Do we need a new duty of care in financial services?

On 17 July 2018, the FCA published a paper on its Approach to Consumers (the Approach), accompanied by a discussion paper DP18/5 (the DP) on the possible introduction of a new duty of care and other alternative approaches (a New Duty).
The Approach sets the FCA’s vision for well-functioning markets that work for consumers, and builds on the November 2017 consultation on its Future Approach to Consumers. The aim is to provide greater transparency on when and how the FCA will act to protect consumers, its policy positions on key issues, and its strategy for ensuring that it advances its consumer protection objective with the greatest impact.
The key question raised by the November 2017 consultation, one of immediate interest to firms and other stakeholders, was whether there was a need to introduce a New Duty.
Some stakeholders suggested that the current regulatory framework was insufficient, was not applied effectively to prevent harm to consumers and did not provide appropriate levels of protection. Some thought the introduction of a New Duty could foster long term cultural change within firms and avoid conflicts of interest. Others by contrast felt that existing FCA rules and common and statute law, complemented by the Senior Managers & Certification Regime collectively represent in practice the same requirements on firms as a duty of care.
The FCA’s objective is therefore to open broader discussion on the merits of a New Duty and understand what outcomes a New Duty may achieve to enhance behaviours in the financial services sector.
To that end, the FCA seeks views on:
  • whether there is a gap in the existing legal and regulatory framework, or the way the FCA regulates, that could be addressed by introducing a New Duty;
  • whether change is desirable and if so, the form it should take;
  • what a New Duty for financial services firms might do to enhance positive behaviour and conduct from firms in the financial services market, and incentivise good consumer outcomes;
  • how the New Duty might increase the FCA’s effectiveness in preventing and tackling harm and achieving good outcomes for consumers;
  • whether breaches of a New Duty or of the FCA’s Principles for Businesses should give rise to a private right of action for damages in court; and
  • whether a New Duty would be more effective in preventing harm (by, for example, enhancing good conduct and culture within firms) and therefore lead to less reliance on redress.
The DP deliberately leaves open for discussion the nature of any duty, i.e. whether it would be more akin to a ‘duty of care’ or to a fiduciary duty, the former being more of a positive obligation than the latter which is, largely, a prohibition (e.g. a firm must not put its own interests above those of the client).

Assessment of the current legal and regulatory framework

The DP reviews the current legal and regulatory framework and notes that it could be said that the current Principles for Businesses (Principles), amplified by detailed rules, address many of the issues cited for introducing the New Duty.

The FCA identifies the following as the most relevant Principles:

  • Principle 2 – a firm must conduct its business with due skill, care and diligence
  • Principle 6 – a firm must pay due regard to the interests of its customers and treat them fairly
  • Principle 7 – a firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading
  • Principle 8 – a firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client, and
  • Principle 9 – a firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgment.

The FCA also points to the client’s ‘best interests’ rule, whilst highlighting that there is no equivalent rule applicable to accepting of deposits and carrying out contracts of insurance, and obligations on firms to take reasonable care in undertaking certain activities.

These are supplemented by the Consumer Rights Act 2015 (the CRA), which implies a term requiring those providing services to consumers to act with reasonable care and skill, and the FCA’s power to enforce breaches of certain consumer protection laws (including the CRA).

The FCA has also concurrent competition powers to investigate and intervene in respect of markets where competition may not be working well, and to enforce against breaches of the competition law prohibitions.

Finally, the FCA is extending its Senior Managers and Certification Regime (SM&CR) to all FSMA authorised firms: this will impose on most employees of financial services firms five conduct rules, including in particular the requirement to act with due care, skill and diligence, and to pay due regard to the interests of customers and treat them fairly. The FCA believes these additional obligations on individuals could help address some of the key cultural and governance concerns which underlie calls for a New Duty.

Proposals for the New Duty

As well as seeking views on the merits, practicalities and consequences of introducing a New Duty, the FCA will consider a range of possible alternatives to address stakeholders’ concerns:

  1. making a rule introducing a New Duty, through the use of FSMA rule-making powers. This approach would require clarification through the issue of guidance and consideration as to how it would sit within the regime, and in particular its relationship to the Principles.
  2. by the introduction of a statutory duty (through a change in primary legislation in Parliament) and supplemented by FCA rules and guidance. A statutory duty would have greater status than the Principles, going further than the requirements of s1C(2)(e) FSMA¹.
  3. the extension of the client’s best interest rule. This would only apply to regulated activities and may require some amendment to some of the Principles.
  4. enhancements to the Principles through the introduction of detailed new rules or guidance, for example through the guidance expected to be published next year on the identification and treatment of vulnerable customers.

Consumer outcomes and redress

While being clear that the best consumer outcome is to prevent harm from occurring in the first place, the FCA addresses the mechanisms available to a consumer when seeking redress when things go wrong.

It is in that regard, the FCA raises what will no doubt be a controversial question as to whether a breach of a New Duty or of the Principles should give rise to private right of damages. The latter reopening a debate had in the context of a 1998 consultation that originally introduced the Principles.

Any extension of private rights of action in respect of breach of the Principles would need to be considered in conjunction with the FCA’s recent discussion of a proposed extension of Principle 5 to unregulated activities, which the FCA may revisit in the future. Such an extension of Principle 5, together with the recognition of a range of industry codes relating to unregulated activities, would assume a wholly different complexion if private rights of action were also added to the mix.

Reflection

The call for duty of care in financial services regulation is not a new one and, as well as having been a priority for the Financial Services Consumer Panel for some time, was considered by the Parliamentary Commission on Banking Standards as well as the Law Commission.

It is not clear from the DP that there is in fact an obvious gap in the existing legal and regulatory framework to be filled – that itself being an open question in the DP. That is, rationally, the fundamental starting point – proceeding to discuss the nature or form of a New Duty, including the potential for the Principles to be actionable, is premature before the underlying problem or gap is properly identified. Clearly there continue to be conduct issues in the market that need to be addressed but rushing to introduce new rules or guidance is not necessarily the best answer.

 

¹ In meeting its objective of securing appropriate degree of protection for consumers the FCA is currently required by s1C(2)(e) FSMA to have regard to “the general principle that those providing regulated financial services should be expected to provide consumers with a level of care that is appropriate having regard to the degree of risk involved in relation to the investment or other transaction and the capabilities of the consumers in question”

Jenny Stainsby
Jenny Stainsby
Partner
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Karen Anderson
Karen Anderson
Partner
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Jon Ford
Jon Ford
Senior Associate
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High Court rejects the first IRHP mis-selling claim brought by private persons under Section 138D FSMA

The High Court has rejected the first interest rate hedging product (“IRHP“) mis-selling claim brought by private persons under section 138D of the Financial Services and Markets Act 2000 (“FSMA“) in the recent case of Ramesh Parmar & Anor v Barclays Bank plc [2018] EWHC 1027 (Ch).

The decision will be of particular interest to financial institutions defending claims relating to the mis-selling of financial products generally, and in particular to statutory claims brought by private persons. The court considered a number of factors which may make for useful comparisons with other cases, in particular in relation to its assessments that there was no advisory relationship and that there was no breach of the Conduct of Business Sourcebook (“COBS“) Rule 10 (which applied on the basis that it was a non-advised sale). The factors of potential wider application are discussed in the decision section below. Insofar as two of the claimants’ complaints were found to amount to technical breaches of other COBS Rules, the court’s decision that no loss flowed from those breaches and therefore the claims still failed, is instructive.

Significantly, the court took a more narrow approach to the use of basis clauses to define the bank/customer relationship as “non-advisory“, than has previously been adopted by the courts in the mis-selling context (and in financial markets transactions generally). The courts have consistently found that basis clauses are outside the scope of the Unfair Contract Terms Act 1977 (“UCTA“) (and s.3 Misrepresentation Act 1967), as they do not attempt to exclude or limit liability, but rather give rise to a contractual estoppel, which prevents the parties contending that the true state of affairs was different to that agreed in the contract: Crestsign Ltd v National Westminster Bank plc & Anor [2014] EWHC 3043 (Ch). However, in the instant case, the court held that UCTA was irrelevant, because COBS 2.1.2 applied and went further than UCTA to “prevent a party creating an artificial basis for the relationship, if the reality is different“. The court therefore held that the bank would not have been able to rely upon the basis clause if it had in fact given advice.

Given the court’s ruling that the defendant bank did not give advice, its conclusions on this issue were obiter dicta and therefore do not have precedent value, but may be persuasive in future cases. However, the court’s suggestion that COBS 2.1.2 goes further than UCTA is ripe for challenge. It is widely accepted that an attempt to alter the character of a relationship retrospectively through the use of basis clauses is unlikely to avoid the scrutiny of UCTA. Indeed, in Crestsign itself, the claimant submitted that it would be “rewriting history or parting company with reality” to define the relationship as one in which advice was not given. However, the court in that case (properly in our view) highlighted that the line that separates provision of information from giving advice may be a fine one, and this may lead parties to legitimately define their relationship to avoid disputes afterwards, with “no violence” being done to history or reality. With this in mind, there is an argument to be made that COBS 2.1.2 does not go any further than UCTA, and as such the bank should have been able to rely on the basis clause if it had crossed the line into giving ‘advice’.

Additionally, and in keeping with other recent authorities, the court held that there was no specific requirement for the bank to disclose its internal credit limits at the point of sale under the COBS Rules for the purpose of demonstrating the breakage costs (see our banking litigation e-bulletin). However, there was a second aspect of the complaint relating to non-disclosure of the internal credit limit considered in this case: the impact of the internal credit limit on the claimants’ future borrowing ability. This aspect caused the court more concern. The court commented that there could be factual situations where disclosure would be required under the COBS Rules if the limit would have a significant impact on future borrowing, although this was not the case on the present facts. However, the court does not seem to have been referred to the Privy Council decision in Deslauriers & Anor v Guardian Asset Management Limited [2017] UKPC 34, in which the contrary conclusion was reached (see our banking litigation e-bulletin).

Background

The claimants were longstanding clients of Barclays Bank plc (the “Bank“) and ran a small disposable gloves business and a small residential property investment business.

The claimants had no prior experience of IRHPs. However, in May 2006, prior to taking out a third loan with the Bank, the claimants indicated to the Bank that they were interested in taking out a fixed rate loan. The Bank no longer offered fixed rate loans. Instead, the Bank suggested that the claimants could enter into an IRHP to manage their interest rate risk.

The Bank provided a number of different presentations over three years which gave information on a variety of IRHPs (including swaps, caps, collars, enhanced collars and structured collars). Following discussions between the Bank and the claimants, in April 2009, the claimants entered into two ten-year interest rate swaps at a fixed rate of 3.48% (the “Swaps“). Relevant details of the presentations and discussions are considered further in the decision section below.

In October 2012, after the past business review into the sale of IRHPs had been announced by the FCA, the claimants made a complaint about the Swaps. The claimants met the criteria of non-sophisticated retail classified customers and were assessed as eligible for the review. However, the review ultimately concluded that the Bank had met the necessary standards at the point of sale and therefore no redress was due. The claimants subsequently commenced proceedings.

Claim

The claimants initially advanced various causes of action, including allegations of breach of various common law duties of care and fiduciary duties in connection with the underlying sale of the Swaps and/or the conduct of the past business review by the Bank (among others). However, the claimants abandoned these claims and instead focused on a sole cause of action: a statutory claim under s.138D FSMA for several alleged breaches by the Bank of the COBS Rules. The claimants claimed that – but for the alleged breaches of COBS – they would have entered into two interest rate cap products, each for a term of five years at a rate of 4.5%.

