UK law sparks bonfire of ‘unfair’ structured product terms

Obscure provisions in UK Consumer Rights Act could threaten issuance programmes

Legal teams are busy eradicating problematic terms from product documentation

For most people, consumer rights laws are typically relied upon only when trying to return items such as a faulty toaster to a department store. In the UK, however, dealers are fretting that new consumer protection legislation could unexpectedly catch structured products sold to retail clients, sparking a scramble to purge documentation of terms that could be considered unfair, or even to redesign some products entirely.

"If you are not aware of it, you should be. It captures a wide range of consumer products – primarily kettles, hoovers and other such things. But it does capture financial products and it contains among other things a 'grey list' of terms that, prima facie, will be considered unfair by the courts. [So] you should be thinking carefully about the way in which structured product terms have been drafted contractually," said Tim Hailes, chairman of the Joint Associations Committee (JAC) on Retail Structured Products, at an industry breakfast meeting in early May (see box: The grey list).

While all industry eyes have been on the Packaged Retail and Insurance-based Investment Products regulation (Priips), behind the scenes an army of lawyers have mobilised to assist issuers in eradicating unfair terms from their contracts and save them from the embarrassment of having their prized products savaged in court.

The consequences for those who fail to do so could be dire. Contract terms could be branded unenforceable, for instance, thereby nullifying provisions issuers thought they could rely on to redeem products early. In the future they may even lead regulators to intervene and ban the sale of offending products.

In a nutshell, an unfair contract term is one that causes a significant imbalance in the parties' rights to the detriment of the consumer. When translated to structured products, vulnerable terms include those that grant discretion to the product issuer and product value calculation agents, which are usually a feature of products with early redemption clauses, and those allowing for a substitution of the securities' underlying assets, as well as variation rights.

If you are not aware of [the Consumer Rights Act 2015], you should be. It contains a 'grey list' of terms that will be considered unfair by the courts
Tim Hailes, Joint Associations Committee on Retail Structured Products

Product manufacturers are now adopting the role of minesweepers and poring over contracts for hidden nasties that could be construed as tipping the balance unfairly in their favour.

In a presentation to the JAC, law firm Ashurst listed five big dangers posed by unfair contract terms: a legal risk that terms would be branded unenforceable in court; a reputational risk arising from potential UK Financial Conduct Authority (FCA) investigations or having to give public undertakings; a product intervention risk that certain products would be banned or amended by the regulator; a prudential risk from product costs being different to those thought to be relevant when the product was first launched; and a governance risk, where management is put in the firing line for failing to spot vulnerable terms.

Investment prospectuses and, in the near future, Priips key information documents (KIDs), will also have to use language that reflects contracts that have been amended to exclude or mitigate unfair terms. That means issuers will have to conduct an exhaustive review of outstanding documentation to hunt for troublesome words and phrases.

The process is already well underway in some quarters, says Penny Miller, a partner in the financial services regulation practice at law firm Simmons & Simmons in London. "We are seeing firms review their terms and conditions in prospectuses, including, for example, any variation rights, substitution provisions, calculation agent discretions in stressed market environments, and generally for plain English,"says Miller.

Back to the drawing board

But the legislation in question, the Consumer Rights Act 2015 (CRA), affects more than just words on paper. There are also ramifications for product design. Some investments that engender vulnerable contract terms under the Act may have to be rethought – if not scrapped entirely.

"The presence of unfair terms in a contract is part of the analysis of whether you have designed the product properly. It is very difficult to gain comfort that your product offerings are free of risk under a CRA analysis, as there is often no black-or-white answer to whether or not a specific term is unfair. Some of these terms have been in place for many years without being queried. So it may be the case that some terms are ripe for review," says Michael Logie, London-based partner in the structured products practice at Ashurst.

The CRA brings together and updates older UK consumer protection rules. Among other things, it expands the scope of those defined as consumers, requires courts to consider the fairness of a contract term in any proceedings put before them relating to a consumer contract – even if this is not raised by either party – and tightens an exemption from the fairness test for terms that specify the "main subject matter" of a contract, making the carve-out harder for product manufacturers to use. The Act also includes a list of example contract terms that would be considered unfair and unenforceable.

