High Court upholds strike out of claim based on allegation a financial institution breached fiduciary duties as a shadow director of its customer

In a recent decision the High Court has held that a financial institution which is alleged to have been a shadow director of its customer will not be liable for breach of fiduciary duty unless the breach is linked to an instruction or direction given by the institution: Standish & Ors v The Royal Bank of Scotland plc & Anor [2019] EWHC 3116 (Ch).

The decision will be of particular interest to financial institutions involved in turnarounds, restructurings and the exercise of control, management or similar rights arising upon default under facility agreements.

Generally speaking, financial institutions will wish to avoid giving directions or instructions to the directors of a borrower company to minimise the risk of being found to be shadow directors. However, because Standish arose in the context of an interim application for strike out, it was assumed that the financial institution would be shown to constitute a shadow director. The decision therefore considered what duties would be owed by the financial institution in those circumstances – would it owe all of the duties that are owed by de jure directors of the company or instead duties which are specific to the directions or instructions given by the financial institution?  The court held that the latter approach now reflects the settled legal position.

Background

The claimants were current and former shareholders in a company named Bowlplex Ltd (the “Company”), which owned and operated bowling sites across the UK. The Royal Bank of Scotland plc (the “Bank”) provided the Company with banking facilities from 2004.

The Company was referred in June 2010 to the Bank’s Global Restructuring Group (“GRG”), following the Company’s breach of financial covenants. As a result, the Company was introduced to West Register Number 2 Ltd (“West Register”), an indirect wholly owned subsidiary of the Bank, and West Register’s employee, Mr Sondhi. Mr Sondhi indicated to the Company that West Register was interested in acquiring 80% of the equity of the Company in exchange for securing the continued support of the Bank.

The Company was subsequently restructured on two occasions. Under the first restructure, West Register acquired 35% of the Company and the Bank agreed to a restructuring of certain of the Company’s indebtedness. It was a condition of the first restructure that West Register would be permitted to appoint an observer to attend the Company’s board meeting and a non-executive chairman.

West Register subsequently appointed a chairman with a background as a turnaround consultant. The Company then implemented a company voluntary arrangement under which the Bank wrote off £4.5 million of indebtedness and West Register increased its equity holding to 60%. Shortly thereafter, the chairman sacked the Company’s managing director and former majority shareholder.

Ultimately, the Company was sold and West Register was paid £13.6 million in respect of its shares.

First instance decision

The claimants contended that the Bank, West Register and the chairman were parties to a conspiracy to enable the Bank or West Register to acquire the Company’s equity at the expense of the claimants via the use of unlawful means. The claimants argued that they had suffered loss in the amount of approximately £18 million, being the value they would have realised for their shares had they not been transferred to West Register pursuant to the two restructurings.

The claimants had initially relied on broad range of allegedly unlawful means, including breaches of contract based on an implied term of good faith. These were struck out by Chief Master Marsh in July 2018: see our banking litigation blog post.

One of the unlawful means alleged by the claimants was that West Register (or alternatively Mr Sondhi) acted in breach of its fiduciary duties as a shadow director. In particular:

  • Mr Sondhi was said to have been a shadow director because he was a person in accordance with whose directions or instructions the directors of the Company were accustomed to act. He had intervened during board meetings, added items to agendas for board meetings, required the Company to instruct professional advisers of his choosing and appointed a turnaround consultant as chairman.
  • As a shadow director, Mr Sondhi was said to owe the Company the duties which are owed by a de jure director, including to act independently in the best interests of the Company without conflict of interest.
  • The claimants argued that, through Mr Sondhi, West Register was also a shadow director of the Company owing fiduciary duties and that, in any event, the Bank and/or West Register were vicariously liable for any breach of fiduciary duty by Mr Sondhi.
  • As an alleged shadow director, West Register was alleged to have breached its duties by refusing the Company’s reasonable proposals to allow the Company to trade through its difficulties and by promoting the restructurings by which it acquired a majority shareholding in the Company. West Register was also alleged to have made demands on management time which prevented management from pursuing alternative financing, leaving the Company no option but to enter into the restructurings.

