Interest Rate Hedging Product (IRHP) mis-selling
What are IRHPs?
IRHPs are a type of derivative, ie. complex financial instruments. IRHP contracts were sold alongside business loans, supposedly to protect the customer against interest rate rises.
The most widely sold type of IRHP is known as a vanilla swap, sometimes referred to as Interest Rate Swap Agreements (IRSAs). With this product, if interest rates go up payments under the IRHP contract go down. Likewise, as the interest rate goes down, the IRHP payment goes up accordingly. The net effect of this is that the customer effectively ends up paying the same amount each month or quarter, rather like having a fixed-rate loan. There are also many other types of IRHP such as caps and collars of various complexity, some of which are structured and particularly dangerous as they cause payments to rocket dramatically as rates go down.
Who were they sold to?
IRHPs were sold by banks to business customers who were entering into new or renewed loan facilities. Nearly 30,000 IRHPs were sold to SMEs in the UK between 2001 and 2012. These businesses were often told by their bank that interest rates would rise and that they needed protection.
What is wrong with IRHPs?
Despite the supposed purpose of the IRHP being to protect customers from interest rate rises, IRHPs exposed customers to huge risks when interest rates fell. This is because a feature of the product is that it has a ‘mark-to-market’ break cost. This means that if a customer exits the product during the term they are liable to pay potentially enormous fees, sometimes up to 50% of the loan’s value. The banks knew they were exposing the customer to the risk of this ‘contingent liability’ but customers did not have this properly explained to them.
In many cases the bank made the purchase of an IRHP a condition of new or continued lending, often introducing it at the last minute so the customer had no choice. The condition of lending was often not legitimate as the customer did not need any interest rate protection. So, whether the risks of an IRHP were not adequately explained or the IRHP was a condition of lending, customers were denied the opportunity of making an informed choice when entering into the IRHP.
It is now widely accepted that IRHPs are inherently unsuitable products for SMEs. This is explained in this document (link to Nick Stoop doc).
What is the consequence of having an IRHP?
While the banks advised that interest rates would rise, rates in fact fell to historically low levels. This meant that those customers who entered into IRHPs did not enjoy the benefit of these low rates, but instead were stuck on substantially higher rates under the IRHP they had entered into. Businesses have therefore been unable to refinance, left facing crippling monthly repayments and/or exorbitant breakage costs to extricate themselves from their IRHP.
The knock-on effects vary in severity. Businesses have been starved of cash during a recession due to paying high interest rates and have stagnated because of an inability to refinance or sell assets. Others have suffered hardship after paying large break costs. Many failed to meet repayments, or were found in default because of a loan-to-value (LTV) breach which led to them being put in ‘Business Support Units’ such as RBS’ Global Restructuring Group which charged crippling fees. Many businesses became insolvent and were pushed into administration and many individuals have been bankrupted.
In some cases the bank included a clause which allowed the bank to terminate the IRHP if it became unfavourable to them after say, 5 years and at quarterly intervals thereafter. In effect, the customer is therefore selling options to the bank. The bank has it both ways – if interest rates fall the customer pays; if the rates go up the bank can end the IRHP.
In many cases the bank sold customers IRHPs for longer periods than the loans they were meant to cover. This meant that the customer still had to make payments under IRHP contract even though the loan had finished and had to pay a breakage cost to terminate the IRHP.
One of the reasons that banks failed to explain the negative aspects of the IRHPs was because the IRHPs were sold by specialist teams who earned high levels of commission by selling them. These employees were introduced to customers by commercial lending managers as ‘advisers’ within the bank whose role was to explain and to facilitate. They were actually salesmen from the banks’ treasury department whose role was to sell a financial product. In some cases the commercial lending managers dealing with customers were also paid commission for IRHPs sold to their customers.
If bank employees are highly incentivised to sell IRHPs it is easy to understand why those bank employees did not explain in great detail to the customer the risks and long-term liabilities that the customer was accepting when they entered into it. It is self-evident that that was not done because once those risks are explained it becomes clear that IRHPs are not suitable products for SMEs.
Aren’t there rules against this?
Yes, by selling IRHPs to unsophisticated business customers the banks breached the FCA Conduct of Business Rules (COBS) and the Business Banking Code, and arguably common law. COBS apply to banks selling an IRSA to a customer, and the most relevant of these are HERE.
COBS 9.2.1(1) – If the bank recommends an IRSA to a customer then it has to comply with the suitability obligation of COBS 9. This requires the bank to take reasonable steps to ensure that any personal recommendation given by it was suitable for the customer receiving the recommendation.
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 field of interest rate derivatives and taken into account their personal financial situation.
COBS 9.2.2 – 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 9.3.2 – 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.
COBS 9.2.6 – The failure to obtain necessary information to assess suitability prohibits the Bank from making a personal recommendation.
The bank often told the customer all about the benefits of an IRHP in a high interest-rate environment and neglected to properly explain the potential risks in a low interest rate one. Often the banks acted as an adviser to the owner of the small business and this brings with it clear responsibilities and a duty of care which in many cases the bank breached.
It is quite clear that in many cases the customers did not understand the IRSA they were sold. Often their background and education meant they were not able to comprehend the arrangements being sold to them. In many cases the bank did not properly advise the customer about the potential costs of exiting the IRSA being proposed by the bank.
If the bank acted as an adviser then it has higher duties to the customer (including possible fiduciary obligations). Whilst in practice banks often advise customers when selling IRHPs, if a dispute arises, they will commonly deny that they did advise the customer. This denial may well be in cases where it is self-evident from circumstances of the transaction that the bank did advise their customer to enter into an IRHP.
The bank will seek to rely on exclusion of liability and non-reliance clauses within the contract. Banks are keen to avoid the potential tortious and contractual liability which can follow from the relationship of adviser. Exclusion clauses are the central means by which banks attempt to exclude liability for negligence. Non-reliance statements are the central means by which banks attempt to exclude liability for misrepresentation.