Interest rate hedging product claims – the current landscape

1.  The FSA review

In 2012, the Financial Services Authority (FSA) announced the findings of its review into interest rate hedging products (IRHPs) sold to small and medium sized firms and in June and July 2012, the FSA agreed with eleven banks that they would conduct a proactive redress exercise and past business review in relation to their sales of IRHPs on or after 1 December 2001.

Specifically, the FSA has agreed with the banks that, for sales to customers categorised under the FSA's rules as either 'private customers' (in respect of sales before 31 October 2007) or 'retail clients' (in respect of sales from 1 November 2007), the banks will:

• Provide appropriate redress to non-sophisticated customers sold structured collars;
• Review sales of other IRHPs (except caps and structured collars) to non-sophisticated customers and provide redress where appropriate; and
• Review the sale of caps to non-sophisticated customers in cases where a complaint is made by the customer and provide redress where appropriate.

In each case, a customer will be regarded as 'non-sophisticated' if it does not meet the FSA's 'sophistication test' and any redress provided is to be by reference to what is fair and reasonable in all the circumstances. The exercise for each bank will be scrutinised by an independent reviewer and overseen by the FSA.

Each bank was asked to undertake a pilot review of a small sample of more complex cases before beginning the full review.  On 31 January 2013, the FSA published a report on its findings from its review of the pilot exercise conducted by Barclays, HSBC, Lloyds and RBS and confirmed that those banks would commence their full reviews in accordance with the approach set out in that report. The FSA has said that it expects those banks to aim to complete their full reviews within 6 months, although the FSA accepts that for banks with larger review populations this may take up to 12 months.

On 14 February 2013, the FSA also confirmed that the remaining banks (apart from the Irish Bank Resolution Corporation, which went into special liquidation on 7 February 2013)  had also agreed to proceed with their full reviews in line with the same approach set out in the  FSA's 31 January 2013 report.

2.  FOS decisions

Although the FSA initially considered the establishment of a scheme effectively extending the FOS's jurisdiction to deal with IRHP complaints, it has recently been confirmed that this will not be put in place.  However, customers meeting the existing FOS eligibility criteria will remain able to refer their complaint to the FOS if they are not satisfied with the redress offered within the review process.

It appears that a number of customers have already complained to the FOS. Indeed, during 2012 two provisional FOS decisions involving the sale of IRHPs were issued –  W Family v Bank E and Business H v Bank S.  The relevant parties in each case were requested to submit further representations before the FOS finalises its determinations. We set out further detail below.

The W Family v Bank E

In July 2007, the W Family took out a variable rate 14 year loan in order to expand their business. At the same time, the family took out a multi-callable swap for a period of 15 years, with an initial two year discounted rate. After two years, a higher fixed rate was payable for the remaining period of the swap. The interest rate payments under the swap were tied to LIBOR, as opposed to Bank E's base rate, on which the loan was based (i.e. there was an element of mismatch).

The Ombudsman found that:

• although the documentation was "unclear and contradictory about whether or not advice was given", the actions of  the bank did in all the circumstances amount to professional investment advice in respect of the swap;
• the bank recommended a swap that was not suitable to the W Family. The Ombudsman described the swap as being "a one-sided deal", which allowed the bank to terminate the swap after two years if rates rose at any time, thereby leaving the customer unhedged against rising rates (although he did not directly consider the impact of including the call feature on the discounted rate offered on the transaction). The swap also did not amortise, even though it was expected that the W Family would start making capital repayments against the loan after the first two years, and the swap also lasted a year longer than the loan itself;
• the bank also failed to explain the potentially onerous cancellation costs associated with the swap.

Business H v Bank S

Business H took out a variable interest rate loan and also bought a "base rate collar" in connection with the loan. (The bank later said that the hedging was a condition of the loan and the lending would not have been granted unless a hedging transaction arrangement had been agreed). The collar was set to cover a sum of £356,000, had a 20 year term and was set to amortise.

The Ombudsman found that:

• the bank's actions in connection with the swap amounted to investment advice;
• the notion of a collar was not inherently unsuitable for Business H in its circumstances, given its desire to minimise the premium for this arrangement. However, a floor of 20 years with the possibility of significant cancellation charges was not suitable overall for the needs of Business H, which was a small operation; and
• the bank also failed to highlight adequately or to explain the potential cancellation charges.

It is interesting to note that in both cases the Ombudsman did not make any formal findings on redress. Instead, he invited both parties to discuss how best an award could be agreed and, to facilitate those discussions,  set out the principles he would take into account if he were to make a formal award.

