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Interest rate hedging products
What are interest rate hedging products?
Interest rate derivatives, which are often known as interest rate hedging products or just ‘swaps’ have caused significant difficulties for small and medium sized businesses that were sold them without proper warning of the risks.
Used properly, hedging or in ordinary language, mitigating adverse changes in the amount of interest payments a business must make is useful tool to provide certainty as to the costs of servicing debt. For most businesses that involves either a fixed rate loan – meaning future interest payments are at an agreed rate for the lifetime of the loan, or a cap rate whereby payments will vary with changes in the variable rate applied to the loan (usually Libor or the Bank of England base rate) but will not exceed the cap rate.
Indeed, for many customers, caps and fixed rate loans might have been appropriate because they are relatively straightforward and crucially, do not involve the business exposing itself to interest rate payments in excess of the fixed or capped rate.
Why interest rate hedging products became a problem
Seizing an opportunity in the early 2000’s to make additional profit on loans to ordinary businesses, high street banks aggressively sold more complex interest rate hedging products usually reserved for more sophisticated counterparties like pension funds and large multinationals who could keep track of their exposure as rates moved.
These products, often called structured collars, enhanced collars or tailored business loans (where a swap was hidden behind a fixed rate loan) involved gambling on future interest rates, with potentially unlimited downside risk to the business as rates fell. They also created enormous break costs if they were ended early, sometimes in excess of the underlying debt. The banks did not tell customers about these break costs which became liabilities instantly added to the bank’s calculation of the customer’s creditworthiness.
Ordinary businesses, focused on their day to day activities simply did not have the capacity to understand or monitor their exposure to these products, as a consequence when rates collapsed in 2009 they faced dramatically increased payments to service their debt. Many could not afford the payments or break costs to exit the trade and either had to refinance at dramatically greater cost or go bust.
The FCA review of interest rate hedging products
The FSA (now the Financial Conduct Authority or FCA) required the banks to review their historic sales of these products. The review had significant flaws, most importantly there was no independent adjudicator to make decisions and no right of appeal, with the banks using ‘skilled persons’ appointed from large consultancy and accounting firms (the same firms who look to the banks for their business) to review their decisions. Many customers felt the banks overstated their appetite for risk and failed to take into account their business objectives in order to justify rejecting complaints. Some customers were excluded from the review entirely by virtue of being too sophisticated, based on arbitrary criteria related to turnover and numbers of employees. Tailored business loans were not reviewed by most banks.
Even when the bank admitted that it did not conduct the original sale properly, the review criteria allowed it to offer an alternative product rather than a complete refund, significantly reducing redress. Customers have also found it difficult to recover their consequential losses incurred as a result of reduced cash flow caused by the mis-sold product. Although the review was said to be ‘open and customer centric’ and therefore did not require legal representation, the banks require customers to prove their consequential losses to a legal standard which some have said seems to be even more onerous than the ordinary standard in civil litigation.
What can businesses do now?
Customers disappointed by the outcome of the review have brought legal claims against the banks, alleging the banks gave negligent advice during the sales process. This has proven difficult, with the banks relying on terms of business which exclude any provision of advice (called ‘basis clauses’) to successfully defeat a number of claims. Naturally the banks choose which battles to fight and so many cases which are settled successfully on behalf of claimants go unreported.
Because most of the products were sold before 2010, the time limit for bringing a legal claim (known as ‘limitation’) relating to the original sale of the product will have generally expired by now in the absence of exceptional circumstances or an agreement with the bank.
An alternative cause of action, pioneered by this firm, is a claim against the bank for failing to conduct the FCA review of the product properly. The attraction of such a claim is that limitation runs from the date of the bank’s final redress decision which will have been made some time after 2012, reviving legal claims that would otherwise be out of time. This means there is still the prospect of redress for customers that were either excluded from the review, refused compensation or refused additional consequential losses. Customers that have been offered redress but have rejected or not accepted it may also still be able to claim.
To speak to our specialist lawyers about interest rate hedging products, call 01392 207 020 or email firstname.lastname@example.org