December 2012 Butterworths Journal of International Banking and Financial Law680

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Feature Key Points�� Banks rarely, if ever, reveal the extra charge concealed in the structure of a swap.�� The 2001 Rights of Action Regulations (which implemented s 150 Financial Services and

Markets Act 2000) must be taken to have been repealed by MiFID.�� A better solution for disappointed investors than the Conduct of Business Sourcebook

(COBS) (and other MiFID implementations) is a straightforward action for breach of contract.

Author Julian Roberts

Should losses on payer swaps be recoverable?Some years ago, when the UK base rate was at 5% or higher, many SMEs took out hedging swaps to “fix” interest rates on their commercial loans. In late 2008 Lehman Bros went bankrupt and interest rates plummeted. Base rate is now 0.5%. For many SMEs facing an exceptionally difficult economic climate, the rates they fixed earlier are proving ruinous.

What are the prospects for SMEs who have been sold hedging swaps to recover damages in the courts? A series of recent cases involving derivatives suggests that this may be difficult. Here, in summary, are the reasons why that conclusion would be premature.

SwapS Sold aS “hedging“

nLoan agreements put out by banks have commonly included clauses

requiring the borrower to acquire “an interest rate hedging instrument acceptable to the Bank and at a level, for a period and for a notional amount acceptable to the Bank...” (NatWest standard term agreement, May 2007).

Typically, banks have themselves offered corresponding agreements to the borrowers. These have regularly taken the form of payer swaps: the bank pays the client whatever variable rate the underlying loan agreement has specified, while the client pays the bank some agreed fixed rate.

Although, on the face of it, payer swaps merely reproduce the effects of traditional fixed-interest loans, there are significant differences. First, they are expensive, though this is not usually made known to the client. Secondly, for the purposes of borrowers they cannot legitimately be described as “rate hedging” instruments. On the other hand, banks like swaps. In order to understand the problem, we need to look at this more closely.

why banks like swapsFor the bank, selling a variable-rate loan coupled with a swap is generally more satisfactory than selling a fixed-interest loan.

CertaintyFirst, it is by no means certain how much a

bank can claim in respect of future interest payments (prepayment loss) in the event of a customer terminating a fixed-interest loan prematurely. In principle, the bank should be compensated if it can only re-lend its capital at a lower rate of interest. However, as the recent case of K/S Preston Street v Santander [2012] EWHC 1633 (Ch) illustrates, quantifying this loss may not always be straightforward. Even if careful drafting avoids the specific pitfall faced by the bank in that case, the decision points up one of a number of difficulties which may arise in recovering indemnity losses.

In contrast, a swap, which is a free-standing agreement separate from the loan, provides unambiguous consequences for early termination. Creating certainty is, indeed, the whole point of a swap, which is a vehicle for ascertaining the market value of an exposure at any given point in time. Premature termination is equivalent to transfer: all the parties need do is establish the value of that transfer and pay accordingly. The sum is actionable as a debt.

higher indemnityThe second advantage is that a swap is commonly more valuable than whatever compensation may be obtained for prepayment loss. Calculating the latter is a relatively unsophisticated procedure and leaves out of account factors which would

otherwise affect the result. In Preston Street, for example, the bank’s expert put the compensation figure on an indemnity basis at £173,463. Using the same assumptions (notional £1,853,901, strike 5.06%, effective 1 September 2011, maturity 28 months, mid-market price), the bank’s claim on a swap would have been around 15% higher, at £199,356 (Bloomberg).

Flexibility over pricingA third reason for preferring swaps is that they allow bank sales staff to be economical with the information they give out about prices.

The superficial simplicity of a payer swap – effectively a “fix” on the rate which the borrower has to pay for a loan – masks a considerable degree of complexity. A payer swap can best be regarded as two options. One is an option sold to the borrower by the bank: if interest rates rise above the rate fixed in the agreement, the bank will make up the difference (this sort of option is commonly known as a “cap”). The other is an option sold by the borrower to the bank: if interest rates fall, the borrower will make up the difference (a floor).