Decision

The principal issues which arose for consideration were:

  1. Was the sale advised or non-advised?
  2. Did the Bank fail to comply with either COBS Rule 9 (if it was an advised sale) or COBS Rule 10 (if it was a non-advised sale)?
  3. Could the Bank rely on ‘basis clauses’ in its contracts with the claimants?
  4. Did the Bank comply with various other COBS Rules?

The court cautioned that each case will turn on its own facts and so the findings made may provide limited assistance in any subsequent case. However, there are a number of points of potentially wider application which arise from the court’s discussion of these issues, which are explored in further detail below.

  1. Was the sale advised or non-advised? 

    The court stated that, in order for the sale to be advised, there must be “a value judgement“, “an element of opinion” or “advice on the merits” on the part of the Bank, in keeping with the principles established in Rubenstein v HSBC [2011] EWHC 2304 (QB) and Zaki & Ors v Credit Suisse (UK) Ltd [2011] EWHC 2422 (Comm). The court noted that the test was an objective one, namely, having regard of all evidence in the factual circumstances of the case: “has there been advice or simply the giving of information?” (as per Thornbridge Ltd v Barclays Bank plc [2015] EWHC 3430 (QB)).The court concluded that the sale was non-advised and that COBS Rule 9 was not engaged in the circumstances. In reaching that conclusion, the court relied on the following factors:

    • The fact that the claimants had a relationship of trust with their relationship managers at the Bank did not mean that the relationship managers were dealing with the claimants as advisers.
    • The absence of an external independent adviser did not necessarily mean that the Bank’s representative was giving advice to the claimants.
    • References in the presentations provided to the claimants to “Barclays Capital’s unrivalled depth of expertise and providing strategic FC to Corporate Risk to the UK Market Place” and the words “Corporate Risk Advisory” beneath the Bank representative’s name, by themselves did not mean that the Bank was giving advice to the claimants in relation to the IRHPs.
    • Generally, to constitute a recommendation, the recommendation must have been made in respect of a particular product (and not interest rate management generally). The fact that the claimants were given information as to the pros and cons of various IRHPs by a specialist in the field authorised by the FCA to do so, in itself did not make the Bank’s representative an adviser, particularly as he did not promote one IRHP over the other.
    • The use of phrases such as “bespoke“, “our more popular solutions“, and “tailoring the protection” in literature or communications did not mean that advice had been given.
    • It was clear from the evidence that the claimants’ decision to enter into the Swaps (rather than the cap product) was not based on a recommendation from the Bank’s representative, but was because the claimants did not wish to pay a premium, having considered all the information available.
  2. Did the Bank fail to comply with either COBS Rule 9 (if it was an advised sale) or COBS Rule 10 (if it was a non-advised sale)? 

    As the court found that there was no advisory relationship, it was not strictly necessary to consider the effect of COBS Rule 9 and whether the Swaps were suitable. However, the court went on to do so, and found that even if COBS Rule 9 had been engaged, the Swaps would have been suitable for the claimants in the circumstances.The court therefore considered compliance with COBS Rule 10 (the obligation to assess the appropriateness of the product), which applied because the court held that the sale was non-advised. The claimants alleged that the Bank was in breach of this rule by failing to carry out an adequate fact finding exercise, so as to ensure the claimants had the necessary understanding of the risks involved in relation to the IRHPs. The court rejected this claim and found that the fact-finding exercise carried out by the Bank had been sufficient, despite the Bank conducting the exercise incrementally.

  3. Could the Bank rely on basis clauses in its contracts with the claimants?The Bank took the position that even if it had been found to have given advice, it could rely on certain ‘basis clauses’ in the contractual documentation. The Bank submitted that similar or near identical clauses to those in the present case had been considered by the court in mis-selling cases, and repeatedly found to be ‘basis clauses’ rather than exclusion clauses, and therefore beyond the remit of UCTA (for example, in Crestsign). The Bank submitted that there was no distinction to be drawn between the words used in s.3 UCTA and those used in COBS 2.1.2. The latter prevents any attempt by a firm “in any communication relating to designated investment business seeking to (1) exclude or restrict; or (2) rely on any exclusion or restriction of; any duty or liability it may have to a client under the regulatory system“.

    The court rejected the Bank’s submission on this issue and instead found that UCTA was irrelevant. The court held that COBS 2.1.2 went further than s.3 UCTA, in that it “prevent[ed] a party creating an artificial basis for the relationship, if the reality is different“. Accordingly, had the Bank in fact given advice, the Bank would not have been able to rely on the disclaimers in the contractual documentation in question or any similar statements in the presentations provided to the claimants to negate this. Such clauses would be void under COBS 2.1.2.

  4. Did the Bank comply with various other COBS Rules? 

    The other aspects of the claimants’ claim centred on allegations that the Bank had failed to provide sufficient information to the claimants in relation to three principal matters, and thereby failed to comply with various other COBS Rules.Potential magnitude of break costs

    The claimants argued that the presentations provided by the Bank failed to give a sufficient explanation of the potential magnitude of break costs. The court rejected this argument, instead finding that the Bank provided the claimants with both qualitative and quantitative illustrations of potential break costs and the documentation made it clear that break costs would depend upon market conditions at the time of termination. Further, on the evidence before the court, the claimants clearly understood the nature, effect and possible magnitude of break costs.

    The court did, however, find that the following wording in the presentations was misleading: “cancelling the contract may result in either a breakage cost or a breakage gain. The principles of the calculation are the same as for traditional fixed rate loans“. The court accepted the claimants’ submission that the principles were in fact wholly different. The court held that this amounted to a breach of COBS Rules 2.2.1, 4.2.1, 4.5.2 and 14.3.2. However, the claimants had not in fact been misled and therefore no loss flowed from those breaches.

    True value of the cap product in comparison to the Swaps 

    The claimants argued that in the presentations provided to them, and in their discussions with the Bank’s representative, the Bank failed properly to identify the true value (in terms of potential future gains and offset of the initial premium) of the cap product in comparison to the Swaps.

    The court found that the Bank failed to state in the written presentations that there could never be a break cost in relation to the cancellation of a cap. It held that this flaw amounted to a breach of COBS Rules 4.5.6 and 14.3.2. However, as the claimants were well aware of the fact that a cap would not involve break costs (from discussions with the Bank) by the time they decided to enter into the Swaps, no loss flowed from the breach.

    Disclosure of the existence of the Bank’s internal credit limit 

    The claimants argued that the Bank should have disclosed the existence of its credit equivalent exposure (“CEE“) limit in relation to the Swaps, and its potential impact on the claimants’ ability to obtain further borrowing in the future. There were two distinct aspects of this complaint: (a) disclosure of the CEE limit would have effectively demonstrated the potential breakage costs; and (b) the CEE limit imposed a hidden fetter on the claimants’ credit and therefore their ability to borrower further sums.

    In keeping with the Court of Appeal’s recent decision in Property Alliance Group Limited v The Royal Bank of Scotland plc [2018] EWCA Civ 355 (see our banking litigation e-briefing), in which the Court of Appeal found that there was no obligation on the defendant bank to disclose its internal credit limit at the point of sale, the court held that it was not necessary for the Bank to disclose the existence of its CEE limit to meet its obligations under the COBS Rules in this case. The Bank could discharge its COBS obligations to explain potential breakage costs by giving adequate examples, and discussing them with the client (as in the instant case).

    The court said that the decisions in PAG (and five other first instance authorities) as to why there was no obligation to make such disclosure, were instructive. This was notwithstanding the fact that those cases were not specifically concerned with whether or not there had been compliance with the COBS Rules. In PAG, it was found that the CEE equivalent could not have been expected to have been revealed, as it was the product of the subjective view of the lending bank about possible movements in interest rates in the future and the length of the outstanding term of the swaps at the time of the break.

    However, the impact of the CEE limit on the claimants’ future borrowing ability caused the court more concern. The court understood that the CEE was not a credit line capable of being utilised by a customer, but was a factor taken into account when the Bank determined whether to grant the customer further lending. On the evidence, the CEE in the instant case had no impact whatsoever on the claimants’ ability to borrow further funds from the Bank. However, the court commented that there may be other factual situations where the CEE limit could have a significant impact on future borrowing and should be disclosed in order for the financial institutions in question to comply with the COBS Rules.

Conclusion

This is largely another welcome decision for financial institutions involved in IRHP (and other mis-selling) claims. In particular, it highlights the relative similarity in the approach of the court in considering claims brought by private persons and other persons that do not qualify under s.138D FSMA. There is still no single reported case involving allegations of the mis-sale of IRHPs in which a claimant has succeeded at full trial. Although obiter, it remains to be seen whether the court’s comment on the need to disclose the CEE will be followed in future decisions.

John Corrie
John Corrie
Partner
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Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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Nic Patmore
Nic Patmore
Associate
+44 20 7466 2298

Court of Appeal finds no contractual duty to prevent counterparty from inflicting economic harm on itself

A recent Court of Appeal decision has found that a broker owed no contractual duty to prevent a “sophisticated and experienced” trader (trading as a private person) from causing economic harm to himself when using the broker’s platform software to trade: Ehrentreu v IG Index Ltd (Rev 1) [2018] EWCA Civ 79. The case arose in the context of spread-betting, where a trader placed a bet in 2008 on the movement of a particular share price, which went “disastrously wrong“. The trader sought to impose various duties on the broker to have closed out the bet at an earlier date and thereby reduce loss on the bet.

At first instance – in addition to the alleged contractual duty – the trader brought a claim as a private person for breach of statutory duty under s.150 (now s.138D) of the Financial Services and Markets Act 2000 (“FSMA“). It was claimed that the broker had not acted in the trader’s best interests by not closing out the bet during the relevant period and thereby breaching the Conduct of Business Rules (“COBS“) 2.1.1R. However, the court below held that there had been no breach of this rule on the facts and there was no appeal on this point.

Accordingly, the appeal focused on the alternative route by which the trader sought to establish a duty: an alleged contractual duty to prevent a counterparty from inflicting economic harm on itself. The court held that it will require “very clear express words in the contract spelling out such a duty, before the Court could conclude that such an exceptional duty arose“. Somewhat surprisingly, the court below had found that the contract did contain such a clause, although the claim had still failed on the grounds that the breach did not cause the loss. It is suggested that the approach of the Court of Appeal sits more comfortably in the context of a regulatory regime which did not consider it necessary provide such protection within the COBS rules to customers.

BACKGROUND

The respondent (the “Broker“) was a spread-betting company regulated at the relevant time by the then Financial Services Authority (“FSA”). The appellant had been a customer since 2001 (the “Trader“).

The relationship between the parties was governed by a Customer Agreement in writing which took effect on 15 December 2007. Under the terms of the Customer Agreement, the Broker was entitled to oblige the Trader to make margin calls in respect of his positions. More specifically, two particular terms were considered in detail on appeal:

Term 16(4):

“(4) You acknowledge that:

(a) where you have failed to pay a deposit or margin call in respect of one or more Bets five business days after such payment becomes due, we are (except as provided in Term 16(5) below) obliged to close out such Bets;

(b) where one or more bets exceed the credit or any other limit placed by us upon your dealings; and you remain in excess of your credit limit for five or more business days, we will:

(i) close any or all of such Bets; and

(ii) refuse to open any further Bets until payments sufficient to bring you within your credit limit have been received by us.”

Term 16(5):

“Subject to the FSA Rules, in the event of your failing to meet a demand for deposit or margin or your being in excess of any credit limit placed on your account, we may exercise our reasonable discretion to allow you to continue to place Bets with us, or allow your open Bets to remain open, but this will depend on our assessment of your financial circumstances.”

