Mis-selling of Interest Rate Swaps to small and medium businesses
Some things businesses should know about interest rate swaps
Background to the mis-selling of Interest Rate Swaps
From about 2001, high street banks started selling Swaps to small and medium-sized businesses (SMEs). These products were typically unsuitable for the business or so complex that many did not really understand what they were buying or the risks involved in such products. However, Swaps often made significant profits for the bank and their sales people were incentivised by large bonuses for selling these products.
Now, many small and meduim businesses are financially struggling as a result of entering into these complex products, often costing thousands of pounds, when they were never warned about the risks of the products in the first place.
So what is an Interest Rate Swap?
In this example, the Business is looking for a loan and approaches their Bank (“Loan Leg”).
Typically the interest rate charged on business loans are Base Rate + x% margin. So if interest rates rise during the period of the loan, the Business will end up making higher payments each month based on the higher rate of interest.
During the discussions about the loan, the Bank suggests to the Business that they use a Swap to “fix” their interest on the loan, which helps protect against future rises in interest rates.
The Business agrees to this and enters into a Swap Agreement (Swap Leg). This has the effect of the Business swapping floating interest payments at Base Rate for fixed interest payments. So on aggregate, each month, the Business will pay the Bank, Base Rate + x% margin on the loan . However, the Swap Counterparty (usually the Bank’s Treasury Division) will pay the Business a floating rate of interest , which cancels out the Base Rate floating component on the loan. The Business agrees to pay the Swap Counterparty 6% fixed .
These three payments will “lock in” or “fix” the rate at 6% + x% margin for the Business and effectively give it the fixed rate loan it wanted to protect against rises in interest rates. It should be noted that the Swap and business loan are two separate transactions, although both products are often supplied by the same bank.
So what’s the problem?
Many Swaps were sold on the basis that they would offer protection against higher loan payments if interest rates were to rise in the future. In July 2007, Base Rates reached 5.75% and many thought that rates would rise further. However, what followed was the ‘credit crunch’, which resulted in the Bank of England reducing the Base Rate to historical lows of 0.5%.
The problem with this is that although the Swap “fixed” the interest rate on the loan, the subsequent payments under the Swap Agreement increased as the purchaser of the Swap had to pay the difference between the Base Rate (what it was receiving under the Swap) and the fixed rate (what it was paying under the Swap). In short, lower interest rates made the Swap much more expensive to service.
Compounding the problem was that many banks had aggressively sold Swaps and other Interest Rate Hedging Products to their business customers. Many of the bankers that sold these swaps were motivated by the large commissions that they would typically earn on these products.
What are other Interest Rate Hedging Products?
Interest Rate Hedging Products are typically separate to the loan. These products were frequently marketed to customers who had a loan with the bank. There are typically three other types of products, in addition to Interest Rate Swaps, that may have been mis-sold to businesses:
- Caps – places a limit on any interest rate rises;
- Collars – enables the customer to limit interest rate fluctuations to within a simple range; and
- Structured Collars – enables a customer to limit interest rate fluctuations to within a specified range, but involves arrangements where, if the reference interest rate falls below the bottom of the range, the interest rate payable by the customer may increase above the bottom of the range.
How do I know if I have an Interest Rate Swap?
Not everyone who has been sold a Swap actually knows that they hold one as many people think they just have a fixed rate loan. You should check with your bank, accountant or solicitor if there is any doubt and ask your bank for a “Swap Confirmation”, which is a document confirming the basic detail of the Swap Agreement.
Typically a Swap was sold at or around the same time as you took out your business loan, particularly if you took out your loan in the period from 2001 – 2010. Attaching Swaps to business loans was common practice by many of the high street banks such as Barclays, RBS, NatWest, HSBC, Lloyds and Abbey National (Santander). Other high street banks may also have sold you a Swap or other Interest Rate Hedging Product.
How to spot if you have been mis-sold an Interest Rate Swap or other Interest Rate Hedging Product
There are some key indications that you should look out for to identify if you have been mis-sold a Swap. These indications could relate to the suitability of product itself or the practices around the sale of the product.
Indication: Your bank did not explain the risks of the Swap
Here, the bank may have failed to adequately explain all the risks of the Swap leading up to the sale, or at the point of sale of the product.
In many instances, businesses did not actually realise that they were entering into a Swap, but rather thought that they were just being sold a type of Fixed Rate Business Loan. Banks often:
- Failed to make it clear that the Loan and Swap were separate products
- Failed to make it clear that there was an alternative product which was more suitable
- Failed to make it clear that the interest rate payable on the Swap was separate to, and in addition to, the margin payable on the Loan
- Failed to make it clear what would happen if interest rates fell to their current levels
- Provided misleading examples of the performance of the Swap in a presentation or email
Indication: Your bank did not explain the Termination Costs of the Swap
The bank may have failed to adequately explain the ‘break costs’ in the event of an early termination of the Swap by the customer.
The actual cost of terminating a Swap can only be precisely calculated at the point of cancellation, as this cost is determined by the live Swaps market when the product is unwound. However, it would have been possible for the bank to give ‘indicative’ Termination Costs, which they often failed to provide. Many businesses that purchased these products were either not aware of any break costs or were not aware of the magnitude of these break costs, which often amounts to 20-50% of the Notional Principal, or size of the Swap.
The bank should have provided clear, fair and not misleading illustrations of these break costs, together with an indication of the possible magnitude of these costs and under what circumstances these would be payable.
