TAILORED BUSINESS LOANS AND MIS-SELLING

TAILORED BUSINESS LOANS AND MIS-SELLING Freestanding hedging products When a bank lends money to a customer, it must borrow that money itself at a variable rate based either upon base rate or LIBOR. Normally, a bank will lend the money to its customer at such variable rate plus a margin so that the margin is its profit. Where the bank lends money to its customer on any other basis, this will involve hedging in one form or another. Hedging involves the replacement of such a variable rate arrangement with one under which the interest rate is limited or fixed in one way or another. The most common way for a customer to hedge is to purchase a product ( a freestanding hedging product ) which runs side by side with the variable rate loan. The freestanding hedging product need not necessarily be with the same bank, be for the same amount or have the same period. The combined effect of the freestanding hedging product and the variable rate loan is to produce an arrangement whereby the total sum paid by the customer (that is to say interest and hedge payments) is limited or fixed The most common freestanding hedging product is a base rate swap. Under a base rate swap the hedge bank (which might not be the same as the lending bank) agrees to pay interest at a variable rate to the customer and the customer agrees to pay interest at a fixed rate to the hedge bank. If the variable rate exceeds the fixed rate, the customer profits. If the variable rate is less than the fixed rate, the hedge bank profits. The combined effect of the base rate swap and the variable rate loan is to produce an arrangement which approximates to that of a fixed rate loan. The Financial Control Authority ( the FCA ) places freestanding hedging products in four categories being caps, base rate swaps, collars and structured collars. All work by creating a system of payments by or to the customer which when combined with the variable rate loan limit or fix the total sum paid. Viewed in isolation, a freestanding hedging product is akin to a bet. Viewed in conjunction with a variable rate loan, it is more akin to insurance. Caps limit the interest payable to a set level. Collars impose and upper and lower limit on the interest payable. Structured collars involve one or more rebound whereby the interest payable increases if base rate or LIBOR falls to below a set level. 1

Tailored Business Loans Until 2005 Yorkshire Bank PLC was a subsidiary of Clydesdale Bank PLC. In that year, Clydesdale Bank PLC took over the activities of Yorkshire Bank PLC and the two banks have operated under one licence since then with Clydesdale Bank PLC trading under its own name or as Yorkshire Bank. Clydesdale bank PLC has assumed the obligations of Yorkshire Bank PLC and it is convenient to treat all products sold over this period as Clydesdale products. A tailored business loan is a Clydesdale product which effectively includes both the loan and the hedge in the same agreement. Tailored Business Loans include fixed rate loans ( FRLs ) but it is more convenient to treat FRLs separately. I use the term TBLs to mean Tailored Business Loans excluding FRLs. An FRL effectively combines a variable rate loan and a base rate swap. A Range Rate Loan effectively combines a collar with a variable rate loan. A particularly onerous product called a Modified Participating Fixed Rate Loan effectively combines a structured collar with a variable rate loan. A particular feature of the sale of TBLs by Clydesdale is the use of a number of different TBLs (often combined with FRLs) for the same customer for reasons which are not obvious. Usually the facility letter will make reference to a number of different types of TBL (setting out the terms of each) and the choice is made later. There are a dozen types of TBL and it is often difficult to determine which one was actually chosen. Indeed, I have seen cases where the terms of the product change over time with no documents to explain the change. Regulation of the sale of hedging products The sale of hedging products since 2001 is regulated by the FCA under the Financial Services and Markets Act 2000. Such regulation is in two forms. The first form relates to any products sold by regulated bodies. The second relates to particular products known as designated investments. The regulation which applies to all products is known as the Principles. The Principles include an obligation to pay due regard to the interests of its customers and treat them fairly and an 2