Over the years, the Trader had placed a number of substantial spread bets on the movement of the market. In August 2008, the Trader bet on the movement of the share price of a particular banking institution. The bet moved against the Trader. On 15 September 2008, the Broker made a margin call on the Trader for £197,195. Thereafter, margin calls with changing margin requirements were made on the Trader on a daily basis. By 14 October 2008, when the Broker closed out the bet, his account was £1,270,350.75 million in debit.

While those fluctuations were occurring, a representative of the Broker frequently pressed the Trader to pay funds to satisfy the margin calls. The Trader sought to reassure the Broker that funds would be forthcoming and pleaded with the Broker not to close out his position.

HIGH COURT DECISION

The appeal had a reasonably complex procedural history, the detail of which is not relevant for present purposes. In the judgment under appeal, the court held that:

  • The Broker was not in breach of its statutory duty under COBS 2.1.1R to act in the Trader’s best interests by not closing out his bets in the relevant period between 15 September and 14 October 2008. The Trader brought this claim under s.150 (now s.138D) FSMA as a private person. In finding that there was no breach of duty, the court had regard to: (1) the fact that it was clear from the evidence that after 7 years the Trader was a sophisticated and experienced trader; (2) he had made payments in the past when requested to do so; (3) he promised to make the payments requested during this period and in making those promises he intended the Broker to accept them; and (4) the general principle behind the rules is that consumers should take responsibility for their decisions. There was no appeal from this conclusion.
  • However, in relation to the Customer Agreement:

o   The Broker had not exercised its discretion under Term 16(5) to keep the appellant’s bets open.

o   The Broker was therefore obliged to close-out the bets under Terms 16(4) and (5), which the Broker had failed to do.

  • Notwithstanding this, the breach did not cause the Trader’s loss; it was the Trader’s decision to continue with his bets which was the cause of his loss.
  • Further, since it was the Trader’s positive decision to keep his bets open when he could have closed them down, and this decision caused his loss, the Trader had wholly failed to mitigate that loss.

The Trader pursued two principal grounds of appeal:

(1)   That Term 16(4) of the Customer Agreement was at least in part to protect the Trader from running the risk of keeping his bets open, and therefore the court below should have concluded that the breach of contract was at least an effective cause of the loss.

(2)   For the same reasons, the court below was wrong to conclude that the Trader failed to mitigate his loss, and the court failed to identify what steps a reasonable man in the position of the Trader ought to have taken and when.

COURT OF APPEAL DECISION

The appeal was dismissed on both grounds.

Contractual duty

The court was satisfied that Term 16(4) was not a provision for the benefit of the Trader.

The court first construed the wording of Term 16(4) and commented that the use of the words “You acknowledge that” suggested that the provision was for the benefit of the Broker rather than the Trader. Despite the references in Term 16(4) to the Broker being obliged to close out the bets, the Court of Appeal found that this should be read as “we will have to do it“, meaning that the Trader could have no complaints if his bets were closed down.

Specifically, the court commented that the provision ensured certainty and whilst that certainty provided some benefit to the Trader and the Broker alike, the obligation was not “intended to protect the individual customer against his own gambling addiction or considered choices”.

The court rejected an argument that Term 16(4) had the same meaning and purpose of a formerly applicable regulatory provision, COB 7.10.5R, which obliged firms to close out a private customer’s position if a customer failed to meet a margin call made for that position for five business days, subject to limited exceptions. COB 7.10 had been replaced by COBS 2.1.1R prior to the Customer Agreement, and this did not provide for the same obligation (as the FSA had considered it was not necessary to protect customers in this way). As such, COB 7.10 was immaterial to the construction of Term 16(4).

The conclusion that Term 16(4) did not impose an obligation on the Broker to act for the benefit of the Trader was borne out by the authorities which consider the duty on one party to protect another party against deliberately causing harm (specifically economic harm) to itself. Referring to Calvert v William Hill Credit Ltd [2008] EWHC 454 (Ch), the court commented that in the law of tort, the existence such a duty was “truly exceptional“. It was submitted by the Broker that the position was even more exceptional in the context of contract law and there were no reported cases in which such a contractual duty had been found (and this was not contradicted by the Trader).

The court commented in that context: “it would require very clear express words in the contract spelling out such a duty, before the Court could conclude that such an exceptional duty arose. The court held that on the facts, Term 16(4) did not contain any such words and was simply not a provision intended to protect spread-betting addicts against themselves. The court noted that this was “scarcely surprising” given that the Customer Agreement was intended to facilitate spread betting.

In the circumstances, Term 16(4) was not inserted for the benefit of the Trader and so the appeal failed. Dealing with a point raised on causation, the Court of Appeal agreed with the High Court that breach of Term 16(4) was merely the opportunity for the loss, not the effective cause. In fact, it was the Trader’s decision to continue on with his bets which was the cause of his loss.

Mitigation

Whilst stating that it was strictly unnecessary to deal with the Trader’s ground of appeal in mitigation, the court proceeded to deal with it briefly.

The Court of Appeal held that it was wrong to say that the court below had not analysed and decided what a reasonable person in the position of the appellant would have done in the circumstances. Further, there was no error in concluding that the Trader had wholly failed to mitigate his loss for the same reasons as it had concluded that it was the Trader’s decision to continue to leave his bets open which was the cause of his loss. As per the Supreme Court in Bunge SA v Nidera BV[2015] UKSC 43, the duty to mitigate is an aspect of the principle of causation, or put another way, causation and mitigation are two sides of the same coin.

The Court of Appeal accordingly dismissed the appeal.

Harry Edwards
Harry Edwards
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Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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Nic Patmore
Nic Patmore
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O’Hare v Coutts: High Court dismisses mis-selling claim and clarifies standard of care required of financial advisors

Overview

In O’Hare v Coutts, the High Court dismissed a claim alleging that the defendant bank breached duties in contract and tort to use reasonable care and skill when recommending five investments that the claimants entered between 2007 and 2010.

The Court held that the bank’s duties when giving advice required proper communication and dialogue with the client regarding the proposed investment, in order to ensure the client understood the advice it was given and the risks arising from the recommended course of action. However, the Court found that the relevant approach in this context was not to assess the bank’s actions by reference to what a body of financial advisors would consider acceptable (the “Bolam test”). Rather, the Court would ask whether the bank had taken reasonable care to ensure the claimants were aware of any material risks. This approach, the Court said, takes into account the lack of any clear industry consensus about the extent of communication required and the fact the bank’s regulatory duties—which are “strong evidence of what the common law requires“—do not require reference to industry practice.

Another key issue was the extent to which it was appropriate for the bank to persuade the claimants to take more risks than they otherwise would. The Court could not find anything intrinsically wrong with persuasive salesmanship, provided the products sold were objectively suitable (in which regard the Court said the Bolam test is still applicable). Although, with the benefit of hindsight, the investments had not performed as well as the clients had wished, the Court nevertheless found that reasonable practitioners professing the expertise of the bank could properly have given the same advice the bank did. The Court therefore concluded that the investments were suitable and the claimants should take responsibility for their own investment decisions.

The case is also interesting for the following reasons:

  1. The bank did not call a pivotal witness, the claimant’s former relationship manager, but relied on his contemporaneous notes. The Court admitted the notes as hearsay evidence and declined to draw any adverse inferences in respect of the weight to be given to them because there was no procedural failure on the bank’s part. Nevertheless, the Court was not always prepared to favour the relationship manager’s written notes over the claimants’ oral evidence.
  2. The Court said that if the claims in contract and tort had succeeded, the claimants’ damages would be limited by the more restrictive test of remoteness under contract law.
  3. The Court found that the bank’s promise to apply discounts in favour of the claimants as a “gesture of goodwill” in settlement of a separate dispute constituted a binding legal settlement.

We discuss the decision in more detail below.

Background

Mr and Mrs O’Hare (the Claimants), whose joint net worth was in excess of £25 million, began their relationship with the bank in 2001. Their relationship manager from 2001 to 2008 was a Mr Kevin Shone, after which a Mr Ray Eugeni took over.

Although Mr O’Hare was an astute businessman, the Court did not accept that he was necessarily an experienced investor. The Court found that he was willing to accept some—but not too much—risk, provided he was properly informed about how much risk he was taking.

In 2007 and 2008, the Claimants invested over £8 million on the bank’s advice in three products from the bank’s new line of “Novus” funds (the Novus Investments). The bank classified these as “wealth generation products” (its most risky investment category). The result was a significant shift in the Claimants’ portfolio towards higher risk investment, concentrated in three untested hedge fund products. The Claimants alleged that the Novus Investments were unsuitable because the bank downplayed the substantial increase in risk, there was no capital protection, and the investments caused the Claimants to expose an unjustifiably high proportion of their wealth to loss.

In 2010, the Claimants invested a further £10 million in two additional products that the bank recommended: RBS International funds called Autopilot and Navigator (the RBSI Investments). Unlike the Novus Investments, the RBSI Investments were classified by the bank as “wealth preservation products” (the bank’s least risky investment category). However, the Claimants alleged the RBSI Investments were unsuitable because the bank should have advised against concentrating so much money in one institution and it should have recommended products other than those of it and its parent.

The market declined in value, following the 2008 financial crisis and the Claimants issued proceedings against the bank, alleging breach of contract and negligence on the part of the bank.

1. Suitability of the products: what standard of care is expected of financial advisors?

The bank undertook to advise the Claimants in their personal capacity, including working with them to understand their “circumstances, objectives and requirements” and to formulate “an investment strategy”. The bank was obliged to give its advice in writing, at such times as it considered appropriate (or otherwise as agreed). Because the bank had undertaken advisory duties, the Court considered whether the products had been suitable for the Claimants (as opposed to just whether the bank has correctly described them).

Uncontroversially, the Court found that the bank owed identical duties in tort and contract to use reasonable skill and care when recommending investments, to the standard of a reasonably competent private banker.

Were the Claimants adequately informed?

The Court held that in the context of giving investment advice, there must be proper dialogue and communication between adviser and client. The bank submitted that this ought to be assessed in line with the traditional test from Bolam v Friern Barnett Hospital Management Committee [1957] 1 WLR 583: namely, by reference to whether a body of financial advisors would consider the extent of its communications acceptable. The Court noted that the Bolam test had recently been overturned in a medical context (so far as the duty to explain is concerned), in favour of a duty to take reasonable steps to ensure the relevant patient is aware of any material risks (see Montgomery v Lanarkshire Health Board [2015] UKSC 11). In Montgomery, the Supreme Court said that a risk is material if, in the circumstances, (1) a reasonable person in the patient’s position would be likely to attach significance to it; or (2) the doctor is aware that the patient would be likely to attach significance to it.

In the context of duties to explain investment risks, the Court also preferred the Montgomery approach to Bolam, in particular because the expert evidence did not establish any industry consensus delimiting the proper role of a financial adviser in this regard. The Court supported its decision by reference to the regulatory regime, which is “strong evidence of what the common law requires“. In particular, the Conduct of Business Sourcebook (COBS), which apply where a sale is advised, includes a duty to explain in similar terms to Montgomery and, unlike Bolam, does not require reference to the opinion of a responsible body within the profession.

The Court went on to say that “compliance [with the COBS] is ordinarily enough to comply with a common law duty to inform, forming part of the duty to exercise reasonable skill and care; while breach of them will ordinarily also amount to a breach of that common law duty.” Accordingly, the Court observed that the content of the various COBS provisions relied on by the Claimants added nothing to the bank’s common law and contractual duty to ascertain the client’s requirements and to advise, including explaining and informing them, about suitable investments. In any event, the Court did not find that the bank had breached any COBS duties.

Applying the Montgomery approach first to the Novus Investments, the Court concluded that the bank’s sales presentations had “left no room for any suggestion that Mr O’Hare did not fully understand the Novus products”, including “an understanding of their higher risk classification as wealth generation products“.

