unsophisticated business).  Banks have operated a purposive “Joint Meeting Programme” whereby the retail arm of the bank would, via the trusted Relationship Manager, introduce the derivatives sales person from the wholesale arm of the bank and each bank official would then jointly meet with the customer in order to sell complex financial instruments such as IRHPs.

In a typical swaps mis-selling case, the bank customer, often a small business, would likely be completely unaware of the contingent liabilities in the proposed complex derivatives and would be unable to comprehend (or be properly informed of) the risks if rates fell. This is because the bank and its derivative sales person would routinely not be transparent about the risks associated with (nor the profits generated for the bank) by the customer’s entry into such financial instruments.

Will the Proposals Prevent Future Derivatives Mis-selling?

The proposals by the Commission on Banking Standards are to be welcomed and are likely to have a deterrent and reductive effect on the likelihood of further mis-selling and manipulation scandals as is their design.  However with reference to swaps mis-selling specifically we consider the net impact whilst welcome will in practice be minimal.

To explain, we have already seen the impact that the fall in base rate in Q4 2008 and Q1 2009 had on the banks sales processes of these products in that the sales presentations from the same sales teams at the major banks were vastly changed to provide more substantial risk warnings around breakage costs (as should always have been the case).

Those clients with early swaps presentations in 2005 to 2008 and then restructuring presentations after the fall in base rate, particularly in 2010 and 2011, will have witnessed for themselves the stark changes in the sales process of derivatives by their bank.

Additional Measures to Deter Swaps Mis-selling

With reference to swaps mis-selling, the Commission could have gone further by correcting some of the legal issues which hamper swaps mis-selling claims brought in England & Wales.  We highlight two such issues below:

  1. Firstly the Commission could have proposed regulation to prevent the banks claiming their role is non-advisory /execution only when in reality it is not particularly in cases of unsophisticated customers being cross-sold a complex financial instrument.  The practice of the banks is to insert small print into the contractual relationship and trade documents stating the relationship with the customer (even a small non-sophisticated business) and the trade of the financial instrument is on a non-advisory execution only basis.  Should a claim for breach of advisory duty subsequently be advanced the banks seek to rely on the legal principle of “contractual estoppel” effectively that the customer should be estopped from asserting the relationship is advisory as they have (in the small print) contracted otherwise.  This is especially unfair when dealing with complex financial instruments and a lack of available independent advice.  The Commission noted this when “referring to interest rate swaps, Abhishek Sachdev [of Vedanta Hedging] explained that there was nowhere for SMEs to go for advice on a complex product: they were sold to unsuspecting customers on “an execution only basis”.”
  2. Secondly,  the Commission could have proposed an amendment to section 150 of the Financial Services and Markets Act 2000 (which gives a statutory right for private persons to bring a damages action for certain contravention in the sales process for regulated financial instruments).  The amendment could bring this statutory provision in line with the way in which other Member States, such as Germany and Ireland, have implemented the EU Markets in Financial Instruments Directive (MiFID) which is the source of s.150 FSMA 2000.  In England & Wales the legal status of the customer as a natural person (i.e an individual) determines access to s.150; an incorporated entity such as a company cannot claim under s. 150 due to the wording deployed by Parliament when transposing the EU directive into our national statutory laws.  This is in stark contrast to the position intended under MiFID and apparent in other Member States where status as an individual is not an issue in terms of making a statutory claim for breaches of rules.

Banks must be forced to ensure their sales teams sell these products in a fair, honest, transparent manner with full disclosure of risks and importantly profit particularly where sales are to unsophisticated small business customers.  Further measures ought to be proposed to ensure (i) banks cease claiming sales to unsophisticated small businesses are non-advisory execution only trades and the default should be advisory responsibility for banks when selling derivatives to retail clients and (ii) that EU laws are properly transposed and implemented in this jurisdiction for the benefit of customers (not lobbying banks) and in accordance with the Government’s stated Guiding Principles for EU Legislation (post-MiFID; April 2013)