Though Chief Master Marsh struck out the claim based on the shadow directorship allegation, the claimants were granted permission to appeal to a judge.

Decision of the High Court (on appeal)

On appeal to the High Court, the shadow directorship allegation was therefore the only unlawful means relied on by the claimants. If the allegation was struck out, the claimants’ conspiracy claim was bound to fail.

Trower J, a company and insolvency specialist in private practice before his recent appointment to the bench, dismissed the appeal.

As the appeal of a strike out application, the court was required to assume that the relevant parts of the claimants’ statements of case would ultimately be proven. It therefore assumed that Mr Sondhi and West Register had given directions or instructions to the board and that, in doing so, they had become shadow directors of the Company because the other directors were accustomed to act in accordance with their directions or instructions.

The main issue on appeal was which of a director’s duties, if any, Mr Sondhi and West Register owed as shadow directors. While the Companies Act 2006 (the “Act”) codified the duties owed by a de jure or de facto director of a company, the application of those duties to shadow directors was left to the common law and equity. The cases before the enactment of the Act had not definitively determined whether a person, once found to be a shadow director, then owes general duties to a company with the same content as the duties owed by a de jure director. The more common result in the few decisions after the Act’s enactment was that such a person would only owe duties in respect of the directions or instructions which had constituted it a shadow director.

The court followed the recent trend. It was “quite clear” based on both the wording of the Act and on the more recent authorities that the full range of fiduciary duties owed by a de jure director are not imposed on a person that qualifies as a shadow director. That is because a person can acquire the status of a shadow director by giving instructions or directions in relation to only part of a company’s business or affairs. For that reason, the shadow director’s duties must be limited to the aspects of the company’s business or affairs which were affected by his directions or instructions.

A shadow director does not, therefore, owe a general duty to act in the best interests of the company. For a shadow director to be in breach of fiduciary duty, it must be shown that the failure to act in the best interests of the company was linked to a matter on which the shadow director had given directions or instructions.

Anticipating this result, the claimants sought to argue that, in this case, the directions or instructions of Mr Sondhi and West Register were sufficiently linked to their alleged breaches. The court rejected that argument. The pleaded acts of Mr Sondhi and West Register were general in nature – they related, for example, to the conduct of board meetings and the promotion of the restructurings. However, the alleged breaches of duty on which the claimants relied related to the pursuit and implementation of the restructurings. The claimants did not allege that either Mr Sondhi or West Register had given any instruction or direction to implement the restructurings, so they could not be liable for a breach in relation to their pursuit or implementation.

The court also rejected an argument that the directions or instructions of Mr Sondhi and West Register had caused the appointment of a turnaround consultant as the Company’s chairman, and that his appointment had ultimately caused the Company then to enter into the restructurings. The claimants were unable to point to anything in their statements of case which alleged how the direction or instruction to the board of the Company to appoint a chairman was said to have caused the Company at some time later to enter into the restructurings. That was particularly so where the chairman had only been appointed after the first restructuring. While Mr Sondhi was alleged to have promoted the restructurings and to have refused to agree to alternatives to it, it was not pleaded that either of these events was caused by the instruction or direction to appoint the chairman.

The judge further held that the application of commercial pressure by Mr Sondhi and West Register so as to leave the Company with no choice but to carry out the acts which they promoted was not the same as Mr Sondhi or West Register giving an instruction or direction from which the status of shadow directorship could flow.

It followed that all of the unlawful means on which the claimants relied were struck out. Their claim in conspiracy could not, therefore, succeed.

Comment

The decision will provide useful guidance and some comfort to financial institutions. Even if they, or their subsidiaries, employees or representatives, are found to have given directions or instructions which constituted them shadow directors of a customer, that will not mean that the bank then automatically owes all of the duties of a de jure director, including a duty to act in the best interests of the customer and not the institution’s own interests.