Similarly, in relation to the (later) RBSI Investments, the Court concluded that Mr O’Hare was “fully aware that the capital would be at risk if RBSI should become insolvent but was happy to run that risk because, he reasoned, RBS was effectively state owned.” Likewise, the Court rejected the allegation that “insufficient information about the products (including costs and charges), and insufficient comparative information about alternatives, was provided“.

Were the investments objectively suitable?

Given the Court’s decision that the Claimants were properly informed, the case turned on whether the investments were objectively suitable for the Claimants (the case being one where it was not disputed that advice had been provided by the bank). In this context, the Court accepted that the Bolam test continued to apply, the relevant question being whether “reasonable practitioners professing the expertise of the defendants could properly have given advice in the terms they did“.

The key issue was the extent to which it was acceptable for the bank to persuade clients to take more risk than they otherwise would (and conversely, when the bank would be required to step in and “save the clients from themselves”). Perhaps in a welcome recognition of commercial reality, the Court did not find anything intrinsically wrong with a financial advisor using persuasive techniques to induce a client to take risks (s)he would not take but for the adviser’s powers of persuasion, provided the risks were not so high as to be foolhardy (avoiding the temptation to use hindsight), the client could afford to take the risks, and the client showed itself willing to take the risks. Critically, the Court said that the duty of care must reflect a balance between the client taking responsibility for investment decisions (even mistaken ones) and the principle that the advisor must sometimes save the client from him/herself.

In considering the (earlier, higher risk) Novus Investments, the Court explicitly applied the Bolam test, ultimately agreeing with the bank’s expert witness that “competent practitioners at the time – avoiding hindsight – would not regard investment in the Novus products as foolhardy for persons in the position of the O’Hares, with their wealth and investment objectives“.

In contrast, the Court did not explicitly invoke the Bolam test in its analysis of the RBSI Investments. This may be because the capital-protected RBSI Investments involved de-risking and consequently, there was less scope for the Claimants to suggest that the products were objectively unsuitable. In any case, Mr Eugeni, in his unchallenged evidence for the O’Hares, said that after the 2010 RBSI Investments, he considered the portfolio suitable and well balanced. As such, the Court’s focus was on whether the O’Hares were properly informed about material risks relating to the RBSI Investments (in light of the fact such a large amount of money was being placed with a single banking institution).

On the evidence before it, the Court held that all of the investments in question were objectively suitable for the Claimants, who should therefore reasonably bear responsibility for their own mistaken investment decisions (even in light of the bank’s salesmanship).

2. The absent witness: will courts draw adverse inferences if key witnesses are not called?

A key factual issue relevant to suitability was the extent to which the Claimants were persuaded by their first relationship manager, Mr Shone to make higher risk investments than would be consistent with their unconditioned risk appetite.

Although he was a material witness, the bank did not call Mr Shone and instead chose to rely on his contemporaneous notes (which were referred to and implicitly adopted as true in the statements of two other Bank witnesses, both called orally). The bank explained that Mr Shone was a former employee and had indicated he was too busy to devote time to the proceedings.

The Court first accepted that the hearsay notes were admissible, by virtue of section 1 of the Civil Evidence Act 1995, which abolished the rule against the admissibility of hearsay in civil proceedings. Moreover, because they formed part of the agreed bundle and the Claimants did not give a written notice of objection in respect of them, paragraph 27.2 of Practice Direction 32 confirmed the notes would be admissible as evidence of their contents.

Section 2(4)(b) of the Civil Evidence Act 1995 provides that a failure to comply with the relevant procedural rules may be taken into account as a matter adversely affecting the weight to be given to hearsay evidence. Here, the Court declined to draw an adverse inference in respect of Mr Shone’s notes because it found that the Court had complied with its obligations under CPR 32 and 33 (given that the witnesses who referred to those notes gave oral evidence). It was open to the Claimants under CPR 33.4 to call Mr Shone for cross-examination, but they did not.

In terms of the weight given to those notes, the bank relied on Gestmin v. Credit Suisse [2013] EWHC 3560 (Comm), in which the High Court had held that the best approach for a judge to adopt in a commercial case is “to place little if any reliance at all on witnesses’ recollections of what was said in meetings and conversations, and to base factual findings on inferences drawn from the documentary evidence and known or probable facts.” Whilst the Court agreed that the approach in Gestmin is “very useful”, it did not accept that the effect of Gestmin was to cause Mr Shone’s notes to be admitted unchallenged (their accuracy having been disputed by the Claimants). Nor did it go so far as to mean Mr Shone’s notes should always be preferred to the oral testimony of the Claimants. Indeed, the Court ultimately preferred Mr O’Hare’s testimony that Mr Shone used persuasion on him over Mr Shone’s notes, which repeatedly described the Claimants as “keen”, without mentioning the exertion of persuasion or influence by the bank.

Although the tactical question of which witnesses to call will always be highly fact specific, this case illustrates the importance of complying with the procedural rules for adducing hearsay evidence in the absence of a witness (and considering whether to apply to cross examine an absent witness on whose hearsay evidence the other party relies).

3. The settlement agreement: when will “gestures of goodwill” be legally binding?

In 2008 and 2009, the Claimants complained that the bank had not properly explained the risk profile of another product called “Orbita Capital Return”, which had performed poorly. The bank had at that time rejected the Claimants’ complaint explaining why it considered that the product had not been mis-sold. Nevertheless, recognising the value of the Claimants’ business the bank agreed as a gesture of goodwill to apply a refund of $250,000 by way of a reduction in fees over a period of time in consideration for the Claimants forbearing to sue. Although Mr O’Hare gave evidence that the agreed currency was pounds sterling, the Court found that Mr O’Hare was genuinely mistaken and that the agreed currency was dollars, reflecting Mr Eugeni’s written notes.

In the proceedings concerning the other products, the Claimants sought to argue that this obligation remained outstanding. In doing so, they sought to exclude discounts that had been negotiated with the bank arguing that these discounts were separate and distinct from the $250,000 that the bank had agreed to pay.

The bank’s primary argument was that the “settlement agreement” was not binding; rather, it was merely a “gesture of goodwill” made without intention to create legal relations. The bank referred to Clarke v Nationwide Building Society [1998] EWCA Civ 469 in which a refund sent in “full and final settlement”, but described as a “goodwill gesture”, was held not to be binding.

The Court expressly declined to hold that Clarke provided authority for a general proposition that offers made as a gesture of goodwill are not capable, on acceptance, of binding the offeror. The Court noted that this was a question that depended on the circumstances of the case. Unlike Clarke, the bank’s offer was made in the context of a pre-existing contractual relationship. This placed a heavy onus on the bank to show that the parties did not intend to be legally bound, which it failed to discharge. Nevertheless, the Court held that the bank had complied with its side of the bargain by applying $250,000 worth of discounts, despite Mr O’Hare’s genuine belief that some of those discounts ought to have been excluded from the sum.

The Court’s approach to this issue highlights the risks in entering into settlements which are not formally documented, given the potential for later disagreement over their terms and the extent to which they have been satisfied. The difficulties here were exacerbated by the absence of evidence from key witnesses (both Mr Shone, who was not called, and Mr Eugeni, who had not given evidence about this point).

4. The damages issue: concurrent claims in tort and contract

Interestingly, the Court said that had the Claimants been successful, it would have confined damages to the more restrictive contractual test of remoteness (rather than the more generous tortious measure). The Court said that it would have taken this approach even in respect of the Novus Investments, where the Claimants’ contractual claim was time barred but its tortious claim was not. To do otherwise would be to allow the Claimants to benefit from their failure to bring the contractual claim less than six years before the cause of action arose and fly in the face of the fact that there was a contractual relationship between the parties.

This follows the approach in Wellesley Partners LLP v Withers LLP[2015] EWCA Civ 1146, where the Court of Appeal said that in cases of concurrent liability in tort and contract, the parties are not strangers and should be confined to the contractual measure of damages (since the contract reflects the consensus between the parties which ought to be reflected when dealing with issues of remoteness).

In this case, the Court doubted whether the distinction would make any real difference. However, in other circumstances, it might be relevant whether the financial advisor is liable for all foreseeable consequences of the breach (for instance, unexpected or catastrophic falls in the market) as opposed to merely loss that is within the reasonable contemplation of the parties at the time the contract is made.

Conclusion

O’Hare v Coutts provides helpful guidance about the extent of financial advisors’ duties to their clients. In particular, the decision erodes the Bolam test in the context of the duty to explain investment risks (as had already happened in cases of medical negligence): in cases where objectively suitable advice has been given, the extent of communications required is simply to take reasonable steps to ensure the client is aware of material risks. On the other hand, the decision affirms that the Bolam test still applies to the assessment of whether the advice given is objectively suitable (which requires reference to whether reasonable practitioners with the expertise of the defendant could properly have given the advice the defendant did).

This decision adds to the theme of recent cases, that make clear that informed investors must be prepared to accept responsibility for their own investment decisions, even where the advisor has used sales techniques to push a particular product or to encourage the investor to take more risk than s/he otherwise would.

The decision also serves to reinforce the basic proposition that evidence at trial should generally be given orally by the witness who proves the fact. Where this is not possible, contemporaneous hearsay notes (albeit admissible) may not be preferred to contradictory oral evidence. Parties who intend to adduce hearsay evidence should take steps to protect themselves by complying with the relevant procedures in the CPR. Equally, parties should consider giving written notice of objection to the admissibility of hearsay evidence which the other side seeks to include in agreed bundles, and consider applying to cross examine the relevant witness, where possible.

Finally, the decision clarifies the approach to damages in cases of concurrent liability in tort and contract. While it may not always be relevant, the Court’s approach of limiting damages to the more restrictive contractual test of remoteness could cushion a bank in circumstances where investments perform poorly due to unexpected or catastrophic changes in the market.

John Corrie
John Corrie
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Hywel Jenkins
Hywel Jenkins
Partner
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Ben Worrall
Ben Worrall
Associate
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Suresh Sivagnanam v Barclays Bank: High Court limits shareholders seeking a second bite of the cherry in IRHP mis-selling cases

Following a number of recent cases relating to the mis-selling of interest rate hedging products, Suresh Sivagnanam v Barclays Bank plc [2015] EWHC 3985 (Comm) is another judgment which is likely to be received favourably by financial institutions.

The mis-selling claim, which was brought against a financial institution by a sole shareholder of a company, has failed at the summary judgment stage. The High Court relied on two grounds to find that the claim had no real prospect of success:

  1. Section 138D of the Financial Services and Markets Act (“FSMA”) (which provides a basis for bringing a claim for breach of statutory duty) is only intended to protect customers who constitute private persons to whom a duty is owed (i.e. customers of the relevant financial institution); and
  2. The well established company law principle that a shareholder cannot bring a claim for reflective loss.

The sensible approach of the Court to the interpretation of section 138D FSMA will be welcomed by financial institutions. This is particularly so against a backdrop of various attempts by claimants to widen the scope of this statutory provision by extending the definition of “private persons” to include corporate entities. See our e-bulletin on Thornbridge Limited v Barclays Bank plc [2015] EWHC 3430 (QB), for our most recent discussion of this trend. In that case, the defendant bank successfully argued that the corporate entity was not entitled to claim for breach of section 138D FSMA as it was clearly acting “in the course of carrying on business” and therefore did not qualify as a “private person.

Background

The Claimant was the sole shareholder of a company, “WHL”. WHL had entered into three interest rate hedging products with Barclays Bank (the “Bank”) between 2006 and 2008 (the “IRHPs”).