3.  Court decisions

Grant Estates Limited v Royal Bank of Scotland²

This is a Scottish case and the first reported judgment on the subject of IRHP mis-selling. In 2007, Grant Estates and RBS entered into a 5 year loan agreement for £775,000 and a swap transaction for the same notional amount. Grant Estates alleged that RBS mis-sold the swap agreement and that, instead of protecting Grant Estates from a rise in interest rates, the swap fixed rates too high and became such a burden on the company that it defaulted on the loan agreement with RBS and fell into administration. The Court rejected the claim on the following grounds:

• Grant Estates was not a "private person" for the purposes of s.150 of the Financial Services and Markets Act 2000 ("FSMA") and therefore had no direct remedy under that provision;
• there was no implied collateral agreement for the bank to advise Grant Estates and consequently no breach of such a contract. This finding was based heavily on the Court's conclusion that there was a written contract setting out what RBS was to undertake and expressly warning Grant Estates that it should obtain its own independent, legal and tax advice; and
• the acts of the bank employees were consistent with a contractual regime in which the customer had agreed that it would not treat any views that the bank expressed in bringing about the derivative transaction as advice on which it was entitled to rely.

Green & Rowley v RBS³

In this first reported English IRHP case, the customers alleged that in May 2005, RBS mis-sold to them an interest rate swap as a form of hedge against their existing loan liabilities to the bank. They alleged that:

• the bank had made various negligent misstatements regarding the operation of the swap, including understating the costs if they chose to break the swap early and inaccurately indicating that the swap transaction fixed not only the base rate but also the margin; and
• the bank owed them advisory duties in respect of the swap because it had positively recommended the transactions and that those duties had been breached because the swaps were not suitable for them (principally because they allegedly required a transaction that fixed not only the base rate but also the margin).

Originally there were also claims for breach of statutory duty under s.150 of FSMA but it was accepted that those claims were time-barred.  Nevertheless, the customers alleged that at least some of the relevant FSA Conduct of Business Rules (the 'COB Rules') informed the scope of the bank's common law duties for the purposes of both the negligent misstatement and the negligent advice claims.

The claims failed in their entirety, with the Court finding that there was no negligent misstatement and that no advisory duty had arisen (and that, in any event, there had been no breach of any such advisory duty).

This case was highly fact-sensitive and the Court's findings turned largely on what was said at a meeting between the claimants and employees of the bank at which information regarding the swap and other similar products was provided. However, as in Grant Estates(above), the contractual documents contained helpful provisions clearly confirming that no advice was being given and the judge cited Grant Estates in finding that such provisions can be invoked to negate or delineate the ambit of any duty of care.

The judge also noted, with respect to the relevance of the COB Rules, that the scope of the duty in a common law action for negligent misstatement (as distinct from an advisory duty) is narrower than and does not necessarily encompass the COB Rules to the extent that the COB Rules include (i) duties to take reasonable steps to communicate clearly or fairly (COB 2.1.3) and (ii) duties to take reasonable steps to ensure that a counterparty understands the nature of its risks (COB 5.4.3).

Whilst future decisions could of course take a different approach depending on the specific facts (including particularly the content of a bank's written terms), these first two IRHP judgments have been welcomed by the financial services industry.

4.  Potential for 'top up' of FOS decisions through court action

The manner in which IRHP claims are pursued may also potentially be influenced by a recent  High Court decision holding that a party who had accepted a favourable FOS decision and been paid the statutory maximum award (then £100,000, now £150,000) by the firm could nevertheless subsequently bring a damages claim for the balance of the full loss they had allegedly suffered, over and above the FOS award: Clark & anor v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669.

The decision departs from previous authority on this issue and, unsurprisingly, permission to appeal has been sought.  If the High Court's decision is upheld, this may have the effect of encouraging potential litigants to seek to fund subsequent court action through a FOS award.  Complainants may also seek to adduce the FOS judgment in support of their court case, particularly given that it is quite common for the FOS to recommend a higher award than its statutory limit (albeit that the test for liability applied by the courts is of course materially different from the test adopted by the FOS).

Read our full briefing on the decision.

5.  LIBOR allegations in IRHP claims

A claim currently pending in the High Court has also raised the possibility of the IRHP claims landscape being overlaid with claims in respect of LIBOR (London interbank offered rate).

The claimants in that action have brought a claim in relation to loans made to them with an associated interest rate swap and interest rate collar agreement, payments under which were set by reference to 3 month Sterling LIBOR.  In a judgment delivered on 29 October 2012, the Court permitted the claimants to amend their pleadings to add claims based on alleged implied representations by the defendant bank (and/or implied contractual terms) as to the integrity of the LIBOR rates. The allegations in this respect rely heavily on regulatory findings against the relevant bank in respect of LIBOR:  Graiseley Properties Limited & ors  v Barclays Bank Plc [2012] EWHC 3093

It is important to note that the Court did not make any considered determination of the LIBOR allegations and was only required to consider whether the points raised reached the threshold of being sufficiently arguable to proceed to trial and be tested. However, this is now an important test case and the trial (listed in October 2013) will be watched closely both by claimants considering bringing similar claims and defendant banks.

¹ Grant Estates Ltd v The Royal Bank of Scotland Plc [2012] CSOH 133.
² John Green and Paul Rowley v The Royal Bank of Scotland [2012] EWHC 3661.