What is an interest rate swap or IRS?

  • Commercial Litigation

We often get asked very similar questions by new clients with potential interest rate swop claims against lenders.

In this article we try and tackle a few of the more common ones.

What exactly is an interest rate swap or IRS?

We have seen several definitions but essentially an interest rate swap (IRS) is a popular and highly liquid financial derivative instrument in which two parties (a borrower and lender) agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another.

What is the new Financial Conduct Authority’s scheme all about?

The above named new City regulator, which took over conduct responsibility from the Financial Services Authority (FSA) from the start of April 2013, has given banks including Royal Bank of Scotland and Lloyds the authority to begin to contact customers to initiate the compensation process, the Telegraph reported.

Barclays and HSBC are also believed to have been given the go-ahead to settle cases.

The decision to allow the banks to begin compensation is a major milestone for the companies involved but we believe clients should be cautious and not lose site of the fact that their claims could become statute barred (see below).

The news comes 13 months after The Sunday Telegraph first highlighted the number of small and medium sized-businesses which had incorrectly been sold overcomplicated banking products based on interest-rate swaps.

The banking sector as a whole has since gone on to set aside in excess of £2bn of provisions to account for future claims.

The “green light”, as one of the banks involved described it, comes after a drawn-out review by the FCA and its predecessor into the level of mis-selling and the way in which small businesses should be compensated.

Is it working?

Not in all cases no.

According to newspaper reports Lloyds Banking Group was apparently forced to withdraw a redress contract for a small business after the terms offered on the compensation deal were questioned by financial experts.

According to one newspaper report an original contract document seen by The Telegraph, concerning a small businessman, was offered a new interest rate hedge to replace his old derivative that would have meant that its break cost would have exceeded a cap of 7.5 per cent of the amount borrowed.

Apparently based on the expert’s analysis, the break costs on the new “simple” product would have actually amounted to closer to 39 per cent of the business’s borrowing and potentially about half of its loan amount.

“The redress trade does not appear to meet the guidelines set out by the FSA [Financial Services Authority] regarding the 7.5 per cent maximum break cost,” wrote the expert in a confidential report.

A separate expert also questioned the benchmark borrowing the rate used by Lloyds on the settlement, pointing out it would end up costing them more.

“Looks worse than what they first sold him! Lots of tweaks in banks [sic] favour, i.e., switch to base rate from LIBOR [London Interbank Borrowing Rate],” wrote the derivatives expert in an email seen by The Sunday Telegraph.

Any other unknowns?

Yes it’s not clear how the compensation levels are calculated or how long the statutory process will take.

As claims can be statute barred after 6 years from the date when the cause of action accrued, we advise all clients who are thinking of instructing us to do so immediately and not to delay.

Otherwise their claim could be struck out under the Limitation Act 1980.

Are there any other issues I should know about?

Another commentator suggests that a new wave of “baby toxic” products could threaten small firms, while another warns that businesses could be prevented from receiving compensation – with the cash instead ending up in the hands of the banks who mis-sold the products in the first place.

Bully Banks, an organisation that represents businesses that have been mis-sold swaps, claims that some of those firms are having their swaps changed for new products with a shorter term or of less size.

The organisation refers to these products as “baby toxic”, and is concerned that businesses are not being allowed to opt out.

Bully Banks chairman Jeremy Roe said:

“Having won the up-front battle in establishing the principle of mis-selling there is real concern that small businesses could lose the war and fail to obtain the full and fair restitution due to them…

Even more concerning for SMEs is the very real possibility that the banks may seek to substitute the IRSA that was mis-sold with another IRSA – a ‘baby toxic’ product as part of the redress process. We need strong guidance from the regulator that this will not be acceptable.”

What if my company goes into administration where the bank appoints an Administrator under the Insolvency Act 1986?

This is an issue we have seen reported in The Times which reported that hundreds of small firms forced into administration as a result of the mis-selling could miss out on compensation.

The article in question pointed out that the banks could end up “compensating themselves as the new owners of the businesses.” In many cases the banks will be the firms’ biggest creditors, and will therefore be paid during the process of administration.

Bully Banks has been lobbying to stop this, and met with civil servants from the Department for Business, Innovation and Skills (BIS) last week to seek assurances that business owners would receive compensation where it is due.

For further information visit our Interest Rate Swap page or email us today if you believe you have a claim.