Law firm Taylor Wessing examines one of the hottest legal topics for bank customers - including high net worth customers.

Laurence Lieberman, a partner in the disputes and investigations team at the international law firm of Taylor Wessing, and his associate Justin Fredrickson, look at one of the hottest legal topics for bank customers - including high-net-worth customers. This is the first half of the article; the second half will be run shortly on this news service.

As many readers know, businesses (some of which may be owned by high net worth individuals) have been taking banks to court over the sale of interest-rate hedging products recently. This has been widely reported, as has the Financial Conduct Authority's recent investigation and review of the subject and the banks' well-publicised reservation of funds to pay redress to customers from the mis-selling of interest rate hedging products. We shall consider this FCA review later on, albeit briefly.

The breakage costs

Typically, if a bank offers a loan to either a customer, be they a HNW individual or a small business owned by HNW individuals, it also offers the borrower various interest-rate hedging products to protect the loan against movements in interest rates. This seems like a good idea for the customer when interest rates are rising because they are hedging against rate-rises. Since the credit crunch of October 2008, however, interest rates have been falling, so the effect of having one of these products in place has been to reverse the flow of money, with the customer now typically having to make a net payment to the bank.

Naturally, many a customer has wanted to extricate itself or himself from such a contract. The only way for it/him to do this is to "break" the interest-rate hedging product and effectively reimburse the bank for its breakage costs.

Many banks sold interest-rate swaps (which can of course include caps, collars, structured collars and other variations) to all types of customer both before and after October 2008. After the recession that followed and the subsequent and remarkable drop in [the Bank of England] base rate, customers who had purchased interest rate swaps in an environment of rising interest rates were now finding that the same products were working against them. This was even worse when those interest-rate hedging products were especially risky for the customer, for example structured collars which cap the gains that the investor might make from the interest-rate hedge but place a seemingly unequal loss when interest rates went the wrong way.

The obvious way to cancel or “break” an interest-rate hedging product that has started to work against a customer's interests is for the customer to pay the breakage cost (or, rather, an "exit cost") of the product. This cost is the difference between the value of the remaining loan repayments at the original fixed rate and their value at the present market rate. It is always paid in full and in the same way. The payment can go either way, though – sometimes it is the bank that has to pay a breakage cost. The final amount to be paid depends on how much principal loan the borrower owes and often depends on the movements of interest rates between years. However, such costs can easily run into the hundreds of thousands. What, then, are customers' other options?

The FCA review

The FCA review is a review of the way banks have been selling interest-rate hedging products to customers. Not all customers are eligible, as eligibility depends on the “sophistication” of the customer. If a customer is “non-sophisticated”, then that customer can take part in the FCA review.

Generally speaking, a customer is sophisticated if he was not classified as a “private customer” or a “retail customer” at the time of the sale, has an aggregate turnover of more than £6.5 million ($10.9 million) net (or £7.8 million gross) or has an aggregate balance sheet total of more than £3.26 million net (or £3.9 million gross) or has more than 50 employees. The complaining party can be a company, partnership or an individual. According to the FCA's website, 29,119 of sales of these products were assessed for eligibility, of which 18,737 were found to be eligible for review.

If a customer is eligible, the FCA review requires the banks to take another look at the way they sold their products by measuring their sales practices against a set of standards, such standards being different from the more stringent legal principles that a court may consider. They must then decide in each case whether to offer redress or an alternative product. One would not expect it to be unusual for HNWs to be classified as “sophisticated customers” and therefore to fall beyond the reach of the FCA review.

Other avenues

For those customers who are not eligible to partake in the FCA review (and even those who are) the normal complaints procedure of the bank in question is still available. There are several ways to tackle this: one might try to try to complain to one's bank or relationship manager, lodge a formal complaint with the bank, complain to the Financial Ombudsman Service, and/or issue court proceedings. Any information that a customer can provide to the bank (including documents, which may ironically have been obtained by prior data requests from the bank), is of use.

Before even going to the FOS, the customer should talk to the bank's complaints service department. The complaint may be resolved but, at the least, the customer should obtain some information and documents from them. Banks are usually predisposed to look into a complaint as part of their customer service as standard and in any case will be obliged to do so under the FCA complaint-handling rules.

The Financial Ombudsman Service

The FOS is a free tribunal that can consider complaints made by customers against banks or financial advisors and complaints for services or products that have been provided, including the sale of interest-rate hedging products. The FOS does not look at the law but strives for what it considers is fair and reasonable in the circumstances. Customers usually have a far better (and cheaper) chance of redress with the FOS than in court. It only has jurisdiction, however, to suggest or make awards of no more than £150,000.

Until very recently, a customer had the option of accepting an award of compensation from the FOS and then going on to claim more in court proceedings. However, in a decision of the Court of Appeal on 14 February 2014 in the case of Clark v In Focus Asset Management & Tax Solutions Ltd, that possibility ebbed away. There, the complainants successfully obtained and accepted an award from the FOS against their previous financial advisors, In Focus. The total amount that Mr and Mrs Clark sought, however, was more than the FOS's jurisdictional amount and they therefore tried to claim the remainder of their alleged loss through the courts. It was In Focus' argument that the Clarks were essentially trying to litigate the same matter twice and the award at the FOS and the parties' subsequent agreement to that award precluded the pair from seeking to recover further loss through the courts (relying on the principle of res judicata, which generally means “the same matter cannot be tried twice”).

The Court of Appeal agreed with In Focus. It ruled that res judicata does apply because it is part of the common law, and that parliament legislates against the background of the common law, and is presumed to intend it to apply. Because the Financial Services and Markets Act 1986 (which applied here) did not cancel the presumption, res judicata applied. This was a significant development in claims by customers against their banks. Customers must now think very hard before accepting or rejecting a FOS award in their favour from now on, as they will only have one bite of the cherry.