DISPUTES OVER INTEREST RATE PRODUCTS

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1 April 2011 DISPUTES OVER INTEREST RATE PRODUCTS 1. Background Complaints to banks about interest rate products have increased greatly as a result of the unprecedented downturn in interest rates. Bank of England base rate started 2008 at 5.50% but by the end of the year had fallen dramatically to 2%. It then declined very rapidly even further to 0.5%. None of this was, or could be, anticipated when an interest rate product was bought, say, at the end of So, the experience has been a painful one for many bank customers. Businesses of all sizes have been hit a number of banks had a very active policy of widely offering these products to their customers. Indeed in many cases the bank effectively made the purchase a condition of new lending saying that it was likely to protect the customer from interest rate rises. Obviously, in more normal conditions, that might indeed have been the effect. A case against a Bank will not be won if it is based purely on a borrower s regret that he made the wrong decision when deciding to fix rates. There have to be substantial reasons for complaint. 2. Typical Interest Rate Products The typical products are interest rate swaps, caps and collars- each of them is a form of "derivative". Putting it simply a derivative is a financial product that is derived from some other (underlying) asset. Rather than the underlying asset being traded there is an exchange of cash or assets over an agreed period based on the underlying asset. So, for instance, interest rate swaps are contracts to exchange cash based on the underlying value of interest rates which may be aligned to Bank of England base rate or LIBOR. 2.1 LIBOR swaps The wholesale market in interest rate swaps is linked to LIBOR, which in the case of sterling is sterling LIBOR. Historically almost all interest rates were linked to LIBOR (but see Base Rate swaps below). By adding a swap to a floating LIBOR loan, the loan is turned into a fixed rate loan, which is the advantage which has been offered to many borrowers in recent years. 2.2 Base rate swap The base rate (a fluctuating figure) is substituted by a fixed rate debt. This is calculated on a "notional principal" this is often the amount of the actual borrowing or the amount of the facility or the total of the anticipated borrowing. In a straightforward case, the business agrees a rate with the bank; if the bank s base rate is higher on specified dates, the bank pays the difference. If it is lower, the business pays the difference. The period of the swap will be a fixed one and should be related to the period of anticipated borrowing, but may not. The swap remains in place for the whole of its agreed period even if the borrowing has been repaid. 2.3 Interest rate cap 1

2 Here, there is an agreed limit on the interest rate that the business has to pay. If base rate exceeds this capped rate, the bank pays the difference. In this way, the business removes the risk/cost to it of base rate rising. In return for this protection, an agreed payment is made to the bank up front. Caps may be linked to LIBOR or Base Rate. 2.4 Base rate collar The "collar" is a mixture of a maximum rate (a cap) and a minimum rate (a floor) so giving the business a form of certainty within this range. The cost to the business is usually less than having a cap, because the bank s price takes it into account that there is a minimum exposure for the bank by there being an interest rate floor. As a result, caps may be attractively priced if interest rates are rising and expected to rise further. Again these can be linked to LIBOR or Base Rate How a collar works A cap is agreed at 6.00% and a floor at 4.25%, and suppose base rate is currently 1%. The floor triggers at 4.25% and so at any base rate from that figure downwards, the customer has to make a payment to the bank. Base rate falls to 4% - the customer pays 4.25% to the bank Base rate falls to 1% - the customer pays 4.25% In practice, interest rate products can vary greatly depending upon the parties' views of the volatility of rates and the customer s appetite for risk. 2.6 Multi-callable Swaps These swaps are designed to greatly favour the bank. A typical scenario may be a swap for 10 years with the right for the bank to end it at the end of the fifth year and then at quarterly intervals after that. In effect, the customer is selling options to the bank. The attraction to the bank is that if the swap begins to work against it (e.g. when interest rates are rising) it can simply terminate the swap without having to pay any compensation to the customer. (For types of option, see below) So, the bank has it both ways putting it simply, if interest rates fall the customer pays; if the rates go up the bank can end the swap. Customers, however, may agree to a multi callable swap because by giving the bank this major advantage, the bank will usually not charge a premium for entering into the swap. 3. Transaction Mechanics Where swaps are entered into by trading businesses, it is usually to hedge against changes in interest rates. For most businesses, the purpose of the swap is to alter the company's interest rate exposure to bring it into line with the management's approach to interest rate risk. Swaps are also used to a very large extent to speculate on interest rate changes but this is a trading function rather than hedging and is usually undertaken by financial institutions rather than other businesses. Although it is standard that interest rate products are calculated on a "notional principal", the concept is not always fully understood and can lead to disputes. A basic example of how the notional principal works is that a customer borrows 2m for five years with the notional principal fixed at 2m for the same period. This means that if the customer repays, say, 2

