What is Sophistication in the FSA Swaps Mis-selling Scheme?

The Financial Services Authority’s announcement on the swaps mis-selling pilot reviews (31 January 2013) brought in a refinement of the 29 June 2012 announced test of sophistication. That test has been explained by the regulator by way of a Paper and a Flowchart which are inconsistent with each other.  

Due to this lack of clear explanation there is confusion amongst swaps mis-selling victims, lobby groups, MPs and commentators about the correct definition and treatment of individual cases. Whilst we wait for the FSA to issue a correction we offer here what we consider the test of sophistication is intended to be.  

FSA communications on Pilot Reviews and start of full review of interest rate swap mis-selling

The FSA yesterday (31 January 2013) issued:

1. a Press Release to confirm the commencement of the banks’ review process (although we understand that no pilot review findings have yet been communicated);
2. a Paper on the Pilot Findings findings in relation to the banks’ own reviews of ‘Interest Rate Hedging Products’ [FSA Pilot Findings Paper]; and
3. a Flowchart designed to simplify and explain the FSA – bank agreed review scheme in relation to the sophistication test [FSA-Flowchart-PDF].

The FSA Flowchart Mis-Defining Sophistication

The FSA Flowchart appears helpfully designed to help the victims of swap mis-selling understand whether or not they fall within the (admittedly complicated) definition of non-sophisticated so as to merit inclusion in the review. Less helpfully, the Flowchart does not accurately reflect the FSA’s policy as set out in their Paper published yesterday resulting in a lot of confusion as to what is the true position.

This quote from the FSA taken from a Telegraph article earlier today clearly implies that the policy remains as set out in the FSA Paper:

“We introduced the £10m notional hedge limit to bring businesses such as farms, B&Bs and small care homes into the review,” he said. “Without this change they might otherwise have been excluded due to the size of their fixed assets and numbers of seasonal part time workers.”

However the article writer (and presumably the MP) seem to be under the impression (due to the FSA Flowchart) that the policy has now been changed per the misleading Flowchart.

The FSA Paper setting out the intended Policy on Sophistication and introducing the £10 million test

The Paper sets out the FSA’s policy on sophistication by first restating the original test, and then explaining how the original test is to be modified. The original test was that a customer would be sophisticated if (at the relevant time) they met any two out of the following three conditions:

• Turnover exceeds £6.5 million;
• Balance sheet exceeds £3.26 million;
• Business has more than 50 employees.

Other customers were correspondingly  non-sophisticated, so the effect was that a customer would be eligible for inclusion if they met none or one of the above conditions.

The modifications set out in yesterday’s paper provide for a number of exceptions, both by way of excluding some businesses which would have been included under the original test and including some businesses which would have been excluded. These exceptions are as follows:

• If a business meets both the balance sheet and employee criteria above (so it would have been sophisticated under the original test), but does not meet the turnover test, then it will nevertheless be treated as non-sophisticated (as so included in the review) provided that the total value of the live swaps is no more than £10 million.
• If a business is part of a group, and the group as a whole meets the test for sophistication, then the business will be treated as sophisticated even though treated in isolation it would have been deemed non-sophisticated.
• Where the business is a Special Purpose Vehicle, and it is connected to a group (even though it is not formally part of the group), it will be treated as sophisticated provided that the total value of live swaps exceeds £10 million. (We believe that the FSA must have intended this to apply only where the group to which the SPV is connected is itself a sophisticated customer, although this is not stated.)

Understanding the New £10 million Test

The key point here is that the £10 million test applies only in two specific situations, i.e. to businesses with turnover of less than £6.5 million, a balance sheet of more than £3.26 million and more than 50 employees and to business which are SPVs connected to but not part of a group structure [which is itself sophisticated].

The published flow-chart makes it appear that the £10 million test has to be met by all customers to meet the definition of non-sophisticated.

It is unfortunate, to say the least, that this is likely to cause customers who are entitled to redress under the scheme to believe that they are not so entitled.

We have already had one enquiry from a client who is non-sophisticated under the original test (because only one of the three conditions is met) but who believed that they might nevertheless be treated as sophisticated because the total value of their swaps exceeded £10 million.

We hope that the FSA will rapidly take action to bring their flowchart into line with their own published policy.

M Ali Akram, Principal, LEXLAW