This structure, like most options written on market indexes, can be valued. The value depends on the relative value of the swap’s two halves (ie, the value of the “cap” compared to the value of the “floor”). If these are equal and balance each other out, the value of the swap is nil (the swap is said to be “fair”, or sold “at par”). If, on the other hand, either party has to provide less than its counterparty, then the swap’s value is no longer nil, but has a positive value to the benefit of the party with the less onerous obligations.

Therefore much depends on being able to value the obligations on each side. Doing this, however, requires access to data and to statistical techniques only available to financial market professionals. Moreover, the

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fact that swaps can, in principle, be structured at par (fairly) and thus have no price, may lead customers to assume that this is indeed the case. No salesman would wish to disturb this illusion, so the fact that the swap actually has a significant positive value to the bank may be passed over in discreet silence.

In consequence, however, the significant commercial advantage of a swap – namely, that one can ascertain a precise market value at any given time – is scarcely ever shared with the customer, at least at the time the deal is made. Typically, the first thing the customer hears of a swap’s market value is when he tries to terminate early and the bank confronts him with a demand for “break costs”.

This advantage does not apply to caps. In relation to price, caps have no countervailing option, or “floor”, to balance them out. Consequently they always have a non-negative starting price, which banks cannot avoid disclosing.

The real cost of payer swapsTypically, swaps sold for “rate hedging” in 2007 had initial negative (for the borrower) market values of 3.5 to 4% of notional. That is a significant amount. On a deal value of, say, £1m, that means that the borrower is paying up to £40,000 for his “hedge” on top of the costs of the loan itself (which generally already has a margin) and any other fees.

If the swap is intended to provide “protection”, then the cost of it has to be weighed against the size of any likely damage. Protection that is disproportionately expensive is no longer protection – it is a waste of capital resources and thus a risk in itself. For this reason, awareness of the true cost – the price – is essential to deciding whether the protection is appropriate.

However, despite claiming in their terms of business to “offer prices” to enable borrowers to make judgments on this question, banks rarely, if ever, reveal the extra charge concealed in the structure of the swap, (although it is not unusual for them to exhibit other free-standing charges – for “structuring” and suchlike).

inappropriate hedgingSecondly, fixing a rate is not the same thing as hedging it. “Hedging” means to insure

against the consequences of undesirable market movements. For a borrower, there is only one undesirable market movement, and that is upwards. Falling interest rates are favourable, and there is no reason to hedge against them. Quite the contrary: giving up the chance of paying less, or refinancing at a better rate, is a substantial risk in itself. This is because (as we see from the cases currently in dispute) it exposes the borrower to a downturn in the economy without allowing him the chance of reducing his financing costs to match.

Against that, it should be noted that in a payer swap the borrower is giving the bank not only the “fee”, concealed or otherwise, but also the promise to keep paying a rate even if market rates fall. This “floor” – effectively an option sold by the borrower to the bank, as we noted – represents valuable consideration in itself.

Given that the borrower’s risk only goes in one direction, a suitable hedge for him is also unidirectional – namely a cap. A cap removes the danger of rising rates while remaining open to benefits from falling ones. For banks, a cap is just as quick and easy to structure as a swap, and for the 2007 deal already mentioned above a cap would – at mid-market prices – have come in significantly cheaper than the 4% charged for the swap (assuming the same notional, strike, inception and maturity). This fact was, it appears, never revealed by the sales staff. Again: borrowers would not be in a position to find this out themselves, nor would most even have known there was anything to enquire about.

The result is that many clients ended up buying over-priced products that were unsuitable for the purpose stated in the contract. The clients were not in a position to assess price or suitability themselves, but since their loan contracts insisted that they put “hedges” in place, and since the bank indicated (not surprisingly!) that these were indeed hedges, and acceptable, the clients agreed.