It has changed the way we think about our structured products issuance programme
Paul Bajer, Credit Suisse

"It has changed the way we think about our structured products issuance programme," says Paul Bajer, a director in the global credit products business at Credit Suisse in London. "In the two years leading up to the Consumer Rights Act, when there was already a lot of guidance around product governance, we undertook an exercise to scrub all of our structured products programmes to identify any nexus of undue discretion or anything else that would be captured by the unfair contract terms provision. Every bank is looking at this," he says.

Just in case some banks failed to get the message, the FCA announced in its 2015/16 business plan that issues surrounding unfair contract terms were one of its "key concerns", adding that the CRA has put the issue into "sharper focus" than in years past. Small wonder, then, that a scramble is underway to purge contracts of vulnerable terms.

Those relating to early redemption rights have experts particularly exercised.

"It's the trickiest feature of all to analyse for unfair terms, and it's one where you have the most obvious crossover between unfair terms and product design," says Ashurst's Logie.

A structured note can be redeemed early in response to a number of contractual triggers. Some of these react to market signals. An autocallable note, for instance, will redeem early if its underlying asset or assets breach a predefined threshold value. But other triggers rest in the hands of the issuers themselves. In addition, the cash amount returned to the investor on early redemption will often be arbitrated by a calculation agent retained by the issuer – a party the investor has no say over. Early redemption terms therefore firmly tilt the balance of rights in a contract away from the consumer.

David Stuff, Cube Investing

"This ban on asymmetry in contracts is a problem. Many issuers retain the ability to call notes at their behest so they can buy them back at will. I remember the clauses relating to early redemption in a series of Barclays notes issued last year were very vague in terms of their valuations. In future they will need to be more specific, which is reasonable," says David Stuff, chief executive at Cube Investing in London. Barclays declined to comment.

Some contracts not intended for consumers as defined by the CRA, but which may find their way into their hands, could also pose problems. Privately placed notes traded between institutions would not be captured by the Act, for instance. But those sold to private banks and then resold to high-net-worth individuals may well be.

UBS provides one example. A UBS structured note term sheet for a privately placed product, seen by Risk.net, explicitly references the Swiss bank's right to redeem the product in case any present or future taxes would be imposed by a jurisdiction in which it operates as a result of changes in laws or regulations. If triggered, the term sheet states that the investor would receive the fair market value of the note, minus a share of the costs of unwinding any underlying-related hedging arrangements, as determined by UBS's calculation agent. If this product found its way into the hands of an individual investor via an intermediary, it would be captured by the CRA.

"That is completely unfair – it's a no-brainer," says one observer. "A retail investor cannot properly analyse the risk of the trigger being exercised, and the amount is unascertainable. It is minus hedge costs, which are completely dependent on internal arrangements that have been set up by the issuer themselves and to which the investor has no visibility." UBS declined to comment on the record.

By the letter of the CRA, these contract terms would be unenforceable in court. An issuer would not be able to simply tinker with the language of the contract either, as the early redemption feature is intrinsic to the product itself. Future series of such notes would have to be redesigned from scratch.

"You can see that having an effect on the issuer's enthusiasm for issuing new notes," says Cube Investing's Stuff.

The story is different when it comes to notes that embed a vanilla issuer call option, one that doesn't have a trigger based on a non-market event the investor has no insight into. Such a term would be captured under the 'main subject matter' exemption of the CRA so long as it is "transparent and prominent".

Issuer callables make up a small percentage of Credit Suisse's overall notes programme, says Bajer, adding his team are confident that the way their features are disclosed and structured will earn the contracts a green light under the CRA.

Chris Taylor, The Investment Bridge

"The inclusion of an issuer call is a key commercial term of the instrument that is agreed with the investor on day one, rather than a second-order term. The issuer says: 'We propose to make this note callable. Here's the value of that call. We will pay you an enhanced rate of interest that reflects the value.' That makes the transaction transparent as it offers an observable price for the call option," he says.

Bajer says it is also crucial that the bond component of the note is redeemed at face value with no breakage costs, regardless of when in the product's life it is called, as this also mitigates the risk of the contract term being deemed unfair.

Ashurst's Logie concurs: "A pure issuer call option, as opposed to one that gets triggered due to some potential tax event or whatever – if it's fully disclosed and the amount payable is known – would be at low risk of being unfair."

