THE LOW DOWN
The financial services regulator tried to deter business owners from using lawyers to make claims against banks when it set up a redress scheme for the mis-selling of interest rate hedging products. Not everyone listened, and the lawyers and financial consultants who saw the process first-hand talk of a system in which the banks, which administered the scheme through ‘independent assessors’, frequently held the whip hand. Decisions on compensation lacked transparency and were based on documents frequently not made available to businesses making the claim – and the process dealt poorly with consequential loss. With the scheme closed to new claims, and all but a handful of claims processed, the Financial Conduct Authority has appointed John Swift QC to conduct a review. Lawyers say serious lessons must be learned, especially since some clients who shunned the scheme did better than those who trusted it.
It is a feature seemingly common to all banking and finance scandals: they take an age to work through. After ‘rogue’ derivatives trader Nick Leeson caused the bankruptcy of Barings in 1995, he fled from Singapore to Germany, faced extradition, stood trial and served a four-year prison sentence. But even by the time he was freed, there were years more litigation stemming from the bank’s collapse still to play out.
Another example. The Financial Services Authority decided in 2005 that compensation for near-universally mis-sold payment protection insurance was a priority. Yet it took 14 years to return £36.8bn, a limitation period finally being set for the end of 2019.
In 2010, information on a potential mis-selling scandal affecting smaller businesses was shared with the FSA. In March that year, solicitor Stuart Brothers wrote to the financial regulator expressing concern over ‘hedging’ products sold to his clients by banks as part of loan deals. As Brothers later told the Gazette: ‘I was staggered, quite frankly, by the lack of interest they showed.’
Businesses affected had found that instead of traditional retail banking products, such as fixed-interest loans, they were steered towards more complex hedging products offered by investment banking arms – derivatives linked to the underlying loan.
But interest rate hedging products (IRHPs) could work in unexpected ways. There were IRHPs that protected the customer against a rise in interest rates, when interest rates subsequently fell and have remained at historically low levels since the crisis. With some products, perversely, customers could see the interest rate they paid to the bank increase, even though the benchmark had fallen. In other instances, the duration of the products exceeded the duration of the loan to which it was attached.
Hedging products were and remain a useful element of business finance, but a particular concern here was that they were mis-sold to what were later termed ‘non-sophisticated’ customers, to whom the risks were not made clear. These were customers who did not appreciate the importance of independent advice. The allegation against the banks was that pressure was applied by salespeople who earned significant commissions for themselves and higher fees for the banks.
Martin McTague, chair of the Federation of Small Businesses, points out: ‘The majority of small businesses have more in common with consumers than big corporations. A lot of small firms are not in a position to assess complex products and – if they feel they’ve been a victim of mis-selling – are often caught between a rock and a hard place: too big for the ombudsman, too small for the courts.’
Fast forward to 2012, and the FSA accepted there was a problem. The regulator’s subsequent review of a sample of 173 IRHP agreements established at least two regulatory breaches in 90% of product sales. In June that year it reached an agreement on the basics of a ‘redress scheme’ with Barclays, HSBC, Lloyds and RBS. Other banks joined later.
The scheme was, depending on your viewpoint, a risky experiment or a groundbreaking model for resolving large-scale mis-selling scandals. Administered and paid for by the banks, it provided independent adjudication for the claims of ‘non-sophisticated’ business-owners on products with a value of less than £10m.
Nothing on this scale had been attempted before for product sales made in such a complex set of circumstances. Controversially, the regulator went out of its way to tell claimants that they would not need independent legal advice to get a fair outcome.
At its height, banks in the scheme employed 3,000 staff to administer it. Some £2.2bn has been paid in compensation, £500m of which was for ‘consequential loss’ claims.
Time to review
The scheme is closed to new applications and almost all claims have now been processed. But the FSA’s successor, the Financial Conduct Authority (FCA), has commissioned a review of the scheme’s operation led by John Swift QC, former head of Monckton Chambers.
Swift’s review closes for submissions on 31 January and its outcome is eagerly awaited, amid suggestions the scheme was structured in such a way that many businesses got less compensation than they should have done.