MiFid and The UK FinanCial MarKeT rUleSduties towards retail clients under MiFidMiFID, as implemented in the Financial Services Authority’s Conduct of Business

Sourcebook (COBS), imposes duties on investment firms which, if actionable, might well assist an aggrieved customer.

Many rules are specific to the particular context and allow for a margin of discretion by the bank. For example, while communications from the investment firm have in general to be “fair, clear and not misleading”, what this means in any particular case is dependent on the circumstances of the recipient or target audience, as assessed by the bank (COBS 4.2, 4.2.2 G). It is thus open to an investment firm to argue that the client was experienced and familiar with the deal in hand. After all, fixing the interest on a loan is something which any businessman would readily comprehend (see the comments of the judge in Grant Estates Limited v the Royal Bank of Scotland Plc and Others [2012] CSOH 133, though this ignores the differences between a fixed-interest loan and a payer swap – see above).

In relation to “complex” financial instruments, which would include swaps of the kind at issue here, investment firms are also obliged to obtain from any retail client “information regarding his knowledge and experience ... relevant to the specific type of product or service ... so as to enable the investment firm to assess whether the investment service or product envisaged is appropriate...” (COBS 10.2.1 R (1)). Here again, however, appropriateness varies with the knowledge and experience of the target audience, and the investment firm is entitled to draw inferences from its own knowledge of the client (COBS 10.2.4-7). As a consequence:

“If a firm is satisfied that the client has the necessary experience and knowledge in order to understand the risks involved in relation to the product or service, there is no duty to communicate this to the client” (COBS 10.2.8).

In addition to “discretionary” duties, however, MiFID also imposes certain absolute duties on investment firms. In relation to retail clients, the duties include in particular the duty to provide information on costs and associated charges, including the total price to be paid in connection with the investment, “so that the client is reasonably able to understand

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the nature and risks of the service and of the specific type of … instrument that is being offered and, consequently, to take investment decisions on an informed basis” (COBS 2.2.1 R, 6.1.9 R; MiFID Implementing Directive Art 33; MiFID Art 19 (3) Indent 4). Information on price does of course lie at the heart of any contractual agreement.

rights of action since Titan Steel wheels and grant estatesTwo recent cases (Titan Steel Wheels v the Royal Bank of Scotland Plc [2010] EWHC 211 and Grant Estates) have rejected derivatives actions by SMEs on the grounds (inter alia) that they could not invoke MiFID duties because this was precluded by FSMA s 150 and the FSMA (Rights of Action) Regulations s r 3. These measures would appear, in essence, to restrict rights of action for breaches of FSA rules to “individuals” whose financial market losses do not arise “in the course of carrying on business of any kind”. Taken at face value, this removes the right to use the rules in actions for breach of statutory duty from anyone except consumers.

However, this restriction dates from 2001, and it is questionable whether it can survive the implementation of MiFID in 2007. In particular, the court’s view in these two cases seems to disregard changes in relation to client classification.

Customer classification prior to MiFidAs a matter of principle, and uncontroversially, breach of a duty imposed by a European directive does not of itself give a right of (“horizontal”) action to the person injured. FSMA s 150, which gives this right to “private persons” in respect of rule contraventions, is thus a bonus, rather than a restriction. That apart, s 150 is probably not, at least since MiFID, limited to the relatively small circle of investors apparently indicated by r 3 of the 2001 Regulations. Most of the current swaps

complaints will have arisen since MiFID came into force on 1 November 2007.

Prior to MiFID, reliance was placed on the financial markets policing themselves with a minimum of outside interference. Market participants were to look after themselves, and breaches of duty by investment firms were to be dealt with administratively, within the COB “regulatory system”. Supervision by the authorities concentrated on keeping complex instruments away from non-experts altogether (see Sharlene Goff in FT, 23 June 2007, and compare, for example, the FSA’s interventions following the “precipice bond” scandal of 2003). To the extent that they dealt with non-experts, firms were not only not allowed to exclude liability for breaches of the rules, but in addition they were not allowed to exclude liability for breaches arising outside the rules, ie outside the remit of administrative sanctions, except insofar as this was reasonable.

