Hedging products get a bit of a trim

Interest Rate Hedging Products often turned out to be extremely expensive. Picture: Bill Henry

A recent Court of Appeal judgment has given further hope to tens of thousands of small businesses seeking redress from the big banks over interest rate swaps (IRS).

Although the case focuses on the specific issue of where the IRS products were linked to the Libor rate, it is another significant decision in the broader discussion over the controversial products, characterised by one protagonist as a David v Goliath fight.

It is estimated that between 2001 and 2011, banks sold around 40,000 IRS products alongside business loans to fix or limit the interest rate payable on the loan. Interest Rate Hedging Products, to give them their full name, often turned out to be extremely expensive and it is believed more than 90 per cent could have been mis-sold, which means a lot of businesses are owed a lot of money.

Hedging arrangement often in favour of the bank

Many small businesses did not know what they were getting into, by taking on what are complex financial derivative instruments. In many cases, these products were effectively forced upon them if they entered into loan agreements; the banks presented the hedging product as a non-negotiable part of the overall loan package. In the vast majority of cases, this hedging arrangement ended up, not unsurprisingly, being very much in favour of the bank.

Most small business customers do not have the financial wherewithal to predict the movement of interest rates as banks do; so the banks bet one way, the customer bets the other, and in almost every single case, the bank wins. An interest rate swap is a bet and it would be covered by the Gambling Act if it was not a regulated financial product.

The recent judgment by the Court of Appeal involved Barclays Bank. In the case – involving both Guardian Care Homes and Unitech Limited – it was argued that where interest rate swaps products were based upon Libor, arising out of Libor manipulation was a relevant factor in deciding the claim. The banks refuted this, but the Court of Appeal decided it was a perfectly arguable case – and its judgment means the allegations can now proceed to be aired at a trial, currently listed to run for six weeks from next April.

Essentially, the claimants argued the banks had breached a fundamental implied term of the IRS agreement – that they would deal fairly around the issue of Libor and not manipulate Libor so that the customer was certain to lose out. This proposition appears uncontroversial. By way of analogy, any person betting on a horse race is entitled to assume that his chosen bookmaker will not fix the outcome.

London Interbank Offered Rate

Libor has become accepted shorthand for London Interbank Offered Rate, the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. This case involving interest rate swaps is the latest example of alleged fraud and collusion by the banks in setting Libor to their own advantage.

Lots of interest rate swaps appear to have been calculated on the basis of Libor rather than base rates, so there could be a significant number of cases.

The outcome of the case will be watched keenly by anyone caught up in an interest rate swap. At the same time, an independent review is being conducted by the major banks under the direction of the Financial Conduct Authority, allowing dissatisfied customers who were sold interest rate swaps to have their cases looked at without going through the court process. Lots of cases are going down this route, given the costs involved in formal litigation – and businesses sold IRS products have really felt the squeeze.

Many were already struggling in a tight financial climate, even before they started paying over the odds for these products; some have gone out of business already, others are finding it really hard. The regulatory path offered by the FCA is a welcome alternative but it does have its own difficulties. Each independent review is taking up to a year, with no certainty over compensation levels.

There is another aspect to this dispute, and that is exit costs. Businesses who decided they wanted to get out of these damaging agreements were hit by punitive charges for ending their contract early – but it is good to see that the Financial Ombudsman Service is finding in favour of a number of small businesses on this point.

Overall, we are beginning to see some positive developments for small businesses landed with IRS – but the wheels of redress are turning very slowly.

• Gordon Deane is a partner at Balfour+Manson www.balfour-manson.co.uk