One consultancy that provided expert evidence to claimants insisted £16bn-£20bn should have been paid out, based on comparing outcomes for clients who entered the voluntary compensation scheme with those who pursued a claim through other channels. Could the way the scheme was first framed and then administered really account for such a shortfall? We cannot know, but there is evidence that administrative flaws led to payouts which stopped short of full redress.
Criticisms of the scheme include concerns that banks’ disclosure of evidence was very limited, and that the assessors’ decision-making process was not transparent – often relying on evidence and information not made available to the business making the claim. The convoluted test to determine who could be admitted to the scheme as a ‘non-sophisticated’ customer also ensured a class of customer was excluded – too small to fund litigation, but large enough to have accumulated over £10m of IRHPs.
Some products carried a presumption of mis-selling if the customer also met a 10-point test that classed them as ‘non-sophisticated’, while others did not (see box below).
The FCA position that expert advice was not needed by businesses entering the compensation scheme was ‘ironic’, notes Jackie Bowie, chief executive of financial products consultancy JCRA, given that many business owners were sold IRHPs which caused them loss without the benefit of independent advice in the first place. Those customers who did instruct lawyers and other experts to support their claim gave those advisers insight into the operation of the scheme which can now be shared.
Collyer Bristow partner Janine Alexander was one. The ‘imbalance of information’ between bank and customer is the first point she raises. Decisions on the validity and quantum of a claim were made on documents seen by the independent assessor but not the bank’s customer. Documents such as notes of meetings between bank staff and the customer, for example meetings at which product sales were made, ‘would get referred to’ without being made available.
‘It was almost like being in a litigation process,’ Bowie observes, albeit without the benefit of disclosure obligations. ‘The banks were forced into it,’ she adds, and there was no sense that ‘customers were being looked after and properly supported’.
‘The basic IRHP redress review was frustratingly slow both to start and then to provide compensation’
Claire Collinson, Claire Collinson Legal
Naturally, the experience of business owners making a claim varied. One factor affecting this, Alexander says, was whether the claim fitted the ‘patterns of behaviour’ the FSA identified early on in its review of the IRHP market as constituting a mis-sale. Claims with a feature that was ‘slightly unusual’ were more difficult than those where patterns could be discerned.
Among the claims falling outside the established ‘patterns’, Bowie adds, were particular products sold by Clydesdale and Yorkshire banks, which had ‘embedded’ the hedging product in loan agreements, which placed the products outside the FCA’s superintendence (as there was no separate product sale).
Claire Collinson, founder of Claire Collinson Legal, took IRHP claims against the banks, both through and outside the compensation scheme, recovering £30m for 120 clients. ‘By and large, the provision of basic redress – return of IRHP payments made where a product had been mis-sold – through the FCA review was, in my experience, reasonably fair,’ she says.
Exceptions included ‘individual cases’ where the bank insisted the business owner would have chosen an ‘alternative product’ of comparable cost to the IRHP ‘which the small business was adamant they would not have entered into’. She is also critical of the length of time business owners waited for compensation.
‘The basic redress review,’ Collinson says, ‘was frustratingly slow both to start and then to provide compensation. Many of the IRHP products had been sold in 2006-2008 and really started to hurt businesses from early-2009 onwards when interest rates dropped and unexpected payments and break costs increased dramatically.’ For such businesses, the wait for compensation paid out in 2013 and later was, she says, ‘a particularly stressful time for many small business owners and more could have been done to get compensation to them earlier’.
The redress scheme may have been streamlined compared to a court process, but it was not small-scale. As noted, banks informed the FCA that at its peak 3,000 staff worked on the redress scheme and 16,000 businesses opted to enter the scheme (13,900 accepted the redress offer made).
FALLING THROUGH THE FLOOR
An interest rate swap is a separate contract to the underlying loan agreement. It is an agreement between two parties whereby one type of interest payment is swapped for another; such as exchanging a fixed interest rate payment for a floating payment. The FCA set out different presumptions for the interest rate hedging products covered by the redress scheme agreed with the banks.
Cap (category C): caps sold to ‘non-sophisticated’ customers carry no presumption of mis-selling, though the FCA identified instances of mis-selling. They were assessed for mis-selling where the customer made a complaint about the sale. A cap can limit increases in a customer’s loan repayments if interest rates rise. The lower the agreed interest rate, the higher the fee.
