14 May 2015 by

Derivative mis-selling claims – next please?

As the FCA’s IRHP review scheme draws to a close (albeit that the independent reviewers are facing possible judicial review), the question that arises is: what’s next?  We can think of at least three fruits that might be ripe for plucking from the derivatives mis-selling tree, namely derivative-embedded loans, structured currency trades and Lender Option Borrower Option loans (or “LOBO”s for short). 

Derivative-embedded Loans 

A derivative-embedded loan is a loan whose interest payment provisions mimic the flows that would arise under a comparable floating rate loan hedged by a separate derivative instrument.  The two products are economically identical albeit that the former is bound up in one tailored contract (hence the frequently applied term “tailored business loan”) and the latter is comprised of a floating rate loan agreement and a related but separate (sometimes called stand-alone) derivative contract.  Thus a fixed rate loan is economically identical to a floating rate loan that is fully hedged with a stand-alone interest rate swap; a capped rate loan is economically identical to a floating rate loan that is fully hedged with a stand-alone interest rate cap; a collared rate loan is economically identical to a floating rate loan that is fully hedged with a stand-alone interest rate collar….and so on.  Not only are the cash-flows identical but, if tailored correctly, derivative-embedded loans give rise to exactly the same break costs (or gains) as a derivative in a standalone context – although the average borrower would be forgiven for not realising that that was the case, so opaque is the typical contract. 

What is notable about derivative-embedded loans is that, on the face of it, they are not regulated as derivative instruments but instead as loans – certainly that is the stance that the FCA (supported by counsel’s opinion) appears to take.  On this analysis they therefore fall outside of the regulatory umbrella that applies to derivative instruments, do not benefit from the Conduct of Business Rules and are outside the scope of the FCA’s IRHP review scheme.  However, increasing numbers of practitioners are coming around to the view that derivative-embedded loans are in fact, just like their stand-alone counterparts, derivatives (or “contracts for difference”, to use the regulatory vernacular) that ought to be regulated as such.  We agree, and our view is that this is worth arguing before the courts.  We are keeping our eyes open for developments in this regard.  A change of stance by the FCA is also not out of the question and we continue to lobby the FCA directly on this issue.     

Structured Currency Trades 

While most businesses face interest rate risk on their borrowings (and are therefore potential candidates for interest rate derivative sales), a sub-set of these will also be exposed to currency risk.  Such businesses will customarily hedge this risk by entering into vanilla currency options or forwards.  But evidence is emerging that some customers have been encouraged by their banks to become party to contracts that contain complex knock-in/knock-out or other features that have little to do with prudent currency risk management.  Such sales have the same flawed characteristics as have been seen in the context of mis-sold interest rate derivatives and ought therefore to be susceptible to legal challenge.  Again, formal intervention by the FCA cannot be ruled out.  And this, of course, is to say nothing of the more general question of the rigging of foreign exchange rates by some of the world’s biggest banks. 

LOBOs

LOBOs are prevalent in the world of housing associations and local authorities.  They were entered into in the early noughties and were typified by a structure pursuant to which a bank would lend money to the borrower at an attractive (below market) rate of interest in return for an option (a form of interest rate derivative) in favour of the bank to call for repayment of the loan at pre-defined intervals.  It is likely that the sub-market rate did not fully reflect the value of the option to the bank and it is also likely that the borrower did not fully factor in the refinancing risk to which it was exposing itself in granting the option – in short the borrower was party to a deal whose economic intricacies and implications it did not fully understand.  Additionally, if entered into before the changes to local government legislation in 2011, the transacting party may have been acting beyond its powers, thereby making the loan contract voidable. 

If you have been affected by any of the above, please call Gary Walker (020 7288 4783) or Simon Bishop (020 7288 4797) to arrange a free consultation.

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