In 2010, WHL and the Bank entered into a written compromise agreement in respect of the IRHPs. Subsequently, in 2015, there was a further review of the Bank’s past sales of hedging products pursuant to an agreement made with the Financial Services Authority (as it then was). At this time, the Bank and WHL entered into a “full and final settlement” of WHL’s claims. The settlement agreement was signed on behalf of WHL by the Claimant in his capacity as sole director, in accordance with which WHL was paid the sum of over £2 million.

The Claimant then sought to bring a claim under section 138D FSMA for alleged losses he had personally suffered as a result of the Bank’s breach of statutory duties (namely the COB and COBS rules, being the regulatory rules covering the period during which the IRHPs were sold to WHL). The Bank issued an application for strike out or summary judgment.

Decision

In a short judgment, the Court granted the Bank’s application for summary judgment, stating it was “entirely satisfied” that there were no realistic prospects of success on the claim and no other compelling reason why the matter should go to trial. The Court set out two principal bases for rejecting the claim as put, which are considered in further detail below.

(a) “Private persons” are persons to whom a duty is owed

The Court considered whether the Claimant was a “private person” within the meaning of section 138D FSMA. It held it was “clear beyond argument” that this provision was only designed to protect customers who constituted private persons to whom a duty was owed (i.e. customers of the Bank). This did not include shareholders of those customers, such as the Claimant.

The Court highlighted a fundamental point in relation to questions of statutory duty – that the person bringing the claim must be a person whom Parliament intended to protect under the provision. The regulatory rules on which the Claimant relied were all specifically aimed at customers of the relevant financial institutions. The point was “made good” simply by reference to the Particulars of Claim. These stated that WHL was a private customer of the Bank within the meaning of COB and later COBS. They went on to allege various breaches of these regulatory rules, all of which were pleaded with reference to the position of WHL, not the Claimant.

The Claimant argued that the Bank had required him to inject further personal money into WHL and to provide further security in the form of personal guarantees and charges over personally owned property. However, the Court found that this was not sufficient to amount to a breach of duty on the part of the Bank under the regulatory rules or FSMA. The Claimant, who chose to invest in a corporate vehicle, could not pierce veil of his own company.

(b) No claim for reflective loss

The Court held that the Claimant’s losses were irrecoverable since they were clearly reflective of WHL’s losses.

The Court reaffirmed the principle that a shareholder of a company cannot sue to recover reflective loss, i.e. loss suffered by the company, which the company could claim for in its own right. Following Gardner v Parker [2004] EWCA Civ 781, the irrecoverable reflective loss is not confined to the individual claimant’s loss of dividends on shares or diminution in value of his shareholding. It further extends to all other payments which the shareholder might have obtained from the company if it had not been deprived of its funds.

The Claimant argued that it had not been established that WHL itself could make its own claim against Barclays. The difficulty which that argument faced was the fact that WHL had reached a settlement with the Bank as part of its voluntary redress procedure. That redress was paid in the sum of nearly £2.4 million and it was “perfectly clear” that the basis of the compensation being made was in respect of any advice that WHL might have had in relation to the sale of the IRHPs. To allow the Claimant to bring this claim would be to permit double recovery.

Comment

This decision ought to give comfort to financial and other institutions that operate redress schemes. The Court has sought to place sensible limits on how section 138D FSMA can be used by claimants. The established principle of reflective loss should also discourage shareholders from making similar claims.

Damien Byrne Hill
Damien Byrne Hill
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Michael Tan
Michael Tan
Associate
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Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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Worthing v Lloyds: High Court finds no continuing contractual duty to correct investment advice

The recent decision of the High Court in Worthing and Another v Lloyds Bank plc [2015] EWHC 2836 (QB) provides helpful clarification for financial institutions as to their duties when providing regulated investment advice under the Financial Services and Markets Act 2000 (“FSMA“) and conducting subsequent reviews of that advice.

In this case, the Court held that the original investment advice given by Lloyds Bank plc (the “Bank“) was reasonable. However, even if the advice had been wrong, there was no continuing contractual duty for the Bank to correct it. Accordingly, the Claimants were not able to avoid the limitation bar to a claim based on the original advice (given in 2007) by casting the alleged omission of a later correction as a continuing breach of duty. On the facts, the Bank was required to conduct periodic reviews in accordance with its terms and conditions. In performing this obligation the Bank duly discharged its duties.

The following further key points in this case will be of interest to financial institutions:

  1. There is a “clear advantage” in financial institutions using standardised documentation when explaining to customers the nature of products and the associated risks.
  2. The Court rejected a complaint that risk-assessment used in this case ought to have involved more specific and concrete questions involving potential percentage falls in an investment portfolio.
  3. There is no requirement under the COBS Rules for financial institutions to carry out a fresh risk/objectives analysis at every periodic review (and it would seem there is no such duty at common law, given that discharge of the duty to exercise reasonable care and skill when providing regulated investment advice requires compliance with the applicable COBS Rules, and no additional common law duty was found by the Court in this case).
  4. The Court’s strong reliance on the contemporaneous file notes of the Bank when giving the investment advice highlights the importance of keeping thorough and accurate notes when giving such advice to customers.

Factual Background

The Claimants, being a husband and wife of high net worth, sought to recover compensation for investment losses. They claimed that the Bank, in advising them to invest in a medium-risk investment portfolio, acted negligently, in breach of contract and in breach of its statutory duties under FSMA and the Conduct of Business Rules, subsequently replaced by the Conduct of Business Sourcebook Rules (“COB” and “COBS” respectively). In essence, they claimed they only ever wanted a low-risk investment and were not properly advised as to the medium-risk nature of the portfolio.

The investment advice followed several meetings during which the Claimants discussed their expectations and objectives and filled out a number of standardised documents designed to assess their appetite, and capacity, for risk. The Claimants also signed various documents which explained the risk nature of the investment portfolio.

The Bank conducted a review meeting with the Claimants approximately one year later. At around this time the Claimants were experiencing financial pressure from an unpaid overdraft account. At the review meeting the Bank set out a number of options to assist the Claimants with the overdraft, but ultimately recommended retaining the portfolio. Later that year, the Claimants decided to sell the portfolio suffering losses of around £43,000.

At a pre-trial hearing, the Claimants had conceded that their causes of action relating to the original advice were statute-barred (the original investment being made in 2007), with the result that they relied upon claims in respect of the Bank (i) failing to correct the original advice; and (ii) providing further incorrect advice at a review meeting.

Decision

The Court dismissed the claim.

Original advice

Although the claims arising from the original advice were statute-barred, the Court considered the reasonableness of that advice in deciding whether there was any duty to correct it. At all relevant times until the making of the initial investment, the giving of investment advice was subject to the COB Rules. The Court found that the Bank had complied with its duties under contract and the COB Rules, as well as its common law duty to exercise reasonable care and skill. The Court accepted the use of the standardised documentation for the purpose of explaining to its customers the nature of its products and the risks attendant on them. That entitlement is now expressly recognised by COBS 2.2.1 R. Interestingly, the Court rejected the claimants’ submission that risk-assessment ought to have involved more specific and concrete questions, such as: “Are you comfortable if the value of the investment falls by 10%? What about 20%? Or 30%?

Continuing duty

The Claimants’ primary submission was that, having given incorrect investment advice in January 2007, the Bank was at all times thereafter under an absolute contractual obligation to correct that advice by recommending that the Claimants either reinvest in a portfolio with low-risk profile or disinvest. This had the same effect as saying that each moment after the giving of the incorrect investment advice was a new breach by way of a failure to rectify the earlier breach. At trial, the Claimants relied upon the terms and conditions to create those continuing contractual obligations, which are set out at paragraphs 32-34 of the judgment. For example:

3. The Service

        ii. We are responsible on a continuing basis for managing the securities in your portfolio, in accordance with the              investment objective and risk category that you have chosen for your portfolio.

       iii. We will contact you from time to time to check whether there have been any changes in your circumstances and         requirements that could affect the way in which we act on your behalf. You should inform us then or at any time if           there are or have been any material changes that may affect your investment objective or attitude to risk for your             portfolio, so that we can discuss with you how best to meet your future needs and objectives.

The Claimants’ amended Particulars of Claim also relied upon an implied obligation under section 13 of the Supply of Goods and Services Act 1982 to exercise reasonable care and skill in and about giving investment advice. However, the argument based on continuing breach of contract required the Claimants to identify the particular contractual obligation that remained unperformed, i.e. the underlying contractual obligation to which the duty of care in section 13 applied. The Claimants failed to do so, and it appears from the judgment that this argument was not relied upon at trial.

The Court held that:

  • The Bank was not under a continuing contractual duty with regard to the original advice; the Claimants were not able to avoid the limitation bar to a claim based on the original advice by casting the omission of a later correction as a continuing breach of duty.
  • The relevant duty (to provide advice in accordance with contractual, statutory and common law duties) arose only at the point of the original advice. It was not the Claimants’ case that the Bank failed to give investment advice at all (which could theoretically give rise to a continuing duty if not satisfied), but that the advice given was incorrect.
  • Once the advice was given, correct or otherwise, the duty to provide advice was satisfied. The Court did not think that the case of Midland Bank Trust Co. Ltd v Hett, Stubbs & Kemp [1979] 1 Ch. 384 provided any support to the Claimants’ argument and nothing in Maharaj and another v Johnson and others [2015] UKPC 28 cast any doubt upon the Court’s analysis (see our blog post on Maharaj here).

The review

The Bank satisfied its duty to conduct the review with reasonable care and skill and in accordance with the COBS Rules (which had replaced the COB Rules by the time of the review). It was not in breach of a strict obligation to correct an error in its original investment advice, because of the conclusions reached above. There was no contractual obligation to carry out a fresh risk assessment at the review, nor was there a statutory duty under the COBS Rules. The contention that the Bank nevertheless failed to advise the Claimants that the portfolio was no longer suitable failed because the claimants’ attitude to risk had not changed. The recommendation provided was suitable in the circumstances (given the Claimants’ main concern was the overdraft not the portfolio), and the future investment objectives of the claimants at that time could not properly be assessed.

Comment

This case provides welcome comfort to financial institutions that, where there is an advisory relationship with a customer, the Court will be slow to find that a bank is under a legal duty to update the original advice on a continual basis.

It is worth just briefly considering whether the position might be different after the recast Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR) come into application.

Although regulatory expectations of suitability assessments under MiFID II are arguably more granular, requiring valid and reliable assessment of the client’s knowledge and experience and risk, and recommendations to be suitable in the context of the client’s risk tolerance and ability to bear loss, it seems unlikely that the court would have come to a different conclusion regarding the suitability of the investment in this case.

Under MiFID II, firms providing portfolio management (such as the Bank in this case) will be required to provide periodic suitability assessments, and firms giving investment advice to disclose whether or not they will provide such assessments. Where these assessments are provided, firms will be required to issue a periodic report containing an updated statement of how the investment meets the client’s preferences, objectives and other characteristics of the retail client. However, ESMA’s Technical Advice to the European Commission on MiFID II and MiFIR suggests that periodic suitability reports would only need to cover any changes in the instruments and/or the circumstances of the client. ESMA accepts (p.106 of its final report) that this falls some way short of an obligation to provide on-going monitoring of suitability. Assuming that the Commission acts on ESMA’s advice, it therefore seems unlikely that the outcome of this case would be substantially different under MiFID II.

Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Angus Tummel
Angus Tummel
Associate
+44 20 7466 2457
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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FCA past business reviews: what duties, if any, do financial institutions owe directly to customers? High Court finds no contractual obligations, but tortious duties are arguable

The recent and somewhat surprising decision of the High Court in Suremime Limited v Barclays Bank plc [2015] EWHC 2277 (QB) is important to any financial institution that has agreed to conduct an FCA past business review or redress exercise.