Substitution and variation

Ashurst cautions that terms related to substitution and variation rights may also be drafted too widely at present, or written in an opaque fashion. Either shortcoming could render a term unfair, but these are less likely to require product manufacturers to go back to the drawing board.

A substitution right allows the issuer to switch out an underlying asset referenced by a product for a different, but comparable, asset. These are commonly baked into equity-linked notes to hedge against a situation in which the underlying share is delisted or ceases trading.

The problem is that these rights, depending on how they are written, could offer issuers space to select a substitute asset that is a poor match for the original – with serious implications for the payout of the product. As the consumer has no say over the substitute asset, this is another example of issuers, perhaps inadvertently, stacking the deck in their favour.

Chris Taylor, London-based managing director at The Investment Bridge, a structured investment consultancy, takes issue with this interpretation.

"[Substitution] is most likely to be restricted to a market disruption event, such as an index or stock becoming uninvestable, which could be the result of anything from a merger to a discontinuation. Substitution in such circumstances is generally undertaken in the interests of making it possible for the product to continue to run in a form and with an underlying that matches the original terms as closely as possible. That will normally be in the best interests of investors rather than being an unfair term that may disadvantage them," says Taylor.

Certain risks in these contracts may be offloaded to investors. But you have to take a view on whether you can do that in a retail context, so firms are building in toggles that may apply these terms for institutional deals and typically disapply them for retail
Michael Logie, Ashurst

If restrictions on the exercise of substitution rights are clearly delineated, issuers should have little to worry about, he says. But others say it is better to be safe than sorry. Ashurst recommends issuers also write into their contracts proscriptive criteria around the selection of a replacement asset, a commitment to preserve the economic rationale for the investor when conducting a substitution, and even a put option exercisable by the note holder in the event a substitution takes place.

Variation rights can be defended from charges of unfairness with similar quick fixes. These rights grant the issuer discretion to amend a contract in response to an assortment of legal, regulatory or market events. For example, an issuer may reserve the right to change the calculation agent responsible for totting up a product's payout. Again, if the circumstances in which the variation rights are exercised are clearly defined, issuers should avoid an 'unfair' branding.

Simmons & Simmons' Miller points out that guidance on variation rights was included in the FCA's structured product development and governance review of 2012, which provides a treasure trove of advice on how issuers can nip unfair terms in the bud but recommends firms go further and give notice of a coming variation to investors before the fact. "Just specifying a valid reason in the contract may not go far enough towards satisfying the test of fairness. It may also be necessary, for example, to provide for notice to consumers that a change has been, or will be, made," states the review.

The presence of these vulnerable terms in retail structured products documentation is partly the legacy of issuers borrowing language from dealer-to-dealer derivatives contracts. Lawyers note an interesting interplay with some International Swaps and Derivatives Association definitions that allow a lot of discretion to be built into contracts, which doesn't work in the consumer market.

Because of this, some issuers are putting processes in place whereby they use a single base contract for all structured products but can switch some terms on and off depending on whether the counterparty is a retail or institutional client.

"Most issuers' structured products programmes have similar contract terms, because you will typically start with the terms and conditions of a medium-term note or warrants programme and then layer on terms taken from Isda definitions. Certain risks in these contracts may be offloaded to investors – for example, hedge unwind costs. But you have to take a view on whether you can do that in a retail context, so firms are building in toggles that may apply these terms for institutional deals and typically disapply them for retail," says Logie.

The amount of work needed to scrub contracts of unfair terms will vary from issuer to issuer. Taylor at The Investment Bridge argues that the UK retail sector is "ahead of these issues", and Bajer at Credit Suisse says its internal review of contract terms in recent years, with the assistance of outside counsel, has put the bank on a sound footing.

 

The grey list

The UK Consumer Rights Act 2015 lists a number of unfair contract terms that would be unenforceable in a court of law. Prior to publication of the act, the Competition and Markets Authority released its own understanding of the impact on contract terms, including a ‘black list' of unfair terms and a ‘grey list' of terms that could be deemed unfair.

The terms on the grey list that are relevant to structured product issuers include:

• Exclusion of liability clauses.

• Unequal cancellation rights.

• Trader's right to vary terms generally.

• Price-variation clauses.

• Entire agreement clauses.

• Transferring inappropriate risks to consumers.

• Trader's discretion in relation to obligations.