Indication: There was a mismatch between the term and size of the Loan and the Swap
Sometimes it may be prudent for a company to ‘over hedge’ their debt. If a company has multiple credit facilities and maintains a core borrowing requirement over a certain period of time, it may make sense for the company to buy an overarching Swap that is larger than the size of any one particular Loan. This can be achieved because the hedging product and underlying Loans are separate agreements. This strategy tends to work well for more sophisticated companies that require this additional flexibility.
However, in many instances the banks have stretched this application and applied it to standard borrowing facilities for SME’s where it is simply not required or not appropriate. Examples of this include selling a Swap with a higher notional than the underlying Loan or selling a Swap with a longer term than the underlying Loan.
Indication: Your bank only provided the Loan on the condition that a Swap was also bought
Often the bank would only provide a Loan if the company also took out a Swap. Although this condition may be based on the bank’s commercial discretion when providing the Loan, the nature of this insistence was often only introduced at the last minute of discussions shortly before the Loan was due to be drawn down, effectively forcing the business to take the Swap as they needed the Loan.
Indication: Your bank failed to adequately explain the risks of a ‘callable’ product
Callable products allow one party, typically the bank, to call or cancel the product early. The bank will usually do this if interest rates have risen as they will make a profit by unwinding the product at higher levels. However, this leaves the holder of the callable product without any protection from the higher interest rates.
In the event that interest rates decreased over time, the bank would not exercise this right to call as they would profit from the holder of the callable product paying a higher fixed rate under the initial terms of the Swap agreement. However, the holder is effectively unable to terminate the product as there would often be significant break costs attached to the callable product. In effect the holder of the product is locked in to paying the higher fixed rate under the Swap and yet, is unable to benefit from the low interest rate environment, as is the case now.
In many cases, the banks simply failed to provide enough information for their customer to assess the risks of the product. As a result, many customers did not understand what they were buying or purchased products that were simply not suitable. It is also likely that the bank, when selling the product, may have breached key regulatory guidance and rules. Further details of these rules are provided in the following section.
Overview of the FSA Review Process
Last year the FSA undertook an investigation into some of the sales practices around the selling of Swaps and found evidence that many of these products had been mis-sold.
The result of this investigation was a publication titled “Interest rate Hedging Products – Information about our work and findings”. This report was subsequently followed up with a review scheme put in place by the FSA, which is used to review and assess redress for mis-sold Swaps.
The FSA review process divides businesses into two distinct groups, one labelled “sophisticated customers” and the other labelled “non-sophisticated customers”. The criteria applied to determine if a business is a sophisticated customer is detailed below. If a business is determined to be a sophisticated customer, then they will fall outside of the FSA review. Only non-sophisticated customers will be eligible for a review. Furthermore, the extent of the review is determined by the type of product sold.
A sophisticated customer is defined, in the financial year during which the sale was concluded, as a customer who met at least two of the following:
- turnover of more than £6.5 million; or
- balance sheet total of more than £3.26 million; or
- more than 50 employees
However, the FSA recently amended the criteria so that any business that holds a Swap of £10m or more is automatically deemed to be a sophisticated customer and therefore cannot use the FSA Review Scheme.
What can I do?
There are several options available to you if you believe that you have been mis-sold a Swap. These could include:
- Wait for your bank to contact you.
- Contactyour bank and explain to them that you believe that you have been mis-sold a Swap on the basis of X, Y or Z. Your bank should undertake a review of your specific complaint on your behalf and notify you of their outcome, on that, and only that, complaint.
- Appoint a firm of qualified professionals that specialise in understanding treasury products and the rules and regulations around the sales processes relating to these products.
Richard is in his early fifties and owns a couple of hotels on the South coast. He came to All Square having previously made an unsuccessful complaint to his bank, Barclays, where he has had a relationship for over 25 years. He offered Barclays both hotels as security for a £2million loan that he took out in 2008.
When Richard took out the loan, he was advised by his local branch Relationship Manager to enter into an Interest Rate Swap to hedge, or protect, against potential rising interest rates on his £2million borrowings. A subsequent meeting was arranged with a Swaps specialist from Barclays Capital, the investment bank, who provided a presentation on Interest Rate Hedging Products. As a result of the meeting, Richard entered into a fixed Interest Rate Swap contact with Barclays.
Although the meeting happened in 2007, Richard did not recall that any of the risks of the Interest Rate Swap were explained during the meeting. Neither did the bank point out that the Swap was also secured on his hotels. Richard is currently paying over £3,000 each month to service the Swap and he cannot refinance the loan with an alternative bank whilst the Swap is in place.
Richard has been told that if he wants to get out of the Swap it is necessary for him to pay a ‘breakage cost’ of over £250,000. Richard feels stuck, as he is obliged to continue to make the monthly payments under the Swap to avoid losing his properties and business.
Richard, Hotelier, East Sussex
All Square Treasury says:
This is a typical case of a potential Swaps mis-sale whereby the risks of the products were not properly explained by the bank at the point of sale. The bank should have asked detailed questions about Richard’s business and risk profile and then determined whether that product was suitable for his particular circumstances. Furthermore, the bank should fully explain all the downside risks of the Swap, which it seems they clearly failed to do.
Richard was proactive in dealing with the situation by complaining to his bank, however, it is important to make sure you are very clear on what grounds you are complaining, why you think the bank mis-sold you the product and how this has affected you. All Square are experts in representing people like Richard and can build a detailed and comprehensive case against the bank to win financial redress for a mis-sold financial product.
Daniel Hall, CFA is the Managing Director of All Square Treasury
For more information on the mis-selling of Interest Rate Hedging Product, please contact Daniel on 0800 0830 286 or email firstname.lastname@example.org