In particular, the court has held that it is arguable that such institutions owe duties of care in tort, such that customers would have private law rights of action against the institution if the terms agreed with the FCA are not followed. However, the existence of such rights has not been finally determined by the court because the questions arose in the context of an interim application to amend Particulars of Claim. Below is a summary of this decision, together with practical implications for financial institutions.

Factual Background

In June 2012, Barclays (the “Bank“) agreed with the then FSA to carry out a review (the “FCA Review“) of its sales of interest rate hedging products since 1 December 2001 to customers who did not meet the ‘Sophisticated Customer Criteria’, and to offer redress as appropriate. In January 2013, following a pilot exercise, the Bank agreed amendments to the specifications of this FCA Review. The two agreements between the Bank and the FSA/FCA are referred to in this bulletin as the “FCA Agreements“.

In accordance with the FCA Agreements, the Bank categorised Suremime as a non-sophisticated customer and invited the company to participate in the FCA Review. Suremime agreed to participate, but did not accept the outcome.

Instead, Suremime pursued civil proceedings against the Bank claiming damages on the basis that the offered redress was inadequate, or alternatively damages for negligent misrepresentation, breach of contract and/or negligent advice, and/or negligent provision of information. In the further alternative, Suremime claimed that by virtue of section 1 of the Contracts (Rights of Third Parties) Act 1999, it had a right to enforce the terms of the FCA Agreements. Suremime later abandoned this last claim when the Bank disclosed a copy of the FCA Agreements, which contained a clause expressly excluding third party rights arising under the terms of the 1999 Act.

Application to amend the Particulars of Claim

Suremime sought permission to amend its Particulars of Claim to introduce new claims, on the basis that as a result of the FCA Agreements:

  1. A contract was created between the Bank and Suremime to conduct the FCA Review in accordance with those terms when Suremime accepted the Bank’s invitation to engage in the FCA Review and incurred expense in so doing;
  2. The Bank owed Suremime an equivalent duty in tort; and
  3. The Bank owed Suremime an equivalent duty in accordance with the principles in White v Jones [1995] 2 AC 207 (the leading case on ‘disappointed beneficiaries’) because the FCA would suffer no loss if the Bank breached the FCA Agreements, but Suremime (as an intended beneficiary of the FCA Review) would have suffered a loss.

The Bank objected to these new claims, arguing that they stood “no real prospect of success“, as per CPR 24.2 (the test which applies on an application for permission to amend).

Decision

Following arguments from both parties, the High Court refused permission for the first claim and granted permission to amend for the remaining two.

Contractual claim: The first claim was refused on the ground that it had no real prospect of success because it faced an “insuperable hurdle” of lack of consideration. The court reached this conclusion because the Bank made it clear that it was going to include the claimant’s swap in the process of the FCA Review, whether or not the claimant engaged with the fact finding exercise. There was no conditionality, meaning that Suremime’s expenses for responding did not amount to consideration.

Tortious claim: Suremime was granted permission to amend its particulars to pursue the second claim because the court decided that it was arguable that the Bank’s entry into the FCA Agreements and conduct of the FCA Review satisfied the relevant tests of: proximity of relationship; foreseeability of harm; absence of a public policy reason for not recognising such a duty; and assumption of responsibility to Suremime to conduct the FCA Review on those terms.

The court held that there was no bar necessarily imposed to the existence of a private law duty by the fact that Suremime could sue the Bank in relation to the original sale, or that such duties would provide customers who were otherwise time-barred with actionable rights.

White v Jones claim: Suremime was granted permission to pursue the third claim because the court was not persuaded that the principles in White v Jones had no potential application. The court focussed on the fact that any loss for failure to implement an FCA Review properly would lie with the customer who was, broadly speaking, the intended beneficiary of the FCA Review.

Comment

Although this was just an application to amend (so the court held that these points were merely arguable), it is of note that the court was prepared to find that a customer may have private law rights of action to enforce the terms of an FCA Review. The court additionally expressed the view that it was “arguably right” that a customer who is a “private person” already has a right of action under section 138D of FSMA to enforce the terms of an FCA Review.

If at trial such causes of action are determined to exist, it may mean that customers who are time-barred from commencing proceedings in relation to the sale of their original investment and are unsatisfied with their review outcome will be able to sue the relevant financial institution for damages because of alleged breaches of the review by that institution. This effectively provides them with a back-door route to bring a mis-selling claim out of time. It is submitted that this would be an undesirable and inappropriate outcome.

The practical implications of such causes of action highlight the importance of:

  1. Considering and negotiating carefully the terms of any undertaking agreed with the FCA;
  2. Record-keeping and processes throughout such a review to demonstrate that the specifications agreed with the FCA have been adhered to in respect of each customer; and
  3. Drafting settlement agreements that provide (to the extent possible) for full and final settlement of all claims.

It is of note that this decision confirmed that the defendant bank did not have any contractual obligation to the claimant owing to its participation in the review, which may be some positive news from the perspective of financial institutions.

Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
John Corrie
John Corrie
Senior Associate
+44 20 7466 2763
Celina McGregor
Celina McGregor
Senior Associate
+44 20 7466 7460
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

Appeal relating to alleged mis-selling of interest rate swaps dismissed: Green and Rowley v RBS

Green & Rowley v Royal Bank of Scotland plc [2013] EWCA Civ 1197

The Court of Appeal has handed down its decision in the first interest rate swap mis-selling case to come before the English courts since June 2012 when the FSA (now the FCA) announced a review into the sales of interest rate hedging products.

In a ruling that will be welcomed by financial institutions, the Court of Appeal has rejected the proposition that, in non-advised transactions, a bank’s common law duty not to mis-state is informed by the relevant COB rules.  The decision effectively rejected an attempt to widen the category of individuals who can bring a claim for breach of the COB/COBS rules.

Factual background

Green & Rowleyalleged that in May 2005 RBS mis-sold to them an interest rate swap as a form of hedge against their existing loan liabilities to RBS. On 19 May 2005, Green & Rowley met with two RBS employees and during this meeting information was provided about the swap and other interest rate protection products.  On 25 May 2005, the parties entered into the swap.  At that time, Green & Rowley had a pre-existing loan liability to RBS of £1.5 million repayable in 15 years on an interest only basis at 1.5% above base rate.  The swap was for £1.5 million and for a term of 10 years.  The base rate remained comparitively flat until about June 2006 when it started to rise significantly.  Between October 2008 and March 2009, the base rate dropped steadily from 5% down to 0.5% and accordingly Green & Rowley became net payers under the swap in significant amounts.

First instance decision

At first instance, Green & Rowley had alleged a broad range of deficiencies in RBS’ conduct and had alleged that RBS:

(i) was liable for negligent mis-statement in respect of information provided to them (the “Information Claim”); and

(ii) gave negligent advice about the swap (the “Advice Claim”).

Originally there were claims for breach of statutory duty but it was conceded that they were time-barred.  Nevertheless, the customers argued that the bank’s common law duty of care not to mis-state included the contents of COB rules 2.1.3 (communications to be fair, clear and not misleading) and 5.4.3 (risk warnings) and that these had been breached.  In particular, they alleged that they had not been properly informed by RBS of the potential break costs associated with the trade both prior to and at the meeting on 19 May 2005.

In December 2012, the High Court in Green & Rowley v The Royal Bank of Scotland plc [2012] EWHC 3661 found for RBS.  The key findings of HHJ Waksman QC, sitting as a Deputy Judge in the High Court, were as follows:

The Information Claim

  • The duty to take care not to mis-state is narrower than the advisory duty where one would expect that relevant professional standards (in particular COB rules 2.1.3 and 5.4.3) would form part of the assessment as to whether it has been broken.
  • Had COB rules 2.1.3 and/or 5.4.3 been relevant to the duty not to mis-state, the Judge held that he would still have found no breach.  This was based on, in part, his findings as follows:
    • The fact that there could be a break cost was stated and illustrations were offered in a brochure found to have been given to the customers.  The Judge held that the explanation was not misleading, unclear or unfair;
    • The risk in respect of break costs was an ‘ancillary matter’ – the ‘essential risk’ (which the customers understood) was the risk they could end up worse off if interest rates fell.   As to break costs, ‘..it was right to say something … but what was said was sufficient’;
    • It was open to the customers to have asked for detail of the costs at or after the key meeting but they did not do so;
    • The fact that a subsequent brochure in 2009 made a reference to a potential ‘substantial’ break cost did not mean that what was said in 2005 was inadequate.    ‘..(T)he drop in interest rates which followed 2008 and has remained was extremely unusual’ ; and
    • As at 2005, the risk of a drop in interest rates to the extent that occurred (and the consequent increase in break costs to the levels seen)  was ‘very much a theoretical risk and not one which needed to be positively stated’, especially bearing in mind the customers’ intentions to keep the loans for at least 10 years.
  • The Judge also observed that it was not clear that causation would have been established (although stopped short of a finding to that effect):

 ..had Green & Rowley been informed simply that the break costs/benefits could be substantial back in May                      2005 it is a matter of complete speculation as to what they would have done – I certainly could not be satisfied                 that they would not have proceeded’.

The Advice Claim

  • It was held that RBS had conducted a non-advised sale and therefore did not owe an advisory duty of care to the customers.

Green & Rowley subsequently appealed, and the appeal was heard by the Court of Appeal on 29 July 2013.  The FCA was granted permission to intervene to make submissions in the appeal.

Court of Appeal decision

The arguments made by Green & Rowley on appeal can be summarised as follows:

  • Issue 1 – a duty of care at common law not to mis-state is co-extensive with a bank’s duty to comply with the relevant COB rules, even in a non-advised situation; and
  • Issue 2 – if relevant, the High Court’s factual findings as to the adequacy of the warnings around break costs were incorrect.

Green & Rowley did not appeal the High Court’s factual findings that no recommendation or advice was given at the meeting of 19 May 2005 or that RBS did not assume an advisory duty of care.

The Court of Appeal dismissed the appeal. Lord Justice Tomlinson considered that arguments relating to Issue 1 were misconceived and that they amounted to saying that the mere existence of the COB rules gives rise to a co-extensive duty of care at common law.  This begged the question “why”?  He noted that Parliament has provided a remedy for private persons for a breach of statutory duty under section 150 (now s.138D) of the Financial Services and Markets Act 2000 (“FSMA 2000”) and that there was nothing which justified “the independent imposition of a duty of care at common law to advise as to the nature of the risks inherent in the regulated transaction“.

Having rejected Issue 1, the Court of Appeal held that it did not need to consider Issue 2 and declined to make any obiter comments regarding the scope of the bank’s duties in relation to the disclosure of break costs. The FCA had been given leave to intervene in the appeal in order to make submissions in this regard but the parties, including the FCA, agreed that it would be inappropriate for the Court to express any views on this point and therefore no such submissions were made.

Those who qualify as ‘private persons’ will, as before, be able to bring claims for breach of the COB/COBS rules under s.138D FSMA 2000 (formerly s.150) so long as they are not time-barred.  In this regard it is worth noting that the customers’ breach of statutory duty claim was dropped before the first instance hearing on the basis that it was time-barred.  Counsel for the appellants admitted at the Court of Appeal hearing that this concession “was “likely” to be wrong2 because any breach of duty associated with the arrangement and execution of the transaction would continue until the execution of the transaction itself“.  The Court of Appeal was not asked to express a view as to when the limitation period began to run.

Commentary

Whilst this case is highly fact specific3, the Court of Appeal’s decision is welcome news for banks as it closes down an attempt effectively to circumvent the proper scope of the statutory cause of action contained in s.150/138D FSMA 2000 and broaden the category of individuals which can bring claims for breach of the COB/COBS rules.  The Court was very clear that to import a common law duty of care which involved taking reasonable care to ensure that Green & Rowley understood the nature of the risks involved in entering into the swap transaction would be to “drive a coach and horses through the intention of Parliament to confer a private law cause of action upon a limited class“.