Instead, the court will undertake a qualitative assessment of the specific directions or instructions given by the financial institution and the duties which ought to attach to them. While it is possible that the directions or instructions pervaded all aspects of a company’s business so that general duties of directorship will be owed, where the directions or instructions are specific to particular acts of the company or areas of its business, the duties of the financial institution will be limited accordingly.

The decision also clarifies that there must be a specific direction or instruction. The application of commercial pressure is not sufficient. Further, the direction or instruction must be directly linked to the act which is said to have been a breach of fiduciary duty. It is not enough that the direction set off a sequence of events which resulted in a breach of duty. That is particularly so where the directors of the Company are required by their own duties to take decisions in relation to those events as they unfold – the appointment of a turnaround consultant as chairman did not cause all of the events which followed.

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Court of Appeal gives guidance on scope of fiduciary duty in “secret commissions” case

The Court of Appeal has found that there was no breach of fiduciary duty where an introducing broker failed to inform its client investors of the amount of commission it received from the financial institution to which it had introduced them: Medsted Associates Ltd v Canaccord Genuity Wealth (International) Ltd [2019] EWCA Civ 83.

This decision represents a novel application of the law in this area and it offers helpful guidance as to the scope of the fiduciary duty that may be owed by an agent to its principal to disclose commission payments. The Court of Appeal confirmed the following general principles of broader application:

  • A principal’s knowledge of its agent’s remuneration may limit the scope of the fiduciary duty that the agent owes to its principal to disclose that remuneration.
  • Generally speaking, where a principal knows that its agent is being paid by another party, it cannot complain that it did not know the precise particulars of the amount paid.
  • However, where there is no trade or customary usage, the principal’s knowledge of the commission may need to be “more specific“. Considering the specificity of knowledge required by a principal, the Court of Appeal noted two factors relevant in the present case:
      • Sophistication of the principal – in this case the investors were wealthy and experienced investors.
      • Degree of secrecy – the commission was less “secretive” because the investors knew that all the commission payable to the broker was payable bythe financial institution (the investors did not pay any commission to the broker themselves, they only paid commission to the financial institution).

In the present case, the Court of Appeal concluded that there was no duty on the broker to disclose to the investors the actual amount of the commission it received from the financial institution. The broker’s failure to disclose the amount of commission it received did not, therefore, represent a breach of the broker’s fiduciary duty.

Background

Collins Stewart (now called Cannacord Genuity, the defendant) is an investment firm. It entered into an introducing agreement with a broker, Medsted (the claimant), under which Medsted would introduce investors to Collins Stewart. The agreement provided that Medsted would be paid a proportion of the commission received by Collins Stewart from introduced investors. The agreement contained a non-circumvention term prohibiting Collins Stewart from dealing with introduced investors directly (this was a point of dispute between the parties, but confirmed by the High Court, see below).

Medsted successfully introduced 16 investor clients who traded through Collins Stewart. Subsequently however, Collins Stewart did business with some of them directly, cutting Medsted out of its share of the commission.

High Court Decision

The High Court found that Collins Stewart was in breach of its obligation not to circumvent Medsted by dealing directly with investors introduced by it, and Medsted had suffered loss by missing out on the payments to which it was entitled. However, the High Court awarded nominal damages, because it found that Medsted owed fiduciary duties to the introduced investors, which it had breached by failing to tell the investors of the precise split of commission as between Collins Stewart and Medsted. In this context a key finding of fact by the High Court was that the investors did not pay a commission to Medsted and so must have assumed that Medsted was receiving payment from Collins Stewart, to which the investors did pay commission (this point was not appealed).

Notwithstanding the above finding of fact, the High Court described the payments from Collins Stewart to Medsted as a “secret commission” and denied any substantive recovery on public policy grounds, because otherwise the court would be assisting Medsted to profit from its own breach of fiduciary duty. Medsted appealed.