obligation to pay due regards to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading. Breach of the Principles cannot give rise to a claim which can be enforced by Court action. However, the Financial Services Ombudsman ( the Ombudsman ) does consider breaches of the Principles when assessing whether compensation should be awarded to a customer. The term designated investment is defined by Article 85 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 to be: (a) a contract for differences or (b) Any other contract the purpose or pretended purpose of which is to secure a profit or avoid a loss by reference to fluctuations in- (i) the value or price of property or any description; or (ii) an index or other factor designated for that purpose in the contract The term contract for differences is not defined. The rules set out in the Conduct of Business Sourcebook ( COBS ) apply to designated investments sold since November 2007. An earlier version of the same ( COB ) applies to designated investments sold between 2001 and such date. The obligations placed on banks by COBS are far wider than those imposed by the Principles. These include: 1) An obligation to act honestly, fairly and professionally. 2) An obligation to provide communications which are clear, fair and not misleading 3) Where a personal recommendation is made, an obligation to take reasonable steps to ascertain the needs of the customer and an obligation to take reasonable steps to recommend a suitability product 4) An obligation to describe the nature and risks of the product Many customers complain about the mis-selling of hedging products. This expression is wide enough to include common law claims such as misrepresentation and negligence. However, the expression is usually confined to breaches of the Principles and COBS. A corporate body (such as a company or an LLP) cannot bring a claim for breach of COBS in a Court (see Grant Estates Limited v The Royal Bank of Scotland [2012] CSOH 133). The effect 3

of this decision is to prevent the majority of business affected by the mis-selling of hedges from bringing a claim in Court. This problem is part of the motivation behind the FCA Review. The FCA has power to require a bank to provide compensation for breaches of its rules and it is this power which underlies the decision made by banks to participate in the FCA Review. Logically, the FCA cannot compel a bank to participate in the FCA Review in respect of the sale of products which are not covered by COBS. The FCA Review The FCA Review only deals with designated investments and the process is aimed at an assessment of whether the bank has complied with its obligations under COBS. Misrepresentation claims cannot be dealt with under the FCA Review and have to be re-cast as breaches of the obligation to provide communications which are clear, fair and not misleading. Clydesdale has produced a leaflet setting out how it intends to review hedging products. Freestanding hedging products are part of the FCA Review. FRLs are not covered at all. TBLs are reviewed outside the terms of the FCA Review but the procedure is broadly similar to the FCA Review. The sophisticated customer test is the same. The major differences are (1) that Clydesdale has not agreed to the measures in the FCA Review which are designed to protect customers pending the determination of the same; and (2) that redress for TBLs equivalent to structured collars is not automatic. While Clydesdale has not accepted that COBS applies to TBLs for the purposes of its review, it is difficult to see how the sale of TBLs can be reviewed otherwise than by reference to COBS. The position which has been adopted by Clydesdale is the result of negotiations between it and the FCA. Clydesdale does not want to accept that TBLs are designated investments because this would open it up to a multitude of Court claims by individuals. It is unfortunate that the FCA has not forced the issue and brought Court proceedings to establish that TBLs are designated investments and that is entitled to require Clydesdale to review the sale of TBLs under the full terms of the FCA Review. However, it is difficult to see why Clydesdale would have agreed to review TBLs under a like procedure to the FCA Review if it had confidence in the strength of its argument. It is difficult to see how a TBL can be anything other than a designated investment. It makes use of a published index (either base rate or LIBOR) and its purpose is to avoid the loss associated with the liability to pay interest at base rate. It is no different in this respect from a 4