The Court of Appeal’s decision is also likely to be welcomed by banks for the fact that it leaves undisturbed the approach adopted by the High Court regarding: (i) the existence of a non-advisory relationship; and (ii) the adequacy of the disclosure regarding break costs.  As noted above, in relation to (ii), at first instance the Judge held that “Had (the) COB rules…been relevant to the duty not to mis-state (contrary to my conclusion) I would still have found no breach” (emphasis added).

The decision also does not alter the High Court’s finding that the COB rules will only inform the relevant common law duties to the extent that a transaction is conducted on an advisory basis as opposed to an execution only basis.  At first instance, the Judge commented that in respect of an advisory duty “one would expect that relevant professional standards (in particular COB Rules 2.1.3 and 5.4.3) would form part of the assessment as to whether it [i.e. the advisory duty] has been broken.”  The Court of Appeal noted that this approach has been endorsed on at least four occasions by first instance judges.  For example, it was held in Loosemore v Financial Concepts [2001] Lloyds PNLR 235 that the skill and care to be expected of a financial advisor would ordinarily include compliance with the rules of the relevant regulator.

1. Mr Rowley was a hotelier and property developer and Mr Green was a residential lettings agent at the relevant times.

2.  The Claim Form was issued on 25 May 2011, more than six years after the meeting on 19 May 2005 but exactly six years after the execution of the swap.

3.  At first instance, the High Court found that Green & Rowley were “intelligent and experienced businessmen“.  RBS were also able to rely on their contractual documentation which contained helpful provisions confirming that no advice was being given.

Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Hannah Cassidy
Hannah Cassidy
Senior Associate
+44 20 7466 2300

Individual fails in large mis-selling claim concerning leveraged investments in structured notes

Basma Al Sulaiman v  (i) Credit Suisse Securities (Europe) Limited; and (ii) Plurimi Capital LLP [2013] EWHC 400 (Comm)

In a strongly worded judgment, the Commercial Court has dismissed a large misselling claim brought by an individual in connection with a number of investments she had made in structured notes on a leveraged basis.  The claim arose out of losses suffered following a margin call in October 2008 which was not met and which resulted in the forced sale of the structured notes. The claim, which sought damages of over USD30m, was brought against the private banking division of Credit Suisse in the UK and Plurimi Capital (an independent financial adviser, also based in the UK).  The Court found that the claim failed on every issue and that the Claimant had been dishonest in the way she had pursued the claim.  While there was sufficient documentary evidence to determine the case, the Court was also not satisfied that the Claimant had complied fully with her disclosure obligations.  The case is fact specific and, for this very reason, highlights the importance of defendants not accepting at face value the professed lack of investment inexperience and limited financial position sometimes put forward by claimants in support of such claims.

Key points

  • It will often be important for defendants to probe and to establish the true investment experience and financial position of claimants in such claims.
  • The FSA code of business rules (COB and COBS) are concerned with substance and not form. If an investment is in fact suitable for the client, then it does not ultimately matter if there have been failings in the process. Failings in internal processes are not the same as failings in regulatory processes.
  • In the circumstances of this case, explanations of the risks associated with investments did not need to be provided orally. The customer was literate and educated and therefore the bank was entitled to assume that she would read written risk warnings if expressed in straightforward terms.
  • A written risk warning which did not specify the consequences of not providing additional collateral was not inadequate. The possibility of the margin call was clear if the customer had given it a “moment’s thought”.
  • Where an investment was made on a leveraged basis, there was no regulatory requirement on an adviser to seek to estimate or advise the customer on the probability or likely size of any margin call, nor was there any obligation on the adviser to satisfy himself that a customer had sufficient assets to meet a margin call.

The facts

The Claimant, Mrs Basma Al Sulaiman, was a Middle Eastern individual who, in 2002, received a very substantial financial settlement as part of her divorce from one of Saudi Arabia’s wealthiest men. In 2003, the Claimant decided to make investments with her new found independent wealth. At this time the Claimant had no experience of investment or financial affairs. In late 2004, the Claimant became a customer of the private banking division of Credit Suisse (“CS“), which agreed to provide her with investment recommendations on an advisory basis. The Claimant wanted to make investments which would provide her with a regular income to cover her lifestyle expenses. The adviser recommended investments in structured notes linked to equity indices and interest rates. These notes provided the investor with a periodic income provided that the underlying index did not drop below a certain level from the “strike” price at the date of purchase.

The adviser understood from discussions with the Claimant that she sought a “double digit” return from her investments. She was advised that returns on investments could be enhanced by investing using borrowed funds which would be made available to her from CS’s parent, Credit Suisse AG (“CSAG“). The Claimant accepted this advice and, in the period between 2005 and 2007, she purchased 18 notes on a leveraged basis. The levels of leverage varied from 60% to 70% of the total nominal sum invested. The lending was secured (by way of a Pledge) against the notes themselves. The notes were exposed to market risk and could fluctuate in value. It was a condition of lending that the borrower was required to keep the loan to value ratio (“LTV ratio“) of the portfolio at a level that was satisfactory to the lender.

In December 2007, the adviser left CS and founded his own investment advisory firm, Plurimi. The Claimant transferred her portfolio of six notes from CS to Plurimi after which she invested in a further five structured notes. In October 2008, the value of the notes dropped significantly in the wake of the collapse of Lehman Brothers and two Icelandic Banks. The Claimant was required, at short notice, to provide additional collateral to support her account, known as a “margin call”. The Claimant failed to meet this margin call and CSAG forced a sale of her portfolio at a total loss of approximately USD31 million. The proceeds of sale were insufficient to repay the loans in full. Consequently, the Claimant lost all of her own capital investment and became indebted to the lender.

Claim under section 150 of the Financial Services and Markets Act 2000

As a “private person”, the Claimant brought a claim for losses caused by alleged breaches of the customer information gathering, explanations of risk and suitability requirements of various FSA conduct of business rules. These rules were contained in the Conduct of Business handbook (COB) for the period up to 31 October 2007 and thereafter in the Conduct of Business Sourcebook (COBS) (so that the latter alone applied to the period of the Claimant’s relationship with Plurimi). In particular, the Claimant alleged breach of COB 5.4.3, COB 5.3.5, COBS 9.2.1 and COBS 9.2.2.

Although a duty of care was pleaded in contract and tort, it was common ground that it added little or nothing to the claim for breach of statutory duty, since the alleged contractual and tortious duties (e.g. the duty to explain the risks associated with such investments) were the same as the regulatory requirements.

The scope and alleged breach of duty to explain the risk of a margin call

The nature of the Claimant’s case developed significantly throughout the proceedings and also during trial. These developments were prompted by the late disclosure of documents held by third party institutions regarding the Claimant’s other financial investments. The Defendants had been pressing for this disclosure for some time.

At trial, the Court found that a number of allegations made by the Claimant in her original particulars of claim were found to be unsustainable, false or dishonest. In particular, the Claimant was found to have misrepresented (i) her wealth and hence her ability to meet a margin call; (ii) her risk appetite and investment objectives; and (iii) her experience of leveraged investments through other financial institutions. The Claimant’s revised (and more limited) case at trial was that her loss was caused by breaches of duty on the part of CS and Plurimi to take reasonable steps to ensure that she understood the risks associated with making investments on a leveraged basis, including in particular the risk of margin calls. It was alleged that that failure to explain meant that the Defendants had failed to take reasonable steps to provide suitable investment advice. In particular, it was alleged that CS and Plurimi failed to explain to the Claimant that:

  • Notes that she purchased with money lent by CSAG would be pledged to CSAG as collateral for the loans;
  • CSAG was entitled to call upon her to provide additional collateral, in the event that the value of the Notes dropped; and
  • If she did not provide such additional collateral within the timescale stipulated by CSAG, her Notes could be sold, whereupon she could lose all or most of her capital.

It was further alleged that, had these explanations been given, then the Claimant would not have invested in the leveraged structured notes and would have invested in something different.

During the course of her relationship with the Defendants, the Claimant had been given numerous written warnings regarding these risks. However, it was the Claimant’s evidence that she had very limited investment experience and was not financially literate. Therefore, she did not read these written warnings but relied upon her adviser to inform her orally of all the risks which she needed to be aware of. Even where the Claimant had signed documents which referred to the risks of leveraged investments, her position was that she was in the habit of signing these documents blind and that generally she did not read standard banking documents (whether provided by the Defendants, CSAG or other banks with whom she dealt). She claimed that, as a result, all references to collateral, margin, margin call and the consequences of non-compliance with the latter, had passed her by. She further testified that she did not read various emails from the adviser which warned her of potential capital losses, nor understood emails which advised her of the risk of leverage on other investments on which she sought his view. The Claimant testified that she did not understand the meaning of the words “pledge”, “margin” or “margin call”, if she was aware of them at all, as the subject was never mentioned in conversations with her adviser. As regards her requirement to have matters explained to her orally, the Claimant’s position was that she would not have understood anything complex which was put in writing. However, she admitted that she had never told him (or any adviser, banker, trustee or trust manager) that she required all explanations to be oral, rather than in writing.

The Claimant adduced the evidence of a financial expert in support of her case. However, during cross examination, the expert (who had adopted unchanged the expert report of another who had died) stated that, in his opinion:

  • The Claimant demonstrated an aggressive approach to investment.
  • Structured notes were safe investments and, generally, in normal market conditions, the value of structured notes remained relatively stable.
  • It was a benign market in 2006 and 2007 and the risk of a margin call between March 2003 and July 2007 was not one which an adviser would have concerned himself about.
  • The existence of the “buffers” or “cushions” between the maximum LTV ratio permitted by CSAG and the actual LTV recommended by the Defendants reduced the likelihood of the margin call.
  • The extreme events of October 2008 were unforeseeable until the brink of their occurrence.

It was also agreed between the parties’ respective experts that there was no regulatory requirement on an adviser to seek to estimate or advise the customer on the probability or likely size of any margin call, nor any obligation to satisfy himself that a customer had sufficient assets to meet a margin call (which was recognised to be a practical impossibility for an adviser to do). The Claimant’s expert’s suggestion that it was “good practice” for the adviser to advise the customer of the minimum margin call was rejected by the court.

As regards the evidence of the Claimant herself, the Court found that her evidence regarding her understanding of leverage and the risk of margin calls was not only inaccurate and unreliable, but dishonest. The Court found that, however unsophisticated the Claimant may have been at the outset of her relationship with CS, she was an intelligent person who had no difficulty grasping financial concepts and that it was inconceivable that she had not discussed and understood the risks associated with leveraged investment.

The Court further found that there was no breach of statutory duty. The Defendants had provided adequate oral and written explanations of the risks associated with leverage, including the risks of a margin call (notwithstanding the fact that the term “margin call” may not have been used) and that the Defendants had taken reasonable steps to ensure that the Claimant understood them. The “Effect of Leverage” document made no specific reference to the consequences of not meeting a margin call but, given the nature of other warnings contained within this document, this possibility would have been apparent to a reader who gave it a “moment’s thought”. As to the oral explanations, the Court held that, in the context of the benign market conditions at the time that the investments were sold, together with the various steps taken by the adviser to mitigate against the risk of a margin call, the risk of a margin call and the consequences of not meeting one were remote and that there was no reason not to have explained them especially as there was no concern about the Claimant’s ability to meet a margin call.

