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SPECIAL REPORT-UK banks say 'smart' clients don't deserve compensation

Tue, 25th Nov 2014 10:28

By Matt Scuffham

LONDON, Nov 25 (Reuters) - Scott Wotherspoon runs a smalltiling firm in Scotland. In 2008, when he bought a shopfittingcompany, he asked his accountants to check its books. There wasno problem with the shopfitter. But Wotherspoon was about to runinto trouble with his bank.

The 43-year-old borrowed about $4 million from Royal Bank ofScotland. As part of the transaction, the bank insisted he buy ahedging product, a kind of insurance policy, so he could keeprepaying the loan even if interest rates rose. If interest ratesfell instead of rising, that would cost extra - whichWotherspoon alleges the bank did not explain. He thinks he isdue compensation for mis-selling, like thousands of otherbusinesses that Britain's financial watchdog has ruled areeligible.

But Wotherspoon now faces a second blow: The regulator won'tlook at his claim because his company is now too big. His storyshows how businesses which may have suffered because of bankmisbehaviour face a new wave of frustration. First, their bankssold them financial products few could understand. Now, thebanks say some of their customers should have known better.

Scandals of all sorts have already cost Britain's four mainbanks more than 36.5 billion pounds ($57 billion) in fines since2009, according to CCP Research Foundation, which examinesethical issues in organisations. Earlier this month, theFinancial Conduct Authority, the main UK financial regulator,levied the biggest fine ever on UK banks for manipulating theforeign exchange market.

The scandal that hit Wotherspoon's tiling firm involvedfinancial products known as swaps. In 2012, the regulator, theFinancial Conduct Authority (FCA), found "serious failings" inthe way banks had sold the swaps to small firms. It set up acompensation scheme and ordered the banks to review nearly30,000 potential victims. Like thousands of other firms,Wotherspoon's was deemed ineligible for compensation - in hiscase, because his firm was ruled to be too big, or financially"sophisticated," and should have understood what it bought.

Swaps are a form of financial derivative - products WarrenBuffet once called "financial weapons of mass destruction."Though they are regularly used by big firms, the FCA said in itsruling that banks should not have sold them to small companies.Such firms aren't sophisticated enough to understand them, theFCA said.

That question of sophistication is at the centre ofWotherspoon's case.

When Wotherspoon took out his loan, and bought the swap asrequired by RBS, his firm, Tilecraft, was small.

But as a result of the deal, Tilecraft grew big enough that,according to the compensation rules, it was now sophisticatedenough to understand swaps.

Wotherspoon says that's wrong.

"I didn't have a clue what I was doing," he said. "We're nota sophisticated business. We're a tiling company... We basicallytook the bank's advice."

In Britain, most small businesses depend for finance on theirbanks. Those looking for advice often rely on their local bankadviser or accountant, who may not know much about swaps. IainCoke, head of financial services at ICAEW, an accounting body,said the type of swap sold to Tilecraft would be unfamiliar tomany qualified chartered accountants.

RBS told Reuters it has been fair, and the Financial ConductAuthority (FCA) defended the way the compensation scheme works.

CONFLICT OF INTEREST

So far, the compensation scheme's administrators say firmswho bought swaps are due redress in 13,913 cases. But the schemehas ruled that they are too financially sophisticated in 10,361cases. If all those firms were in the scheme, they would addbillions to the compensation bill, derivatives experts say.

In cases like Wotherspoon's the compensation scheme equatessize with sophistication. This, say critics such as theFederation of Small Businesses (FSB), is too crude a measure.

Abhishek Sachdev, a derivatives expert, says the scheme hasserious shortcomings. These include a fundamental conflict ofinterest: The scheme was set up by the FCA, but relies on thebanks themselves to decide who is eligible for compensation.

The banks work with assessors including big accountancyfirms such as KPMG which, while independent, are appointed bythe banks.

For mis-selling swaps, the banks set aside 4.4 billionpounds to compensate small businesses. So far, they have paidout 1.5 billion pounds. Barclays said last month it was reducingits total payout budget.

"There are very significant 'get out' clauses and banks areprepared to go to incredible lengths to manipulate it," saidSachdev, who has given evidence to parliamentary committees onthe scheme.

Wotherspoon's bank, RBS, is state-owned after a45-billion-pound bailout in the 2007-9 financial crisis. ChiefExecutive Ross McEwan said in February the bank was "the leasttrusted company in the least trusted sector of the economy." Hehas vowed to make it "the most trusted bank." It is Britain'sbiggest lender to small firms and has nearly half the cases inthe compensation scheme.

The FCA said around 200 customers have raised concerns aboutthe review process over the past six months. Some small businessowners have told Reuters their banks offered alternativeproducts which they didn't want. Others, who were advised by theFCA they did not need to use lawyers, say the banks brought intheir own attorneys who took evidence their customers hadprovided and used it against them.

British Bankers Association Chief Executive Anthony Brownesaid in July that a huge amount of work had been done to reformthe banks. RBS told Reuters it had worked with the regulator to"ensure that all customers mis-sold these products get fair andreasonable redress." The BBA said banks have tried to be asprofessional and efficient as possible. "Thousands of customershave been happy with the compensation they've received," said aBBA spokesperson.