Simple collar (category B): these were assessed to determine if they were mis-sold. A simple collar involves a ceiling and a floor. As interest rates rise, loan repayments will increase, but increases are capped at the rate agreed as the ceiling. Similarly, as base rates fall, any reductions in loan repayments are limited to the rate agreed as the floor.
Structured collar (category A): these were deemed to be mis-sold when the sale was to ‘non-sophisticated’ customers. Structured collars enable customers to limit interest rate fluctuations within a range. However, while the ceiling functions in a similar way, the floor is more complex and customers can end up paying increased interest rates if the base rate falls below the floor.
Some of the strongest criticism of the scheme is reserved for its ability to assess consequential loss claims. While some claims for consequential loss were ‘ludicrous’, Bowie says, other clients could cite concrete ways in which the terms of their IRHP prevented a viable, time-critical business deal or sale happening. For such reasonable claims, she says, the scheme’s assumption that 8% covered the ‘opportunity cost’ caused by the IRHP ‘didn’t touch the sides’ of the customer’s loss.
‘In all cases where I considered the bank had taken an incorrect approach to consequential loss, the independent reviewer agreed with the bank,’ Collinson says.
Abhishek Sachdev, chief executive of consultancy Vedanta Hedging Advisory, also raises the issue of consequential loss. In his submission to the FCA’s review, shared with the Gazette, he writes: ‘As the review process unfolded hardly any SMEs were awarded anything material regarding consequential loss.’
Like Bowie, he had seen loss claims that were ‘hugely exaggerated and not formulated correctly’. But, he adds, dismissal of consequential loss claims by assessors included claims supported by the evidence of forensic accountants.
Such experiences prompt comment on the place of the independent reviewers – paid for by the banks and mostly drawn from leading accountancy firms. As McTague puts it: ‘Where banks set up schemes to address mis-selling, there’s always going to be the accusation that they’re being allowed to mark their own homework.’
‘The involvement of the independent reviewers gave little comfort to customers that there was any robust testing going on of bank decision-making,’ opines Collinson. ‘They remained silent during meetings, there was no ability to make direct contact with the independent reviewers… in the vast majority of cases the independent reviewers agreed with the bank’s analysis of a claim.’
Her experience of some claims supports the view that on consequential loss, the reviewers relied too much on the banks’ own analysis. Collinson adds: ‘This was subsequently established to be the case for a number of my clients who rejected FCA review consequential loss results and went on to pursue a consequential loss claim by other means, including through the [Financial Ombudsman Service].’ On a number of such claims, ‘a significantly different and more favourable outcome has been achieved than had been offered under the FCA [scheme]’, she says.
Under review, therefore, should be the consistent advice of the FCA to business owners against taking legal advice. The advice was given at the scheme’s foundation in 2012 and, despite criticism from the start, continued to be repeated by the FCA. Writing to Andrew Tyrie, then chair of the Treasury Select Committee, FCA chief executive Martin Wheatley said in 2015: ‘We have concerns that some customers may be spending a significant amount of money on claims management companies or advisers, on claims for consequential losses that do not appear to have a reasonable chance of success.’
Encounters with the 3,000 staff hired by the banks to review IRHPs included ‘very junior people’, one lawyer tells the Gazette, ‘just out of university… [and] given some training’. Another notes that many they met at meetings had been seconded from product sales jobs in the same bank. Their ‘product sales perspective’ was not adequate experience for working on assessments, they added.
In completing his review for the FCA, Swift will also hear criticism of key parts of the redress scheme’s scope and assumptions. Vedanta’s Sachdev writes: ‘There was a wholly misplaced focus on the complexity of IRHPs which led to poor outcomes.’ Business owners were in many cases less disadvantaged by the complexity of products (an assumption made in the redress process) than by the ‘breakage cost’ of the product they had been sold.
Meanwhile, ahead of Swift’s review, have lessons already been learned? McTague sees some progress: ‘We’ve fought hard for progress in this space. The Financial Ombudsman Service is now taking on more business cases and we’re helping to establish a new, independent redress system for mid-sized firms.’ His hope is that ‘the FCA, FOS, courts, banks and alternative redress providers work together to ensure that every business owner who has been a victim of mis-selling receives the compensation they’re owed – including for consequential loss’.
The FCA was contacted by the Gazette for this feature but declined to comment.