freestanding hedging product. On this basis, a private individual who is outside the scope of Clydesdale s review (or is dissatisfied with the same) should be able to bring a claim for breach of COBS. A number of TBL customers have commenced proceedings in the Administrative Court in order to establish that the decision by the FCA to exclude TBLs from the FCA Review is unlawful. Permission to apply for judicial review has been refused. The case is called R (on the application of Dr. Julian Jenkinson, Simon Bridbury Properties (St. Albans) Ltd, Summerpark Homes Ltd and UK Estates Ltd) v the Financial Control Authority). Unfortunately, the extempore judgment is not yet available. The judgment does not establish that TBLs are not designated investments. It only deals with the legality of the actions of the FCA. The sale of fixed rate loans The sale of FRLs is subject to the Principles and the 2005 Business Banking Code. These can be relied upon in any reference to the Ombudsman. There is a good argument that the Principles have been breached where the customer is forced to consolidate its borrowings and include them all within a single FRL (so that the customer is effectively required to hedge in respect of previous borrowings which were not hedged when made) and where the FRL is sold after the collapse of Lehman Brothers on 15 th September 2008. It is difficult to see any justification for the sale of any hedging product after that date. There are a number of FOS adjudications where the adjudicator has relied upon breaches of the Principles or the 2005 Business Banking Code in finding in favour of a customer of a FRL. The most widely reported is that of Jim McGrory. The application of COBS to FRLs is more difficult because they do not obviously involve the avoidance of loss by reference to a published index. Indeed, the normal payments made under an FRLs are set and do not fluctuate by reference to any published index (base rate or LIBOR). This is a difficult point for a non-lawyer to appreciate because the reality of the situation is that a base rate swap is designed to turn a variable rate loan into an FRL. A base rate swap is a designated investment but the agreement which it seeks to create in substance might not be. The arguments that need to be raised in order to establish that an FRL is a designated investment 5

have to be more subtle and include the following: 1) The break cost on termination of an FRL is calculated by reference to a published index. Break costs are calculated by reference to anticipated future base rates or LIBOR over the remaining term of the FRL Precisely how break costs are calculated is a closely guarded secret and no bank will reveal precisely how they are calculated on a voluntary basis. 2) The bank will normally enter into a freestanding hedging agreement with another bank which mirrors the FRL. This will be a designated investment. The FRL is a designated investment because it is associated with and passes on the risks of a designated investment. At some stage, the application of COBS to FRLs will need to be determined by the Court. Any such claim will need to be brought by an individual with a good claim for breach of COBS on its merits. Ideally, such a claimant would be someone who did not need a hedge at all (because he or she had sufficient resources to live with a sustained period of high base rate) or someone whose FRL is for far too long a period. An ability to bank elsewhere and an ability to finance expensive litigation would also be required. If FRLs are not subject to COBS, then the customer will be left to pursue common law claims. The claims which apply in particular to Clydesdale include the following: 1) Misrepresentation as to the terms of the FRL as opposed to the bank s view of future interest rates (see Lakeside Inns v Yorkshire Bank). The most significant terms of an FRL are not difficult to explain. However, there is an argument that the use of the term fixed rate loan in this context is a misrepresentation because until recent times fixed rate loans could be terminated on notice with relatively modest tapering beak costs. 2) Negligence. In the light of Green & Rowley v The Royal Bank of Scotland [2012] EWHC 366, it will be necessary to show that the bank has crossed the divide between providing a recommendation and giving advice as the suitability of the FRL for the requirements of the customer. 3) A redemption action. If the FRL is secured by a charge over land and the customer is in a position to terminate the FRL and redeem the charge, it can apply to the Court to set the terms of redemption. In effect, it can require the bank to prove its entitlement to its break cost. There are two elements to this. The first is the entitlement of the bank to break costs at all. The second is the quantum of the same a) As to the first point, Clydesdale s standard terms sand conditions limit its ability 6

to claim break costs to an indemnity for its costs of breaking its own hedging arrangements. It is widely believed that Clydesdale did not enter into any formal hedging arrangements with other banks. If this is the case, it cannot claim any break cost. This point remains untested. b) As to the latter point, the position of Clydesdale is no different to other banks. No bank will provide a proper explanation of break costs other than that they are calculated by reference to anticipated future interest rates. Even at a time when the Governor of the Bank of England has stated on record that base rate will not change for the next two years, break costs can vary significantly from month to month. How this can be the case is not clear. There is no reason why any customer should accept a break cost provided without a detailed methodology and calculation. My own personal experience of Clydesdale is that its calculations can produce figures which are difficult to understand. I have a case where the customer took out two completely different products on the same day for the same amount and same period, yet the break costs were the same. I would love to know how this can be right. Sean Kelly Chancery House Chambers Leeds LS1 4LY Tel: 0113 244 6691 Fax: 0113 244 6766 www.chanceryhouse.co.uk Friday 13 th December 2013 7