Such non-experts were termed “private customers” (FSA Handbook, COB 2.5.4 R of 01.12.2001, and Glossary). Although the terminology differs slightly, “private

customer” in the FSA Handbook overlaps with the term “private person” in FSMA s 150, both indicating the character of a consumer – ie a natural person acting for purposes which are outside his trade, business or profession. In this respect, the COB rules articulate the basic pre-MiFID distinction between professionals, who have to sort out their differences administratively, and private consumers, whose COB and non-COB rights cannot be curtailed by exclusion clauses. The reference to non-COB rights is significant, as this provision would be futile unless it was intended to be itself actionable outside the administrative arena, in the courts, as breach of statutory duty.

In other words, the intention of the original, pre-MiFID distinction, as articulated within COB as well as within the Rights of Action Regulations, was to give rights of

action over rule breaches only to consumers, understood as natural persons (“individuals”) acting for purposes outside their business or profession, and in that context the exclusion of liability for non-COB violations was also disallowed.

The MiFid changesMiFID changed this. By the early 2000’s there was already a significant increase in retail interest in derivatives and other complex products (MiFID, recital 2). Consumers were not just trading shares and bonds, they were getting into more and more exotic products. Even the humble business loan (as we see) was being coupled with a derivative instrument.

MiFID’s response was to introduce a much more detailed classification of financial instruments (Annex I) and of investors (Annex II). The default position on investors now was that everyone was a “client”, and most of those – with the exception of “eligible counterparties” – were entitled to some degree of protection. And the default position on financial instruments was that – with the exception of “non-complex” ones – some degree of client care was required in each case (MiFID Art 19 (6), Implementing Directive Art 38).

From this perspective, the “hands off” approach of the pre-MiFID era is no longer applicable. For MiFID, the clients requiring protection are not just consumers and natural persons – they are anyone who is not clearly at home with modern financial instruments. Modern “retail clients”, as they are now called (and this concept will cover the great majority of SMEs), are buying much more complicated things than stocks and bonds, and they are suffering substantially greater losses than those covered by the statutory compensation scheme.

The crucial question is the treatment by the financial market rules of exclusion clauses. Prior to MiFID, the Conduct of Business rules envisaged only two categories of “customer” in this context – professionals and individual consumers.

However, individual consumers are no longer constitutive for the MiFID scheme of things. In the UK’s interpretation of the “client’s best interest rule” (COBS 2.1, MiFID

The crucial question is the treatment by the financial market rules of exclusion clauses.

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Biog BoxProfessor Julian Roberts is a Barrister and Rechtsanwalt practising from 10 Old Square, Lincoln’s Inn, London. Email: julianroberts@tenoldsquare.com

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Art 19 (1)), breaches of financial market rules now attract three levels of protection. At the most basic level, breaches of the “regulatory system” itself – which includes non-binding guidance as well as the rules proper (see COBS Glossary Definition) – are in any event sanctioned administratively, and liability cannot be excluded. This applies for the benefit of all clients (COBS 2.1.2 R). For liability arising “other than under the regulatory system” exclusion clauses are only permissible in relation to retail clients if they are “honest, fair and professional” (COBS 2.1.3 G (1)). The assessment of this is, presumably, a matter for the courts, since by definition such issues fall outside the “regulatory system”. Finally, as COBS notes, there remains liability arising towards consumers within the scheme applicable to unfair contract terms (COBS 2.1.3 G (2)).

