A difficult combination: 'mis-sold' complex derivatives products
In private some commercial litigators marvel at the fact that more litigation has not emerged from the banking crisis and the UK’s prolonged period of recession and slow growth. But one source of potential claims against the UK’s four largest banks has been getting increasing attention this year - small and medium-sized enterprises (SMEs) who believe they were mis-sold complex derivatives products whose main aim was to protect them against the (as it turned out) unrealised threat of a rise in interest rates.
The first claims were brought around two years ago, though in each instance, cases headed for trial have settled before they got to court. But only now are business owners, many of whom believe they have lost anywhere between hundreds of thousands to millions of pounds, gaining significant attention for this issue. The Financial Services Authority (FSA) will decide within the next month whether to investigate the sale of these products. More than 40 MPs from the major parties are urging the Treasury Select Committee to hold hearings on the issue. Claimants’ after-the-event (ATE) insurance premiums have fallen and litigation funders are willing to back what they estimate are 4,000 higher-value claims.
Case by case
The use of complex derivatives to ‘hedge’ against events that would harm an enterprise are an established part of business practice. And lawyers acting for claimants are at pains to point out that, unlike payment protection insurance, which the FSA judged was generically mis-sold, interest rate swaps (IRSs) are legitimate and useful products for some corporate customers.
Instead the contention is that IRSs were sold to many businesses for whom they were not appropriate, under some pressure, and in circumstances where those businesses were unable to obtain independent advice. But although each case needs to be looked at on its merits, Eddie Dervish, senior partner at Hugh Jones & Co, who has been taking instructions from clients on these cases for two years, says: ‘These cases follow a distinctive pattern, to the point where I can predict what a client’s account will be.’
That pattern involves an initial approach by the business owner’s trusted relationship manager regarding the business’s financing. The manager then says they cannot help further with finance, but that colleagues from the derivatives side of the bank can. Presentations from colleagues follow, stressing only the risks of interest rates rising, ‘the selling starts’ and finance is made dependent on the purchase of the derivatives product (IRSs).
James Ducker, now an expert witness who also renegotiates terms with banks on behalf of clients, once sold IRSs for two major banks. He relates the pressure, as he witnessed it, within the teams that sold such products. ‘There is enormous pressure to meet targets,’ he says, ‘but on top of that people can meet targets and still find their work being reviewed because colleagues have outstripped their performance’. That, he says, is the context in which the high-pressure approach recalled by business owners, and confirmed by lawyers who have reviewed their cases, can be suggested. Pressure, Ducker adds, is also transmitted to relationship managers who ‘need to do well’ for such colleagues by lining up opportunities with their customers.
A further common complaint from business owners who contacted the Gazette following previous coverage of these claims is that the derivatives product contained expensive break clauses that were poorly explained using low-cost examples. Perhaps more significantly, the derivatives products applied for a term that far outlasted the term of the finance agreed - effectively locking the customer into high-interest financing for years longer than they had expected.
A hard start
Evidence of alleged mis-selling gathered by solicitors who have brought, or are preparing, claims includes: emails from the client’s bank; the bank’s own recordings of telephone conversations; information provided by the bank; and evidence of the bank’s assessment of their customer’s business needs.
But of course the existence of compelling evidence is not the only hurdle to bringing a claim. There is also the timescale involved - typically, preparation takes five or six months before a claim is lodged and, for a case that runs almost to trial, a further 12-18 months from that point. The most recent case known to have settled was that of Wand Property, advised by SRB Legal. As has been widely reported, the trial had been scheduled to start in Bristol Mercantile Court on 16 April, with what appeared to be an expensive defence of a claim of only tens of thousands of pounds, to have been led by Sonia Tolaney QC.
The challenge of funding such cases has been eased by funding arrangements that continue to develop. As already reported by the Gazette, litigation funder Norton Accord has the backing of three funds for what it believes could be 4,000 cases in the £2m-£4m range totalling £1bn. Under this arrangement, loans fund law firms’ work in progress on pre-vetted IRS mis-selling claims. The deterrent represented by the prospect of paying a bank’s costs if a case is lost has been mitigated by the increasing willingness of ATE insurers, which have taken note of the banks’ settlement records, to offer historically low premiums. And solicitors are offering a combination of conditional fee and part-conditional fee agreements.
