Interest Rate Swaps (Robert Morfee)
Monday, June 19, 2017
We are getting a flood of cases over interest rate swaps. If you are a small business, the chances are you are reading this because you have one of these wretched contracts and know all about them to your cost. So you may not need to read the next few paragraphs, in which I explain them.
What are interest rate swaps?
These are contracts, almost always with an investment bank, or the treasury department of a High Street bank, which amount to a bet that interest rates will go up or down.
Banks sold these contracts to business customers supposedly to ‘protect’ the customers against rising interest rates. The bank’s reason for making the recommendation was usually that the customer could protect himself from paying no more than a capped or fixed interest rate, even if interest rates moved upwards. But at the time they were often falling!
These contracts come in many shapes and sizes – such as a cap and collar, extendable swap, structured collar but all form part of the `interest rate protection family`. They all involve the customer taking a bet on future interest rate movements with an investment bank. Who was in the better position to know how interest rates are going to go? The investment bank, of course!
Swap v Borrowings
An interest rate swap is a completely separate product from the underling loan facility and the amount “protected” is calculated on a notional amount for a specified term. An example of how this notional amount works is; suppose a customer borrows £1m for a 5 year term and enters into a swap with a “notional amount” of £1m for the same period. The customer has hedged / protected 100% of the loan by term and amount. If the customer then decides after two years that he wants to repay half of the loan facility, the notional amount will remain at £1m and so will the interest rate for the remainder of the term. Therefore, the customer will be paying a fee to protect against rising interest rates on £500,000 in borrowings he does not have.
The only way to terminate these products early is to pay the breakage cost, which is determined by “mark to market” valuations at the time. These can be substantial, sometimes as much as 30% of the total borrowings.
Many customers were informed that taking out these products would provide protection from rising interest rates, which had, by February 2008 climbed to 5.25%. However, as interest rates started to fall (and these have remained at a record 0.5% since March 2009) many business and individuals who purchased these products have been left facing high monthly repayments or breakage costs to terminate the contract.
The common feature of these contracts is that the bank failed to provide the customer with a `clear, fair and not misleading` explanation of the risks associated with the products. In these scenarios the salesperson may have highlighted the benefits but neglected to explain the potential danger inherent in the product.
Entering into a transaction which does not prove beneficial does not, of itself, give rise to a claim for damages or the repayment of the money paid to the bank. Depending upon a case by case assessment, however, there often will be.
The Regulatory Rules
Interest rate protection products or swaps are financial derivatives or specifically “contracts for differences” within Article 85 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. Those advising on them therefore have a duty to comply with the statutory rules at the time of the transaction.
In summary there is (and was) a duty on the bank to:
- Provide a ` clear fair and not misleading` explanation of the product.
- Take reasonable steps to ensure that the client understands the product and the risks involved.
- Ensure the product is suitable.
- Avoid conflict of interest between the bank and the customer and certainly disclose any conflict there is. (More of this below).
The bank is, in essence, selling to its own customer a bet on interest rates it has already priced against the customer, so there is an obvious conflict of interest between bank and customer. The bank’s duties as to conflict in respect of swaps sold before 1 November 2007 depend on common law and are open to debate. For swaps sold after 1 November 2007 the law is much clearer. The EU’s directive on these and related topics came into force then. This made it mandatory to avoid conflict. I therefore take the view that it would be a very unusual swap contract with a bank’s own customer that was lawful if made after 1 November 2007.
There was also commonly a practice of `bundling`. This is selling one or more products as one. An interest swap will often be sold as a condition of a business loan. This is fundamentally unlawful when sold with a regulated product after 1 November 2007 and depending on the circumstances, probably unlawful in the case of earlier swaps.
Avenues for redress
There are the usual two, the courts or the Financial Ombudsman Service (FOS). Only very small businesses and private individuals can use the FOS, and so far it has a dismal record in these cases. So in reality it’s the courts which are the best avenue.
Banks have a record of settling these claims on confidential terms, so that the news does not get out that there is a way of escaping these contracts. But you must have a case, show that you understand the law, and have the heart for a fight. Otherwise the bank will give you the brush off.
It helps to have solicitors who will take work on a no win no fee basis, and will offer to find insurers to cover the risk of legal proceedings. My firm will.
But bear in mind the limitation periods. You have basically just 6 years from the contract. There are sometimes ways to get round this rule, but taking early legal advice is essential.
The FCA scheme
The regulator, now called the Financial Conduct Authority, has imposed a redress scheme on the banks. The banks are very keen that their swap customers put their faith in the scheme and avoid claims in the courts.
The scheme has not been running long, and is proving slow. It will certainly produce some redress for some customers, but my experience of such schemes is that they are slanted so as to minimise redress, whilst satisfying politicians that something is being done.
There is no waiver of limitation periods under the scheme, so a customer using it and not taking legal proceedings at the same time can easily find his claim is timed out before the redress scheme gets to a conclusion in his case – which may turn out to be unsatisfactory.
In principle, I take the view that swap claimants should participate in the scheme, but even the least litigious should at least take legal advice on how to preserve their rights.