By Paul Spibey, Partner at law firm Mills & Reeve LLP
The latest stage of the FSA’s investigation into the mis-selling of interest rate hedging products (IRHPs or “swaps”) has seen the regulator announce that 90% of the sales reviewed in its pilot study did not comply with its requirements. The FSA ordered the four banks under investigation to review their sales and offer appropriate compensation to their clients where applicable. Seven other banks have also agreed to review their sales of IRHPs.
The FSA has come under sustained political pressure to investigate this issue and take appropriate action. This is because there is a widely held view that complex interest rate swaps were sold to unsophisticated small businesses, and that the banks did not do enough to explain the nature of the product and the associated risks. Swaps were typically sold between 2004 and 2008, when interest rates were higher, but have performed poorly after interest rates fell to historic lows in 2008. As a result of this, companies found themselves tied into making repayments at much higher rates than would have been available on the open market. The banks have also been criticised for failing to explain, at the time of sale, the charges that would apply if the company wished to terminate the agreement at an early stage.
With small and medium sized enterprises (SMEs) at the heart of the coalition government’s strategy for stimulating the UK economy, and often reported as being in a vulnerable position relative to their larger counterparts, this has become a very hot political potato. It will also be viewed as another example of the banks’ mis-selling of financial services products in recent years, following on from PPI, and will not help the banks’ cause as they look to regain the trust of their customers and the wider public.
Yet, it is encouraging to note from the recent victory for a defendant bank in Green & Rowley v RBS, heard in the Manchester Mercantile Court, that some sales of these products can be defended. RBS sold a swap to Mr Rowley, a hotelier, and his business partner, Mr Green, in 2005, in order to hedge against movements in the interest rate on an underlying loan of £1.5 million. The swap was relatively straightforward and the claimants benefited from it until market conditions changed in 2008. They enquired in 2009 about terminating the swap, but were told this would cost them as much as £138,650, so they decided not to take any action.
Green and Rowley did not have sufficient evidence to substantiate their claims of negligence and breach of duty. By contrast, the bank had a helpful contemporaneous note of what was discussed at the initial meeting when the advice was given. Furthermore, the claimants were unable to pursue claims under section 150 of the Financial Services and Markets Act 2000 (FSMA) – which should have been their strongest line of argument – since claims under the FSMA were statute-barred.
This claim very much turned on its own facts and does not constitute a panacea against the majority of claims that will arise from swaps. Whilst it should be noted that only 10% of claims in the FSA’s recent investigation were fully compliant, this case confirms that judges will find in favour of banks in appropriate cases. There are however steps banks must now take when dealing with sales of IRHPs and similar financial products.
First, any bank that sold IRHPs to relevant customers can expect to have to conduct the same review of its past business as the aforementioned eleven banks are doing now. This will have wide-ranging implications for banks, from resources to financial provisioning. The overall redress expected to arise from IRHP mis-selling, though very substantial, is not however expected to be as significant as that from PPI mis-selling.
It is also important to note the FSA’s emphasis on the “sophistication test”, with “unsophisticated” customers deemed to be unlikely to have understood the risks associated with these products. This underlines the importance for banks to explain the product fully to customers and to pay regard to the customer’s profile and standing, from the smallest SME to a large plc.
Similarly, banks may be able to raise causation defences if it can be proved that the customer would have gone ahead anyway, following a non-compliant sale, had the sale been fully compliant. This possible defence is referred to in the FSA’s recent findings, and harks back to the “insistent customer” defence is outlined in guidance issued previously by the FSA on pension and endowment mis-selling.
Finally, the decision in Green & Rowley reminds us of the importance of keeping careful notes of meetings when advice is given regarding the sale of interest rate swaps and other financial products.
Paul Spibey is an expert in claims involving financial institutions and acts both for financial institutions and their insurers. He can be reached at [email protected]