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Mis-selling of Interest Rate Derivative Products

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Have You Been Mis-Sold A Swap?

The mis-selling of interest rate caps, swaps and collars to SMEs hit the headlines recently, and the leading banks have found themselves under the spotlight of the Financial Services Authority as it considers a full-scale investigation into the alleged mis-selling of complex financial packages.

Most businesses borrow at rates offered by their bank, which will typically be at a floating rate based on LIBOR (London Inter-Bank Offer Rate) plus a margin for the bank.  Interest rate volatility can have a dramatic impact on financing costs and cash flow for business borrowers.   The most common tools used to minimise exposure to interest rate fluctuations are swaps, caps and collars. These derivativeproducts represent a highly specialised area of financial services requiring considerable understanding.

The problem is that the products banks offer to borrowers to reduce their exposure to interest rate fluctuations can themselves have hidden risks and costs which are at least as damaging to a borrower as the interest rate fluctuations they were designed to guard against.  It is estimated that tens of thousands of these derivative products have been sold, mainly between 2005 and 2008. However, as interest rates have fallen to historic lows in the last few years borrowers can find themselves tied in to unsuitable products by the extortionate and unexpected costs involved in moving to a more appropriate product.

The three main derivative products are:

Base rate cap - this sets a ceiling on the borrower's interest rate costs.  When the floating rate is above the cap rate, the bank agrees to pay the difference between the floating rate and the agreed cap rate.  In return, the borrower pays the bank a premium which can be upfront or in installments.

Base rate swap - this allows a borrower to convert a floating rate loan for a fixed rate debt.  If the floating rate is higher than the agreed rate on the 'roll-over' date, the bank pays the borrower the difference.  If the floating rate is lower than the agreed rate then the borrower pays the bank the difference.

Base rate collar - this is a combination of a cap and a minimum interest rate or 'floor'.  The borrower limits exposure while benefitting from favourable rate movements within an agreed range.

Typical complaints

These products offer savvy borrowers a valuable facility, can save them money and allow them to fix financing costs.  However, these products are very lucrative for the banks which sell them and questions have been raised as to alleged mis-selling.  Some typical concerns are as follows where: 

  • the borrower did not understand what was being sold and the bank's promotional literature highlighted only the benefits of the product;
  • the borrower never wanted to buy the product but it was made a condition of a loan or of continuation of a loan;
  • the very substantial break costs were never explained;
  • the bank was able to terminate the contract if rates moved against the bank; or
  • The borrower did not understand that the product, and the need to continue paying for it, would continue even if the accompanying loan was paid off.

Mis-selling

Mis-selling is essentially a breach of duty owed by the entity (typically a bank) selling the product to the purchaser (usually the borrower).  It is often, if not invariably, characterised by the failure to inform fully or to mis-describe the attributes of a financial product resulting in the sale of a product that is unsuitable for the needs of the borrower.  With sophisticated and complex products such as interest rate derivatives, it is easy to understand how the affected business can believe that it has been mis-sold a particular product.

Remedies

Individuals or small businesses, defined as those with a turnover of less than €2 million or fewer than 10 employees, can bring a complaint to the Financial Ombudsman Service which has wide powers, including the power to award compensation up to £150,000. 

The FSA's Conduct of Business Rules (COBs) set out, principally in COB 9, the requirements for the seller of a financial product to have obtained sufficient information from the purchaser of that product so as to ensure recommendation of only a product that is suitable for that customer's needs.  Also the seller must assess the expertise, experience and knowledge of the customer to establish that it was capable of making an informed decision and that it did in fact understand the risks involved.  The customer must also be capable of bearing the risks should those risks materialise.  If a complaint is brought before the Financial Ombudsman Service and where the customer can show that the seller has failed to comply with the relevant rules, then the Ombudsman will make an award.

Claims can be brought in the courts where damages are likely to be greater than £150,000 or where the claimant is not a small business.

Section 150 of the Financial Services and Markets Act (FSMA) allows individuals and sole traders (defined in FSMA as "private persons"), to claim for loss suffered as a result of contravention of the applicable COB in the courts.  The action is essentially an action for breach of statutory duty.

If the borrower is not a 'private person', and accordingly section 150 of FSMA does not provide a remedy, then a remedy will be available through the courts, if it can be established that the conduct of the bank constituted a breach of its contractual duty or its general duty of care to advise the customer, or of it can be established that the bank made an incorrect representation about the product to the detriment of the customer.

The essential issues in most claims are:

  • did the bank have a duty to advise the borrower; and
  • do the terms of the contract between the bank and the borrower lawfully exclude liability? 

If a bank can be said to have acted as an adviser, then it will have much higher duties to a business than if it did not.  Invariably banks will say that the nature of the relationship between the bank and its customer was such that no duty to advise arose and that it was an 'execution only' relationship.  Each case will be determined on its facts and the primary method of establishing the nature of the relationship will be to look at and to interpret the contract between the parties.  Other factors, such as the size and sophistication of the business or whether it had the chance to enter into a similar contract with other banks but without similarly onerous terms, will be relevant but are unlikely to displace a very clearly worded contract.

Exclusion clauses are one of the most fought over and written about areas of contract law.  The courts and parliament do apply certain limits on the use of exclusion clauses and further rules as to their interpretation, for example that, in the event of ambiguity, they are construed by against the party seeking to rely on them (i.e. the bank).  The limits that apply to exclusion clauses are specific rather than general and the role of the borrower's lawyer is to persuade the court that one or more limits should govern the exclusion clause in question and as such it should not be given legal effect.

Businesses therefore need expert advice from solicitors specialising in resolving disputes between banks and their customers to give them the best chance of avoiding the costs and restrictions involved with unsuitable financial products.


 Patrick Selley

Profile: Patrick Selley - Keystone Law
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Profile Patrick Selley

Patrick is an experienced commercial litigator who has taken many cases to trial in the High Court and the Court of Appeal. Patrick strongly believes in using flexible approaches to dispute resolution; he is a qualified mediator and a Fellow of the Chartered Institute of Arbitrators. Previously, Patrick has conducted professional negligence defence work, but he now acts for claimants, particularly against solicitors and financial advisers.

Patrick was admitted as a solicitor in the UK in 1983 and in Hong Kong in 1986.

Patrick is a keen exponent of mediation from the outset having been a director of ADR Net and, with Bond Pearce, a branch founder of the Centre for Mediation in the 1990’s. Trained with both CEDR and ADR Net Patrick has successful experience of many mediations both as mediator and advocate. In addition to his work as a litigator and a mediator, Patrick also runs mediation training courses for non legal professionals.

 

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