The FSA has today published a long-awaited press release setting out the findings of their ‘pilot scheme’ in relation to the mis-selling of complex interest rate derivatives to small businesses. We interpret the FSA findings and add legal comment based on our lengthy experience of reviewing cases and advising hundreds of SMEs on mis-selling.
Over 90% of Swaps Sales Non-Compliant
This release is generally good news for the victims of mis-selling, as the FSA seem finally to have acknowledged the scale of this problem, after a long period of lobbying by small business groups, derivatives experts, MPs and this firm. The FSA have found that 90% of the sales examined in the pilot review did not comply with their regulatory requirements. To outsiders this will no doubt seem an astonishing proportion, although it is not surprising to us, as we know from the many cases that we have seen that banks’ sales teams routinely ignored their regulatory duties.
Areas of Regulatory Concern for Mis-sold Swaps
The FSA identify five problems in particular, which we also have found in a very large number of cases, specifically: (i) break costs were not adequately explained, (ii) no attempt was made to assess the customer’s attitude to risk, (iii) sales teams routinely made recommendations to customers despite the banks stating that they were providing a non-advisory service, (iv) the amount and/or term of the derivative products sold exceeded the amount and/or term of the underlying loan, resulting in the customer being ‘over-hedged’ and (v) the banks salespeople were motivated by a desire to maximise their own commissions or bonuses – in many cases this led directly to the over-hedging previously mentioned.
We may also add, although the FSA seem to have overlooked it, that banks salespeople routinely downplayed the possibility that interest rates would fall. The conversations were exclusively focused on the benefits to the customer if rates rose, with little or nothing being said about the cost to the customer if rates fell.
Our Concerns About the FSA’s Proposals
However, while we are pleased that the FSA has at last woken up to the problem, we continue to have serious concerns on behalf of our SME clients in respect of the FSA’s proposed solution.
In particular, the proposed review process will involve the derivative sales being reviewed by an ‘independent reviewer’ who will in fact be appointed by the bank. It may therefore be doubted whether the reviewers will be truly independent and we have already had reports of telling conduct at meetings with swaps victims. The FSA say that in the pilot study they found that the independent reviewers did robustly challenge the banks’ views. However, the very fact that they knew that the pilot cases would be closely examined by the FSA means that the reviewers may well have been more conscientious in dealing with these. If the customer is unsatisfied with the outcome of the review, it is not clear how they will be able to challenge it.
In our view, it could never be appropriate for a non-sophisticated customer to be over-hedged. This is because over-hedging, where the hedge exceeds either or both of the amount and term of the underlying loan, is by its nature a speculative position and is not performing the proper commercial function of a hedge. Hedging is intended to reduce a business’s exposure to interest rate risks, whereas over-hedging and other speculative positions instead add new risks. Therefore we are concerned that the FSA indicate only that the consequences of over-hedging ought to have been clearly explained. We consider that any over-hedged position ought to be treated presumptively as a mis-sale, unless the bank can produce compelling evidence that the customer instigated the trade and was determined to proceed with it despite advice to the contrary.
We also have concerns over the proposed remedies. Extraordinarily, the FSA state that “redress will not be owed to the customer in all cases where the sale did not comply with the regulatory requirements.” They also say that in some cases the appropriate redress will be the substituting of an alternative product, and this may result in customers receiving less than the full compensation to which they should be entitled.
In particular, the FSA do not say anything about the common scenario where the bank made the hedge a condition of the loan. In those cases it may be said that, even if the customer had been properly informed, they would still have entered into the hedge in order to obtain necessary finance. This does not address the fundamental point of whether it was appropriate for the bank to insist on such a condition.
The FSA indicate that where an alternative product should be substituted, this should have potential break costs of no more than 7.5% of the amount hedged, as the FSA consider that if customers had been properly advised, this would be the maximum liability they would have been prepared to accept. If this is right in relation to alternative products, surely the FSA ought to apply the same standard to the original sales? Indeed, we agree that few customers would have entered into hedging arrangements had they appreciated that (in a plausible but pessimistic scenario, as the FSA put it) they might be liable for break costs which we have often seen amount to 30-40% of the value of the loan. Therefore all of these products should be treated presumptively as mis-sales.
Tailored Business Loans
The FSA press release entirely fails to address the issue of Tailored Business Loans. This may be because it only covers the pilot in relation to the ‘Big Four’ banks, and the treatment of Tailored Business Loans may have to await the announcement of the results from the other pilots “in the coming weeks”, as these products were mostly sold by the smaller banks. Tailored Business Loans were products with ‘built in’ derivatives. In our view these should clearly be treated in the same way as stand-alone derivative products, as the issues are identical, i.e. that customers were being sold complex products which were not properly explained with no real understanding of the risk involved. However, we are still awaiting any indication from the FSA as to how these products will be treated in the review or indeed whether they will be included at all.
Keeping Open the Option of Legal Action
Because of the concerns detailed above, we consider that it is important for the victims of mis-selling to keep alive the option of seeking redress through the courts.
Unfortunately, this gives rise to a further serious concern we have with the FSA’s report, which is that it ignores a potentially crucial problem regarding limitation dates. The period for bringing a legal action for derivatives mis-selling will usually be six years from the date of the sale (or from the sales presentation). Given that this problem mostly occurred in the period 2003-2008, as time goes by, progressively more victims will be excluded from legal redress. They then risk finding themselves with no legal remedy if the banks’ review proves unsatisfactory.
We therefore consider it essential that the victims of derivatives mis-selling seek professional legal advice at the earliest opportunity, so that the necessary steps can be taken to safeguard their legal rights. We are extremely concerned by the suggestion at the end of the FSA press release that the victims of mis-selling will not need external assistance “because the process is straightforward”. No doubt the banks would prefer that victims merely accept whatever partial compensation they choose to offer, but the whole problem of mis-selling interest rate derivatives arose because these are complex products on which customers will require professional advice in order to understand their position.
M Ali Akram, Principal, LEXLAW