Heather Buchanan is Director of Policy at the All Party Parliamentary Group (APPG) for Fair Business Banking
Having spent the last two years examining the pitfalls of the relationships between businesses and their banks, it is impossible to pin down exactly what can be, if anything at all, that magic bullet that will help create a level playing field and stabilize commercial relationships. Businesses are, on the whole, poorly served by both regulation and law, and one thing is certain, an overhaul of banking culture alone will not produce the desired panacea. In order to properly address the deeply rooted problem, we need to look beyond culture, not only to the regulation and law that underpins a commercial financial relationship, but also to the avenues of dispute resolution that exist when things go wrong. To set the stage, we must first look at some basic facts and figures.
According to BIS and the ONS, private enterprise in the UK constitutes 5.4m private businesses with a total employment of close to 26 million and an annual turnover of over £3.8 trillion. It's no wonder private enterprise and SMEs are called the 'lifeblood of the economy'. Of these, 96.3%, or over 5.1 million, have 10 or fewer employees and are classified as micro-businesses and could, in principle, approach the Financial Ombudsman Service (FOS) regarding a banking dispute for a small claim of up to £150,000. At first glance, this seems pretty good going.
However, the remaining 3.7% not covered by the FOS in fact employ 67% of the workforce in private enterprise — over 17 million — and generate 82% of the total turnover, or £2.9 trillion pounds. These are not insignificant numbers. To be clear, this figure represents employers of over 50% of the entire workforce of the UK.
You would therefore assume that there would be adequate and logical safeguards to provide a level of protection for businesses as consumers of commercial financial products.
However, whilst the banks are still perpetuating the illusion of banking based on trust, long-term relationships, good faith and advice, the reality is that no such safeguards exist either in regulation or in law for businesses. For absolute clarity, average consumers are protected, businesses are not. As previously mentioned, the FOS can only act in cases of microbusinesses up to what is, in fact, a very small sum, and the Financial Conduct Authority (FCA) neither regulates the commercial lending sector nor gets involved in individual cases, leaving businesses in a very vulnerable position.
In fact, these businesses that fall outside of the regulatory structure, whether they be care homes, small hotels with 12 employees or a large construction firm of 1,000 employees, are all considered financially sophisticated in the eyes of both regulation and law, and the only principle that is sacrosanct is that of contract law and caveat emptor. Is buyer beware really appropriate here?
So what does this mean in practical terms for businesses and their relationship with their lenders?
I'd now like to tell you a story about a hotel group.
The group was acquired in 1997 through a management buy-out. In late 2007 it refinanced with its bank and was compelled, as a condition of their agreement, to buy an interest rate swap that set interest at the peak of the market. When the recession came along in 2008 and 2009 interest rates dropped, but the Group’s payments under the loan and swap remained the same. And whilst their turnover suffered, as did the entire industry, the business never missed a payment to the bank.
In 2011 the Bank was demanding revaluations of property assets across the board. The Group had loans of £18 million and the valuation instructed by the bank came in at £12 million. As a result, the group was deemed high risk, despite keeping up all payments, and the Bank then imposed punitive interest rates and crippling terms that further squeezed the business of cash flow. However, the business still maintained all of its payments. The directors carried on and, in 2014 they were able to secure an offer of funding for £12.25 million to refinance away from their current lender. They made an offer to the bank, who declined saying it was insufficient.
Shortly thereafter the Managing Director was online and actually saw his Hotel Group for sale. Before he could call the Bank the next morning he received a notification that the loan and overdraft, together with all of the security, had been sold to Cerberus, a US vulture fund that specialises in buying up swathes of unregulated commercial lending via offshore vehicles. The Managing Director later was advised that Cerberus had paid £11.5 million for the loan - three quarters of a million pounds less than the directors had offered. Two months later, Cerberus contacted the directors of the company and served a demand, requiring payment of £18 million pounds within two weeks. On the day they could not pay, administrators took over and fired the board of directors. The Hotel Group was split up and sold.
In this case, the Bank was in the process of cleaning up its balance sheet, and it was advantageous to be able to sell a cashflow-positive hotel chain, because within the sale of commercial debt package to Cerberus the bank also sold less healthy loans and security in other businesses that they wanted off of their balance sheet. In essence, the hotel group was a sweetener in the deal. The management team that had built up the business over the past decade lost over £2.5m they had put into the business and were cast aside whilst the vulture fund cashed in on the fruits of their labours.
This is not an isolated story. In fact, this story is, perversely, happier than most. At least in this case the businesses were sold as going concerns and continued trading. Other similar cases have seen the businesses closed and only the assets sold on, resulting in the loss of hundreds of jobs at a time. There are literally thousands of businesses that have been forced to the wall through sharp practices such as this. It is perfectly legal, and, critically, it is still happening, as this case shows. Indeed, as the High Street banks are trying to rebuild their reputations, they are increasingly selling off the loans that they do not want to a multitude of vulture funds that operate in this market.
But why is it so easy for the system to be abused and how can we redress the balance of power?