Thus MiFID – and in response, COBS – shifts the boundaries between different categories of client. There is now no longer a stark contrast between individual consumers who may, and businesses or professionals who may not, invoke the financial market rules in court. Between these two there is a new, third category of “retail client”. The provisions of COB 2.5.4 R, which applied only to consumers (“private customers”) have since MiFID been transferred to retail clients, a category embracing more than just individual consumers (COBS 2.1.3 G). As we saw, this provision confers a right which can of necessity only be used outside the administrative system, in the courts, and thus presupposes that it may itself be invoked there.

Regulatory policy has changed, and the rules governing the financial markets prior to November 2007 have been superseded at those points where they are incompatible with the MiFID rules. This brings implied repeal into action – leges posteriores priores contrarias abrogant (R v St Edmunds, 1841). Specifically, “private person” in FSMA s 150 cannot now be understood to refer only to consumers, but must be interpreted to include retail clients as well. MiFID, and COBS, have by implication repealed s 3 of the FSMA Rights of Action Regulations

2001. As retail clients, SMEs should be entitled – in appropriate cases – to bring breach of statutory duty actions invoking the financial market rules as “private persons”, unencumbered by the “course of business” restriction.

MiSrepreSenTaTion or breaCh oF ConTraCT?The main premise of the judgments in the existing derivatives cases, including in Grant Estates, has been that the Bank by careful drafting of the agreement successfully excluded liability for anything it might have said about the products. The case pleaded by the claimants has been that the bank advised them of certain matters in relation to the derivatives, and that this advice induced them to enter the contract. The courts

have held, against this, that the agreements defined the parties’ relationship in such a way that no advice was involved – whether or not any such “advice” actually ensued – and consequently that no reliance, and no causation, could be pleaded (see Grant Estates, paras 73–76, and the cases relied on).

Put this way, the case is basically a matter of (tortious) misrepresentation.

However, if the facts are pleaded as we have indicated above, the issue is not misrepresentation, but breach of contract. Non-reliance clauses are designed to avoid disputes concerning matters not contained in the written agreement (Gloster J in Six Continents Hotels [2006] EWHC 2317 at [54]). In the cases we are considering here, however, there are written agreements relating specifically to the matters complained of.

First, the agreements (the loan agreements) specify that the instrument produced by the bank is a “rate hedge”. As we saw above, it is not – and the fact that it is not is a principal cause of damage.

Secondly, typically, there are written terms of business specifying that the Bank will offer prices for its transactions (see

Grant Estates at para 29). The Bank does not do this. Instead, it conceals prices by means of opaque structures. The failure to offer, let alone agree a price goes to the heart of the contract. (It is also worth repeating that the provision of price information is one of the absolute duties imposed by MiFID. Another point of interest is that the bank’s failure to reveal its price – namely the negative initial market value structured into the swap – was central to the reasoning of the German Federal Supreme Court in Ille Papier v Deutsche Bank XI ZR 33/10 [2011]).

Although both of these breaches are breaches of COBS, they are also breaches of express contractual terms. In that respect they are actionable independently of COBS, and liability is not excluded by

the FSMA Rights of Action Regulations, however narrowly these may be interpreted.

ConClUSionThe implementation of FSMA s 150 contained in the 2001 Rights of Action Regulations invokes a client classification which is no longer applicable. To the extent that this reveals a direct incompatibility, the 2001 Regulations must be taken to have been repealed by MiFID. The consequence is that the right of action accorded by FSMA s 150 to “private persons” should be extended to all “retail clients” under the new classification. That would include most SMEs in the situation we have considered.

However, as litigation in other jurisdictions has shown, COBS (and other MiFID implementations) are not necessarily the Holy Grail for disappointed investors. A better solution for them, wherever it is available, is a straightforward action for breach of contract. Exclusion clauses cannot be effective against liability for breaches of explicit terms of the contract. The facts of the “hedging swap” cases show a clear route to resolving these disputes.� n

...if the facts are pleaded as we have indicated above, the issue is not misrepresentation, but breach of contract.