Mis-sold Interest Rate Swaps
In 2012, the FSA carried out a review into the sale of Interest Rate Hedging Products (IRHP’s) to small and medium sized businesses; from this review the FSA found ‘serious failings. In March 2013, the FSA published partial results of a ‘pilot review’ carried out in the sale of 40,000 IRHP’s to ‘non-sophisticated customers’. During the review, the FSA looked at 173 sales and found that over 90% of the sales failed to comply with one or more of the required regulatory elements. Since these findings, public attention has been drawn to this mis-sold financial product, it has also been featured on the BBC, awareness continues to grow over this issue and the detriment it has had on businesses and consumers.
What is an Interest Rate Hedging Product or SWAPS?
An IRHP is a financial product that aims to minimise the risk of fluctuating interest rates; these were generally sold at the same time a loan was taken out with the customer’s bank. When the products have been properly sold, they provide an excellent way of safe guarding businesses against interest rate rises. These products however can range in their complexity and are difficult to understand.
Interest Rate SWAPS is a term that is covers a wide range of financial hedging products. A SWAP, of whichever IRHP had been sold, is when this product is used to ‘hedge’ or ‘bet’ against any future increases in interest rates. The bank would then compensate the customer should interest rates continue to rise which can then be used to off-set the increase in loan repayments.
There are four main types of IRHP’s:
- Caps—this product has an upper limit on any interest rate rises
- Collars—this product limited any interest rate rises and decreases to a small and simple range
- Structured Collars—this product is similar to a Collar but the customer may possible pay a higher interest rate than the baseline rate
- Swaps—this product allowed businesses to ‘fix’ the interest rate
The high commission and incentives that were offered to the advisers for the sale of these products led to SWAPS being sold to small and medium sized businesses and ‘un-sophisticated’ customers, as deemed by the FSA, has led to this mis-selling scandal.
Obligations of the Adviser or Sales Person for mis-sold Interest Rate SWAPS
- Provide the customer with appropriate, comprehensible, fair, clear and not misleading information on all the features, benefits and risks.
- Ensure that if the IRHP exceeded the term or values of any lending arrangements, the potential consequences were clear and understandable.
- To obtain sufficient personal and financial information about the customer, including the customer’s investment objectives, level of education, profession or former profession and any relevant past experience of IRHPs.
- Take reasonable steps to ensure that the personal recommendation is suitable for the customer.
Demonstrate customers had been provided the information with consideration of the:
- Customer’s knowledge and understanding of these types of products generally;
- Customer’s interaction during the sales process;
- Complexity of the product;
- Quality and nature of all information provided during the sales process, including when and how the information was provided.
How was this service mis-sold?
These complex products were sold on the basis of protecting customers from future interest rate rises; however there were many associated risks that were not fully explained to the customers leading to the possible mis-selling of these products.
- Customers were not made fully aware of what the financial impact would be when interest rates fell;
- Banks were able to cancel the product at any time with no charge’
- There were high exit fees associated with any cancellation of the product by the customer, sometimes as high as 50% the original loan value;
- Customers were pressured into taken out the policy as some were informed that it would help to approve the original loan.
The FSA IRHP’s Pilot review found these serious failings:
- Failure to ensure the customer/s fully understood the risk;
- Failure to fully inform the customer/s of the associated exit costs;
- Allowing “over-hedging” to occur, i.e. when the amounts and/or duration did not merry up with the underlying loans;
- Allowing non-advised sales processes to turn into advice being given to the customer/s; and
- Allowing the rewards/incentives to be a key driver in the above ‘failing’ sales practices.
The FSA estimates that 40,000 IRHP’s have been sold to small and medium sized businesses since 2001, with the majority of selling taking place between 2005 and 2008. This occurred when interest rates were around 5.5% and they were expected to rise even further, however, the Bank of England interest rate dropped to a historic low of 0.5% leading to a huge negative impact on many businesses with these products.
Currently, there is no clear and definite redress programme for SWAPS or associated timeframes; however the FSA has outlined a basic ‘Principles of redress’ for customers of ‘non-compliant’ sales of some IRHP’s. The redress awarded needs to put the customer back in the position they would have been in had the breach in the regulatory requirement not taken place.
The types of redress proposed by the FSA are:
- Full redress—putting the customer back to the original position had the sale of a IRHP’s not taken place. The redress needs to include all payments made by the customer, any ‘break costs’ paid and an exit from the IRHP free.
- Alternative product—offering the customer a different product and/or different profile for the product which may include amount, duration or structure of the IRHP. This redress is suitable for customers where a different IRHP would have been purchased had the sale been compliant. The redress should be offering an alternative product and refund of any difference in payment amounts between the two products as well as any difference in ‘break costs’ that had been paid.
If the customer is offered the alternative product redress, the following principles should also be included:
- The alternative product should be ‘simple’; the FSA believes that had a sale of IRHP’s been compliant, then the customer would have originally purchased a ‘simple’ product such as: Cap, Vanilla Collar or Vanilla swap.
- The alternative product should not have a ‘break cost’ that is in excess of 7.5% of the original hedge amount. The FSA believes that had the original sale been compliant, the customer would not have chosen a product with such a high ‘break cost’.