Outside the discussion of culture, there are three key areas that facilitate scenarios such as the one I have just described.
In the first instance, the initial imbalance of power that is created at point of contract sets the stage for a relationship that is open to abuse by the larger party. The need for contractual clarity and transparency between parties is recognised as basic, good business practice. However, the financial sector does not adhere to these principles when dealing with unregulated sectors and products, choosing rather to use its market advantage to impose onerous and non-negotiable contractual terms on businesses that are unable to negotiate or challenge them. This is the case for almost all commercial lending.
These obtuse contracts and onerous covenants at the outset of a relationship, coupled with the lack of any judicial oversight of the insolvency process at the end, are a toxic mix. It means that, should a lender or, in the case above, the purchaser of a loan book, wish to exit a particular market, cease a particular relationship or, indeed, acquire a particular asset, there are no real barriers for it and no adverse legal consequences should it act unfairly or, indeed, aggressively, during that process.
Secondly, there is no mechanism in law that allows the owner of the business to challenge the appointment of an administrator and put the case forward in court for the survival of a business. Even when the behaviour of the bank itself has caused the insolvency, once the formal process of insolvency has been initiated, the business owners have control of their business — often built up over decades or even generations—taken away from them and the owner of the loan book enjoys the full benefit and protection of insolvency law, even in cases where misconduct — such as mis-selling of toxic products - has been clearly established and, indeed, admitted by the lender. In short, if a secured creditor sees fit to shut a business down, regardless of the consequences or the causes, it is very easy for it do so.
This 'creditor friendly' system makes the UK an attractive investment for ‘vulture’ funds that are able to buy up unregulated, secured commercial loan books at a discount, call upon the onerous contractual terms of the initial contract, and strip the assets of a company without any regard for the repercussions in terms of economic or personal impact to the businesses’ owners, unsecured creditors — including HMRC and local councils — and employees. In cases where there are personal guarantees behind the loan, the impact usually extends to personal bankruptcy and the loss of pensions and the family home.
Lastly, and perhaps most important of all, there is no universal forum through which businesses can air their grievances or be given access to speedy, affordable dispute resolution. The current landscape for dispute resolution between businesses and secured creditors is heavily weighted in favour of the lender. Initial complaints must always go via a bank’s internal complaints procedure, and should a satisfactory outcome not be obtained, there are currently only two avenues of recourse for a business: the FOS and the courts.
Bearing in mind that only micro businesses with fewer than 10 employees, a turnover of less than 10m euros and a claim of less than £150,000 can go to the FOS, the remaining businesses, who represent, at a minimum, 67% of employment and 82% of turnover in the private sector, must take up matters with the courts. This invariably becomes a dispute based on the initial contract, which is already heavily weighted in favour of the lender. To add insult to injury, the business is considered to have equal resource—both financial and intellectual—to fight its corner. It is, quite simply, not workable for most businesses to take on the might and resource of a multinational bank. Until such time as there is an effective forum in which businesses can truly come to the plate as an equal and be heard, the abuse of power will undoubtedly continue.
How do we move forward from here?
The financial crisis of the last decade has shown cracks in our system that must be addressed if we are not to have a repeat of events in the future. The toxic culture in banking institutions contributed to the financial collapse, but if we are to address the root causes of the problems, we must look not just to the culture that fanned the flames of the economic collapse, but also to the regulations and laws that fail businesses time and again.
Looking at culture alone is just not good enough; it is equally important that our legal and regulatory structure allows for a system that can work alongside the challenge of culture within institutions and act as deterrents for poor behaviour in the first place. Positive changes in culture were achieved through reform of employment law and the tribunal system in the sixties, and there is no reason why the same cannot happen in banking.
I need to be very clear here. I am not talking about over-regulation, just effective regulation with checks and balances in the right areas. And, critically, an unbiased, affordable forum through which businesses can be heard.
So what do businesses want and need from a commercial banking relationship? It is really quite simple. In order for a commercial relationship to thrive, and for the so-called life-blood of the economy—private enterprise—to flourish, the relationship between lender and borrower needs to be clearly defined, and the current imbalance of power acknowledged and addressed. Lending relationships are long term and must take into account the cyclical nature of the economy.
So, I leave you with these questions. What is the human cost of the benign phrase we hear of 'cleaning up’ balance sheets? What safeguards need to be implemented in order to create the level playing-field that exists in rhetoric, but not in reality? And what system can we implement to give businesses the voice they need to defend the rights not only of the business, but of all of its members?
Heather Buchanan is Director of Policy at the All Party Parliamentary Group (APPG) for Fair Business Banking. An APPG is a cross-party interest group, with parliamentarians from the Government and opposition parties, and cross-house, made up of both peers and MPs.
The APPG for Fair Business Banking is chaired by Calum Kerr MP (SNP). It currently has over 110 members. The group puts forward recommendations that will allow businesses and the financial sector to rebuild trust following the banking crisis, including better rules on transparency and clarity, learning from experience of other countries, and structural reforms to finance to encourage new institutions whose business model actively supports private business.