Reliance and causation

The Claimant was found to be a strong minded individual who was prepared to press ahead with investments against the advice of the Defendants and her other advisers. This was not itself enough to show that there was no reliance. However, by the time the Claimant invested in the first disputed note in April 2006, the Court was satisfied that the Claimant fully understood the risks of leverage and margin calls. Even if no explanations of the risks of a margin call had been given and she had subsequently discovered this risk at some later date, she would not have been put off from investing in the Notes right up to October 2008.

As to causation, the adviser had recommended to the Claimant that she should meet the margin call and the Court accepted that she had sufficient assets to do so. However, it was plain that a decision had been made by the Claimant not to meet the margin call. This was probably done in the hope that CSAG would not insist on the additional collateral. This decision was considered by the Court to be so irrational as to be almost incomprehensible. This irrational decision broke the chain of causation and any failure to explain the risks of margin calls did not cause the Claimant’s losses.

Comment

This judgment follows the Court of Appeal’s decision in Zaki v Credit Suisse (UK) Ltd [2013] EWCA Civ 14 where it was also found that the rules are concerned with substance and not form. If an investment is in fact suitable for the client, then it does not ultimately matter if there have been failings in the process. In this case, there were no breaches of the regulatory requirements.

The case further emphasises the fact that the regulatory requirements are qualified by the requirement to take “reasonable steps”. What constitutes “reasonable steps” will vary from customer to customer depending on their circumstances. The requirement to provide explanations of risk can be satisfied by both written and oral explanations. In the absence of a clear direction to the contrary, an adviser is entitled to assume that a literate and educated investor will read written warnings if expressed in straightforward terms.

The case also highlights the importance of defendants probing and establishing the true investment experience and financial position of claimants to such claims. There seems little doubt that the outcome of this case was significantly influenced by the Court’s findings of dishonesty against the Claimant.

Rupert Lewis (Partner) and Ralph Sellar (associate) advised Credit Suisse Securities (Europe) Limited.

Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Ralph Sellar
Ralph Sellar
Associate
+44 20 7466 2805

Interest rate hedging product claims – the current landscape

1.  The FSA review

In 2012, the Financial Services Authority (FSA) announced the findings of its review into interest rate hedging products (IRHPs) sold to small and medium sized firms and in June and July 2012, the FSA agreed with eleven banks that they would conduct a proactive redress exercise and past business review in relation to their sales of IRHPs on or after 1 December 2001.

Specifically, the FSA has agreed with the banks that, for sales to customers categorised under the FSA’s rules as either ‘private customers’ (in respect of sales before 31 October 2007) or ‘retail clients’ (in respect of sales from 1 November 2007), the banks will:

  • Provide appropriate redress to non-sophisticated customers sold structured collars;
  • Review sales of other IRHPs (except caps and structured collars) to non-sophisticated customers and provide redress where appropriate; and
  • Review the sale of caps to non-sophisticated customers in cases where a complaint is made by the customer and provide redress where appropriate.

In each case, a customer will be regarded as ‘non-sophisticated’ if it does not meet the FSA’s ‘sophistication test’ and any redress provided is to be by reference to what is fair and reasonable in all the circumstances. The exercise for each bank will be scrutinised by an independent reviewer and overseen by the FSA.

Each bank was asked to undertake a pilot review of a small sample of more complex cases before beginning the full review.  On 31 January 2013, the FSA published a report on its findings from its review of the pilot exercise conducted by Barclays, HSBC, Lloyds and RBS and confirmed that those banks would commence their full reviews in accordance with the approach set out in that report. The FSA has said that it expects those banks to aim to complete their full reviews within 6 months, although the FSA accepts that for banks with larger review populations this may take up to 12 months.

On 14 February 2013, the FSA also confirmed that the remaining banks (apart from the Irish Bank Resolution Corporation, which went into special liquidation on 7 February 2013)  had also agreed to proceed with their full reviews in line with the same approach set out in the  FSA’s 31 January 2013 report.

2.  FOS decisions

Although the FSA initially considered the establishment of a scheme effectively extending the FOS’s jurisdiction to deal with IRHP complaints, it has recently been confirmed that this will not be put in place.  However, customers meeting the existing FOS eligibility criteria will remain able to refer their complaint to the FOS if they are not satisfied with the redress offered within the review process.

It appears that a number of customers have already complained to the FOS. Indeed, during 2012 two provisional FOS decisions involving the sale of IRHPs were issued –  W Family v Bank E and Business H v Bank S.  The relevant parties in each case were requested to submit further representations before the FOS finalises its determinations. We set out further detail below.

The W Family v Bank E

In July 2007, the W Family took out a variable rate 14 year loan in order to expand their business. At the same time, the family took out a multi-callable swap for a period of 15 years, with an initial two year discounted rate. After two years, a higher fixed rate was payable for the remaining period of the swap. The interest rate payments under the swap were tied to LIBOR, as opposed to Bank E’s base rate, on which the loan was based (i.e. there was an element of mismatch).

The Ombudsman found that:

  • although the documentation was “unclear and contradictory about whether or not advice was given“, the actions of  the bank did in all the circumstances amount to professional investment advice in respect of the swap;
  • the bank recommended a swap that was not suitable to the W Family. The Ombudsman described the swap as being “a one-sided deal”, which allowed the bank to terminate the swap after two years if rates rose at any time, thereby leaving the customer unhedged against rising rates (although he did not directly consider the impact of including the call feature on the discounted rate offered on the transaction). The swap also did not amortise, even though it was expected that the W Family would start making capital repayments against the loan after the first two years, and the swap also lasted a year longer than the loan itself;
  • the bank also failed to explain the potentially onerous cancellation costs associated with the swap.

Business H v Bank S

Business H took out a variable interest rate loan and also bought a “base rate collar” in connection with the loan. (The bank later said that the hedging was a condition of the loan and the lending would not have been granted unless a hedging transaction arrangement had been agreed). The collar was set to cover a sum of £356,000, had a 20 year term and was set to amortise.

The Ombudsman found that:

  • the bank’s actions in connection with the swap amounted to investment advice;
  • the notion of a collar was not inherently unsuitable for Business H in its circumstances, given its desire to minimise the premium for this arrangement. However, a floor of 20 years with the possibility of significant cancellation charges was not suitable overall for the needs of Business H, which was a small operation; and
  • the bank also failed to highlight adequately or to explain the potential cancellation charges.

It is interesting to note that in both cases the Ombudsman did not make any formal findings on redress. Instead, he invited both parties to discuss how best an award could be agreed and, to facilitate those discussions,  set out the principles he would take into account if he were to make a formal award.

3.  Court decisions

Grant Estates Limited v Royal Bank of Scotland2

This is a Scottish case and the first reported judgment on the subject of IRHP mis-selling. In 2007, Grant Estates and RBS entered into a 5 year loan agreement for £775,000 and a swap transaction for the same notional amount. Grant Estates alleged that RBS mis-sold the swap agreement and that, instead of protecting Grant Estates from a rise in interest rates, the swap fixed rates too high and became such a burden on the company that it defaulted on the loan agreement with RBS and fell into administration. The Court rejected the claim on the following grounds:

  • Grant Estates was not a “private person” for the purposes of s.150 of the Financial Services and Markets Act 2000 (“FSMA”) and therefore had no direct remedy under that provision;
  • there was no implied collateral agreement for the bank to advise Grant Estates and consequently no breach of such a contract. This finding was based heavily on the Court’s conclusion that there was a written contract setting out what RBS was to undertake and expressly warning Grant Estates that it should obtain its own independent, legal and tax advice; and
  • the acts of the bank employees were consistent with a contractual regime in which the customer had agreed that it would not treat any views that the bank expressed in bringing about the derivative transaction as advice on which it was entitled to rely.

Green & Rowley v RBS3

In this first reported English IRHP case, the customers alleged that in May 2005, RBS mis-sold to them an interest rate swap as a form of hedge against their existing loan liabilities to the bank. They alleged that:

  • the bank had made various negligent misstatements regarding the operation of the swap, including understating the costs if they chose to break the swap early and inaccurately indicating that the swap transaction fixed not only the base rate but also the margin; and
  • the bank owed them advisory duties in respect of the swap because it had positively recommended the transactions and that those duties had been breached because the swaps were not suitable for them (principally because they allegedly required a transaction that fixed not only the base rate but also the margin).

Originally there were also claims for breach of statutory duty under s.150 of FSMA but it was accepted that those claims were time-barred.  Nevertheless, the customers alleged that at least some of the relevant FSA Conduct of Business Rules (the ‘COB Rules’) informed the scope of the bank’s common law duties for the purposes of both the negligent misstatement and the negligent advice claims.

The claims failed in their entirety, with the Court finding that there was no negligent misstatement and that no advisory duty had arisen (and that, in any event, there had been no breach of any such advisory duty).

This case was highly fact-sensitive and the Court’s findings turned largely on what was said at a meeting between the claimants and employees of the bank at which information regarding the swap and other similar products was provided. However, as in Grant Estates(above), the contractual documents contained helpful provisions clearly confirming that no advice was being given and the judge cited Grant Estates in finding that such provisions can be invoked to negate or delineate the ambit of any duty of care.

The judge also noted, with respect to the relevance of the COB Rules, that the scope of the duty in a common law action for negligent misstatement (as distinct from an advisory duty) is narrower than and does not necessarily encompass the COB Rules to the extent that the COB Rules include (i) duties to take reasonable steps to communicate clearly or fairly (COB 2.1.3) and (ii) duties to take reasonable steps to ensure that a counterparty understands the nature of its risks (COB 5.4.3).

Whilst future decisions could of course take a different approach depending on the specific facts (including particularly the content of a bank’s written terms), these first two IRHP judgments have been welcomed by the financial services industry.

4.  Potential for ‘top up’ of FOS decisions through court action

The manner in which IRHP claims are pursued may also potentially be influenced by a recent  High Court decision holding that a party who had accepted a favourable FOS decision and been paid the statutory maximum award (then £100,000, now £150,000) by the firm could nevertheless subsequently bring a damages claim for the balance of the full loss they had allegedly suffered, over and above the FOS award: Clark & anor v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669.

The decision departs from previous authority on this issue and, unsurprisingly, permission to appeal has been sought.  If the High Court’s decision is upheld, this may have the effect of encouraging potential litigants to seek to fund subsequent court action through a FOS award.  Complainants may also seek to adduce the FOS judgment in support of their court case, particularly given that it is quite common for the FOS to recommend a higher award than its statutory limit (albeit that the test for liability applied by the courts is of course materially different from the test adopted by the FOS).

Read our full briefing on the decision.

5.  LIBOR allegations in IRHP claims

A claim currently pending in the High Court has also raised the possibility of the IRHP claims landscape being overlaid with claims in respect of LIBOR (London interbank offered rate).

The claimants in that action have brought a claim in relation to loans made to them with an associated interest rate swap and interest rate collar agreement, payments under which were set by reference to 3 month Sterling LIBOR.  In a judgment delivered on 29 October 2012, the Court permitted the claimants to amend their pleadings to add claims based on alleged implied representations by the defendant bank (and/or implied contractual terms) as to the integrity of the LIBOR rates. The allegations in this respect rely heavily on regulatory findings against the relevant bank in respect of LIBOR:  Graiseley Properties Limited & ors  v Barclays Bank Plc [2012] EWHC 3093

It is important to note that the Court did not make any considered determination of the LIBOR allegations and was only required to consider whether the points raised reached the threshold of being sufficiently arguable to proceed to trial and be tested. However, this is now an important test case and the trial (listed in October 2013) will be watched closely both by claimants considering bringing similar claims and defendant banks.

 

1 Grant Estates Ltd v The Royal Bank of Scotland Plc [2012] CSOH 133.
2 John Green and Paul Rowley v The Royal Bank of Scotland [2012] EWHC 3661.

Damien Byrne-Hill
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