3 1.5m, the notional principal of the swap still remains at 2m and so, the interest rate product continues to be calculated on this amount for the remainder of the five years. This can cause particular problems for customers who repay loans early (for instance, a house builder that is contractually obliged to pay the proceeds of each house sale to the bank as sales take place). Typically interest rate products are subject to the very complex International Swaps and Derivatives Association ("ISDA") Master Agreement. This is a standard agreement but which is tailored to the particular deal by the use of a Schedule of specific terms. The aim of using a standard agreement is to reduce the opportunities for dispute. 4. Break Cost If a Swap is broken before the end of its term then a substantial break cost may be payable. In November 2010, for instance, this could be as much as 20% of the notional amount. So, a swap with a notional amount of 10 million may well have entailed a break cost of 2 million. This is commonly the mark to market figure that is the market value (reflecting in part the value the swap might have had to the bank if it had not been broken.) It is frequently difficult to ascertain from the bank how this figure has been calculated. The reason they will give is that it is the market price that happens to be applicable at the point the swap is broken. However, we use an expert who can check the bank s figure and also see whether there is any room to negotiate a lower figure although the magnitude of any reduction is unlikely to be great. 5. Types of options The bank may have included in the swap clauses that allow it to end the swap if the swap becomes unfavourable to the bank. These rights of termination are called options. There are three main types that figure in interest rate swap transactions:- European option This can only be exercised once. American option The bank can exercise this at any time before the expiry date of the swap. Bermudan option The swap contract enables the bank to end it on more than one specified date. There are many other options that can be applicable to financial services transactions but the above three are the most common for interest rate hedging. 6. The Popularity of Interest Rate Hedging Products The majority of derivatives are traded between parties (that is, "over-the-counter") rather than via an exchange and the largest market is in the City of London. Being OTC products, interest rate swaps come in a huge number of varieties it is basically whatever the parties agree between themselves. In the case of large transactions, they can be structured to the specific needs of the parties with, for instance, the legs of the swap being in the same currency or in different currencies. Usually, the swaps are fixed-for-fixed, fixed-for-floating or floating-for-floating. A fixed rate for floating rate swap (or floating rate to fixed rate) if it is no more than a commitment to swap the interest liabilities is called a vanilla swap. 3

4 The Bank for International Settlements has reported that as at December 2006 the notional amount outstanding in OTC interest rate swaps was US$230 trillion. The damage caused to banks and other traders by the collapse of this market has of course been one of the features of the recession. 7. Disputes Complaints we are handling against banks about interest rate products have centred around a number of allegations including that:- The customer did not understand what was being sold to him. The product was mis-sold. The bank were aware that some of the loan would be repaid during the period of the notional principal. The customer was not aware of the magnitude of the break cost (this is very common indeed). The customer was not aware of the implications of the bank s ability to terminate the swap. The FSA Conduct of Business Rules (COBS) have not been complied with. A duty of care was owed by the bank to the customer and was breached. The swap will be unsuitable for the customer, for instance, where the loan is linked to Base Rate and the swap is linked to LIBOR or if the term of the LIBOR rate on the swap is different from the term of the interest rate on the loan (e.g. 1 month LIBOR versus 3 month LIBOR). The most common allegation is that the customer did not have sufficient understanding of the product to be aware of the implications of interest rate falls, and/or that the bank's promotional material highlighted the benefits of the product but obscured the possible downside. This is less likely to be the case for a vanilla product, but more likely for a more complex structure. 8. Financial Services Authority Rules A typical consideration is whether the bank complied with FSA requirements relating to suitability and risk. Very briefly, the position under the FSA Conduct of Business Rules is as follows:- COBS 3 normally the business is classified as a retail client which means that it is entitled to the highest level of regulatory protection. COBS 9.2.1(1) if the bank is in the position of recommending the interest rate product, then it has to comply with the suitability obligation of COBS 9 requiring it to take reasonable steps to ensure that any personal recommendation given was suitable. COBS 9.2.1(2) to enable it to make a suitable recommendation the bank should have obtained information regarding the customer's knowledge and experience in the 4

5 field of interest rate derivatives, his personal financial situation and his investment objectives. COBS the information the bank obtains has to be sufficient to enable it to have a basic understanding of the essential facts about the customer and to establish a reasonable basis for believing that the product is such that the customer has the necessary experience and knowledge to understand the risks involved. Also, that it meets the customer's investment objectives, and that the customer is able to financially bear the related risks. COBS the bank has to carry out an adequate assessment of the expertise, experience and knowledge of the customer in the field of interest rate derivatives to establish that he was capable of making an informed investment decision and capable of understanding the risks involved. The nature of the information the bank has to obtain is indicated in COBS COBS the failure to obtain necessary information to assess suitability prohibits the bank from making a personal recommendation or taking a decision to trade. A breach of COBS can lead to a complaint to the Financial Ombudsman Service (providing the business does not have a turnover greater than specified limits) and it can award compensation up to 100,000 and has power to make a non-binding" recommendation" for a higher payment. 9. If the Bank has Duties as Adviser If the bank acted as an adviser then it usually has higher duties to the customer (including possible fiduciary obligations). Whilst in practice banks often advise customers when selling interest rate products, if a dispute arises, the bank will commonly deny this and will seek to rely on exclusion of liability clauses. Banks are keen to avoid the potential tortious and contractual liability which can follow from the relationship of adviser. For further information please contact: Stephen Rosen, Head of Financial Services Disputes E: Stephen.rosen@collyerbristow.com T: +44(0) Disclaimer The content of this document is provided for general information only and does not constitute legal or other professional advice. Appropriate legal or other professional opinions should be taken before taking or omitting to take any action in respect of any specific problem. Collyer Bristow LLP accept no liability for any loss or damage which may arise from reliance on information contained in this document. Collyer Bristow LLP