Westpac is expected to pay a maximum penalty of $1.8 million in relation to a $12 billion interest rate swap transaction in October 2016, the largest of its kind in Australian financial market history.
The Federal Court has declared the bank engaged in unconscionable conduct when it engaged in pre-hedging ahead of an interest rate swap transaction with a consortium comprising AustralianSuper and IFM entities. The interest rate swap related to managing interest rate risk associated with the consortium’s purchase from the NSW government of a 50.4 per cent stake in electricity provider Ausgrid.
The consortium sought to enter into the interest rate swap transaction to hedge the interest rate risk associated with the money it had borrowed to fund its stake in Ausgrid. That borrowing was at variable interest rates and the consortium wanted to protect itself from the risk of those rates increasing by converting that interest rate exposure to a fixed rate for the full term of the loan.
It is understood Westpac’s derivatives trading desk achieved a trading profit of approximately $20.7 million on the day the swap was executed (of which $3.7 million was allocated to the sales team as commission).
The Australian Securities and Investments Commission (ASIC) previously alleged Westpac breached s1043A of the Corporations Act (insider trading), s12CB of the ASIC Act (unconscionable conduct), and s912A of the Corporations Act (breaches of the general obligations of an Australian financial services licensee).
The court has now declared Westpac’s conduct was unconscionable in that:
- Westpac was aware of its client’s concern about trading prior to the swap transaction (pre-hedging) that had the potential to adversely affect the price of the swap transaction to their detriment. Every basis point increase to the price of the swap transaction would involve a cost to the consortium of about $4.7 million.
- Despite being aware of its client’s concerns, Westpac acted on an internal plan to pre-hedge up to 50 per cent of the interest rate risk by trading in significant volumes of interest rate derivatives in the market before the swap transaction was executed.
- Westpac failed to obtain client consent or give clear and full disclosure about the extent of its planned pre-hedging.
- Once Westpac commenced its on-market pre-hedging trading, the consortium could not protect itself against the risk that Westpac’s trading would increase the price of the swap transaction to the consortium.
The court also declared that Westpac failed to have adequate arrangements to manage the conflict of interests between it and the consortium and did not do all things necessary to ensure that the swap transaction was provided to the consortium efficiently, honestly, and fairly.
The court reserved its decision on whether to make an order requiring Westpac to complete a compliance program with an independent review of its pre-hedging practices and controls, including relating to conflicts of interest management and client communications.
ASIC deputy chair Sarah Court described the judgment as a “significant outcome which assists to clarify expectations regarding pre-hedging, particularly around disclosure and consent where the pre-hedging can have a detrimental impact on the counterparty to the transaction”.
She said: “Appropriate conduct for pre-hedging is an issue of global significance. In this case, Westpac’s behaviour was unconscionable and exposed its client to significant risk. Westpac’s conduct was also in stark contrast with several other banks.”
Notably, the $1.8 million penalty is the maximum the court could order for statutory unconscionable conduct in 2016, when the conduct occurred. At the time, a contravention of s912A of the Corporations Act did not attract a penalty.
Since 2016, civil penalties have significantly increased and the current penalty for unconscionable conduct in breach of the ASIC Act or for a breach of s912A of the Corporations Act is at least $15.65 million for a corporation.
For a large entity, the maximum penalty may potentially be $782.5 million or three times the benefit derived (whichever is greater).
Ms Court added: “We share the court’s concern regarding the maximum penalty available in relation to the conduct and note that had Westpac engaged in similar conduct today, the maximum available penalty would have been significantly higher.”
Along with the maximum penalty of $1.8 million, Westpac is expected to pay $8 million for ASIC’s litigation and investigation costs.