Perhaps a bigger problem is claimant business-owners’ continued and unavoidable reliance on banking facilities as they bring a complaint. When a problem is raised, Ducker notes, ‘banks can be fairly aggressive in their tactics’. Bracewell Law partner Chris Hale, whose firm is preparing cases for more than 30 clients, cites examples where banks have had ‘a pretty hard response’. He says: ‘Clients have been referred to [banks’] restructuring teams when they have raised this issue.’ Dervish relates ‘threats to appoint receivers’ in such circumstances.
Evidence and information sought by solicitors seeking to assess the viability of business owners’ claims include: Contract particulars. Documentation signed by the customer - including facility agreements and interface between International Swaps and Derivatives Association signatories and those of bank mandate. Compliance by the bank with its statutory and regulatory obligations under the Financial Services and Markets Act 2000 and the Conduct of Business Sourcebook. Misrepresentations in promotional literature and pre-point-of-sale discussions with the bank. The extent to which the bank ascertained the circumstances and product knowledge of its customer. The period when these products were sold - in some instances after the collapse of Lehman Brothers. Any duress suffered by the customer. The complaints policy of the bank.
Evidence and information sought by solicitors seeking to assess the viability of business owners’ claims include:
Documentation signed by the customer - including facility agreements and interface between International Swaps and Derivatives Association signatories and those of bank mandate.
Compliance by the bank with its statutory and regulatory obligations under the Financial Services and Markets Act 2000 and the Conduct of Business Sourcebook.
Misrepresentations in promotional literature and pre-point-of-sale discussions with the bank.
The extent to which the bank ascertained the circumstances and product knowledge of its customer.
The period when these products were sold - in some instances after the collapse of Lehman Brothers.
Any duress suffered by the customer.
The complaints policy of the bank.
Source: SRB Legal
With property commonly sought as security by the banks, a further complaint related by Collyer Bristow partner Stephen Rosen, whose firm is advising on some of the larger claims reported by the Gazette, is that perfectly legal steps can be taken by a bank to put a customer in breach of their covenants. ‘The bank will say, if ever you [the client] were to default, this would be the penalty,’ he says. The penalty is added as a contingent liability - a figure that can trigger a breach, and consequently the renegotiation of the business’s financing arrangement. The new arrangement may offer credit on worse terms, Rosen adds.
Did banks advise?
Rosen notes: ‘These cases always have a lot of exclusion clauses.’ What is more, banks do not hold themselves out as offering ‘financial advice’, and the paperwork accompanying these agreements commonly states this. It is a picture that solicitors advising on claims believe sits uneasily with the style and manner of marketing their clients experienced.
Dervish says: ‘I have had one client who speaks no English and another who barely speaks any. To obtain independent advice, they would have needed to find a translator who was also expert enough to explain derivatives.’ Such bank customers, he argues, should never have been targeted with these products. Likewise, he feels that some of the smaller, ‘hard-working but unsophisticated’ business owners he has advised were wrongly targeted by their banks. (Website bully-banks.com has been set up by some business owners as a central source of information and registration of potential claims.)
With early cases, Dervish contacted the FSA to ascertain who could have given his clients ‘independent advice’ on IRS products. The FSA did not respond, but Dervish notes: ‘We could only identify two sources - an adviser to very large corporations and another whose fees were utterly disproportionate to the amounts involved.’ At the very least, Rosen argues, the banks should have been quite clear in stating ‘this is a derivative, it is complex and you should take the advice of a solicitor’.
The law firms which spoke to the Gazette typically had around 30 cases in total either concluded or, mostly, still open. Alleged misrepresentation is central to almost all cases. Of particular concern, according to SRB Legal partner Stuart Brothers, is the presentation of the exit fees for IRSs. ‘We very seldom see that a proper explanation was given regarding how an exit fee would apply,’ he says. An ‘illustration’ of an exit fee that was in the hundreds of pounds might be given to a client whose own exit fee could end up being in the hundreds of thousands.