But conservative lawmaker Mark Garnier, who is part of agroup which oversees the work of Britain's finance ministry andfinancial regulator, said he is not convinced firms are gettinga fair deal.

"We will continue to push for businesses to get their moneyback," he said. "We are very angry and we are doing our levelbest to put pressure on the regulator. There are still very,very bad habits in banks."

"THIS IS THE SWAP FOR YOU"

For Wotherspoon, financial sophistication arrived in aPorsche driven by an RBS saleswoman.

It was April 2008, and his business had made a profit of510,000 pounds the previous financial year on sales of 5.5million. One of its clients had come up for sale and Wotherspoonsaw an opportunity to expand. The acquisition would takeTilecraft's annual sales to around 21 million pounds.

Tilecraft agreed to pay 2.2 million pounds for the firm.Wotherspoon's accountants did due diligence, and RBS agreed tolend Wotherspoon 2.6 million pounds to fund the acquisition andexpenses related to it.

He says RBS then said he would need to buy a swap, to ensurehe could keep repaying if the interest payments on his loanrose. "It was definitely a condition. There were no maybes." RBSdeclined to comment on the sale process.

The loan agreement did not stipulate that the swap must comefrom RBS, but Wotherspoon says he believed that was what thebank meant. "They said, 'Before you sign the paper we'll get ourswaps lady in, who will tell you what swap you should get.' Shesaid, 'This is the best swap for you,' then jumped into thePorsche she had waiting outside to go and sell it to somebodyelse," he said.

Wotherspoon had agreed to buy something called an'amortising base rate collar.'

What the saleswoman didn't tell him, Wotherspoon said, isthat if interest rates were to fall significantly, his companywould be liable for extra charges.

Seven months later, in Nov. 2008, the Bank of England cutinterest rates by 1.5 percentage points.

The move was meant to help small businesses by making loanrepayments cheaper. For people holding swaps like Tilecraft's itdid the reverse. The extra charges eventually amounted to159,000 pounds including the cost of breaking the agreement,contributing to the company making a loss of 455,000 pounds inthe year to March 2010.

TOO BIG TO COMPENSATE

Tilecraft applied to join the compensation scheme in Maylast year. It learned that it was considered too sophisticatedto be eligible six months later. Under the terms of the scheme,firms were too sophisticated if at the time of an agreementtheir sales were more than 6.5 million pounds, their assetsworth more than 3.3 million pounds, they had more than 50employees or they already held hedging products worth over 10million pounds.

When Tilecraft bought the shopfitting firm, it was smallerthan all those cutoffs. But the acquisition took its annualsales over the limit. Because the swaps deal was finalised afterthe takeover, Wotherspoon failed the test.

"It's all down to dates, really," said Wotherspoon.

RBS declined to comment on the timeline of the sale, butsaid Tilecraft was 'sophisticated' under the guidelines, anoutcome agreed with the independent reviewer, acting on behalfof the regulator but appointed by RBS.

FSB, the small business lobby, says the sophistication testbears little relation to reality. Of more than 10,000 othercompanies that failed the test, 4,803 were rejected on groundsof size alone. It's not clear how many grew too big only as aresult of buying a swap.

"The application of the sophistication criteria inevitablyleft many small firms that should have been compensated out inthe cold," said John Allan, national chairman of the FSB. "Thecriteria were by definition arbitrary and lacking in nuance."

TOO BIG TO FAIL

If firms like Tilecraft were eligible for compensation, thebanks' compensation bill would increase. Derivatives expertSachdev estimated the industry would need to pay out 25 billionpounds, more than five times the funds set aside, of whichalmost half would come from state-owned RBS. That calculation isbased on banks paying out average compensation of 850,000 poundsfor each claim.

That could make it more difficult for the government to selloff stakes in the banks it bailed out: RBS and Lloyds BankingGroup.

The prospect of such a bill - on top of the costs of otherpast misconduct - encourage banks to ensure as few cases aspossible get into the scheme, industry specialists say.

As the scheme stands now, the only chance for firms likeTilecraft to recover their losses is legal action. Few have thefunds.

"I'd rather put my effort into getting business and justkeeping going," said Wotherspoon.

When Tilecraft fell into the red, RBS moved the account intoits Global Restructuring Group (GRG), a turnaround specialistfor ailing businesses. In May 2010, GRG lent Tilecraft 96,250pounds to buy its way out of the swap the bank had soldWotherspoon. As security, it took a 10 percent stake inTilecraft and increased the interest on its loans to 3percentage points above Britain's benchmark interest rate,according to Wotherspoon. RBS declined to comment on thoseactions.

Earlier this year, the FCA launched a separate inquiry intothe way RBS had handled companies in difficulty. The regulatordefended the sophistication test as necessary to make the schemeworkable.

The FCA said the independent assessors who check the banks'ruling on compensation claims are not being lenient with thebanks, and it is satisfied the vast majority of businessesallowed into the scheme are happy with their compensation. (1 US dollar = 0.6393 British pound) (Edited by Sara Ledwith)

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