‘Think about what clients wanted from the trade and what they ended up with - the outcome was the complete opposite. The potential use of duress on the part of the banks is a particular concern'
Instances of remote selling are common, Brothers adds. Aside from the fact that remote selling was more likely to leave an electronic or recorded trail of what occurred, Brothers questions the practice of remote selling itself. ‘How could they [the bank’s staff] satisfy themselves that this was an appropriate product for the customer?’ he asks. Hale’s colleague Michael Brennan, formerly a lawyer at HBOS Treasury, also stresses problems with the ‘suitability’ of what was sold: ‘Think about what clients wanted from the trade and what they ended up with - the outcome was the complete opposite.’ The potential use of ‘duress’ on the part of the banks is a particular concern, he adds.
As already noted, for clients who persist with a claim banks have so far sought to settle before trial. Brothers suggests that banks’ reluctance to fight a case all the way may stem from a fear of a new precedent being set. ‘The precedents on contract estoppel are bank-friendly,’ he notes. ‘Banks don’t want to test these principles at such a low level.’ Meanwhile, a team at the FSA has started to look at how these derivative products were sold. In a statement sent to the Gazette, a FSA spokesperson said: ‘The work we are doing at the moment is to find out more about the products sold, how they were sold and whether they met customers’ needs. We have already received some detailed information from banks in connection with their sales of interest rate swaps which we are considering and we have also spoken to a number of customers who have been affected. If we find widespread evidence of breaches or mis-selling we will take appropriate action.’
The Gazette contacted the major banks named by solicitors acting for clients in interest rate swap claims. Three responded. Lloyds TSB has asked us to note that its market share of these products is relatively small. A spokesperson for HSBC provided the following statement: ‘Although we cannot comment on individual customers, we strive to meet our customers’ needs and believe we have extensive processes to ensure our customers are provided with appropriate products. We aim to build long-term, mutually beneficial relationships with our customers, based on transparency and ongoing dialogue. Should a customer have any concerns at all about their banking arrangements with us, we are always happy to look at their particular circumstances.’ An RBS spokesperson said: ‘We have procedures in place to ensure these products are sold in accordance with regulations. Any customer who feels that procedures have not been followed should contact the bank.’
What the banks say
The Gazette contacted the major banks named by solicitors acting for clients in interest rate swap claims. Three responded. Lloyds TSB has asked us to note that its market share of these products is relatively small.
A spokesperson for HSBC provided the following statement: ‘Although we cannot comment on individual customers, we strive to meet our customers’ needs and believe we have extensive processes to ensure our customers are provided with appropriate products. We aim to build long-term, mutually beneficial relationships with our customers, based on transparency and ongoing dialogue. Should a customer have any concerns at all about their banking arrangements with us, we are always happy to look at their particular circumstances.’
An RBS spokesperson said: ‘We have procedures in place to ensure these products are sold in accordance with regulations. Any customer who feels that procedures have not been followed should contact the bank.’FSA action does not bring with it the immediate prospect of a resolution for business owners who believe they were the victims of mis-selling - in June the regulator will simply announce interim findings, and whether or not it intends to investigate further. But solicitors acting on claims believe it is a ‘helpful’ development. ‘FSA action may speed things up,’ Hale notes, though in the short-term he thinks that some banks’ positions have ‘solidified’ as a result of added political and media attention.
The ‘pressure’ such interest creates, Rosen confirms, ‘affects the landscape’. For the same reason, if the Treasury Select Committee heeds calls from 40-plus MPs and investigates further, it will be regarded by claimants’ advisers as further helpful scrutiny of this area. ‘These are commercial disputes, not a crusade against the banks,’ Rosen stresses.
But, as Brothers concludes, this is a set of cases being brought in an area of significant public policy interest: ‘SMEs that have been sold these swap agreements have not benefited from historically low interest rates. The very purpose for which the government has been keen to keep interest rates so low has been wiped out by the banks counteracting any such benefit through the sale of IRSs.’
Eduardo Reyes is Gazette features editor