Court of Appeal Decision

The Court of Appeal upheld Medsted’s appeal, finding that it had not acted in breach of the fiduciary duty it owed to the introduced investors by failing to inform them of the amount of commission it received. In particular, it looked at whether it was within the scope of Medsted’s duty to the investors to inform them how the commission was to be divided between itself and Collins Stewart.

The Court of Appeal in this case considered authority of the same court in Hurstanger Ltd v Wilson [2007] 1 WLR 2351. In Hurstanger, additional commission was paid by a lender to a broker, over and above what had been expressly agreed between the lender and borrower, but a pre-contractual document stated that “in some circumstances this company [a lender] does pay commission to brokers“. The borrower alleged that the additional commission paid to its broker amounted to a “secret commission“. The Court of Appeal in Hurstanger made the following observations/findings:

  • It noted the serious consequences of finding that a secret commission has been paid which, in addition to amounting to a breach of fiduciary duty, is a category of fraud.
  • It questioned whether there was a “half-way house” between the situation where there has been sufficient disclosure to negate secrecy, but nevertheless the principal’s informed consent has not been obtained – because a finding of fraud would be unfair where there has been only partial or inadequate disclosure.
  • The Court of Appeal ruled that it was a “half-way house” case: the pre-contractual document was sufficient to negate secrecy, but insufficient to obtain the borrowers’ informed consent, because – among other things – the lender should have informed the borrower of the amount of the commission. It found that this amounted to a breach of fiduciary duty by the broker, but not the payment of a secret commission.

Applying Hurstanger to the present case, the Court of Appeal held that the investors’ knowledge of Medsted’s remuneration by Collins Stewart, meant that the scope of Medsted’s fiduciary duty to the investors was limited.

Referring to Bowstead & Reynolds on Agency (21st edition; 2018), the court said that where a principal knows that its agent is being paid by the opposite party, it cannot complain that it did not know the precise particulars of the amount paid. Where there is no trade or customary usage, the principal’s knowledge of the commission may need to be “more specific“. Considering the specificity of knowledge required by the investors in the current case, the Court of Appeal noted two principal distinctions with Hurstanger.

  1. Sophistication of the principal – The court noted that an important factor in Hurstanger was the unsophisticated nature of the borrowers, whereas the investors in the present case were wealthy and experienced investors.
  2. Degree of secrecy – Moreover, the commission was less “secretive” than in Hurstanger because the investors knew that all the commission was payable by Collins Stewart; there was no question that any extra commission was being paid over and above what had been agreed.

The court concluded that there was no duty on Medsted to disclose to the investors the actual amount of the commission it received from Collins Stewart. Medsted’s failure to disclose the amount of commission it received did not, therefore, represent a breach of the broker’s fiduciary duty (unlike in Hurstanger, in which the Court of Appeal held that the fiduciary duty had been breached, although the payments in question did not amount to secret commissions).

The Court of Appeal therefore allowed the appeal.

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Sharp & Ors v Blank & Ors: Directors’ duties owed to company not shareholders when seeking shareholder approval for transaction

In a recent decision in the Lloyds shareholder litigation, the High Court has struck out a number of aspects of the claims against the defendant directors based on alleged fiduciary duties to shareholders: Sharp & Others v Blank & Others [2015] EWHC 3220 (Ch). Herbert Smith Freehills is acting for Lloyds and the director defendants.

The decision helpfully confirms that, in general, directors owe fiduciary duties to the company rather than directly to shareholders when providing information to shareholders about a transaction. It recognises that broader fiduciary duties can arise in exceptional circumstances where, on the facts of a particular case, there is a “special relationship” between the director and the shareholders. However, that special relationship must be something over and above the usual relationship that any director of a company has with its shareholders. It is not enough that the director, as a director, has greater knowledge of the company’s affairs or that the directors’ actions have the potential to affect the shareholders; as the court commented, these factors will almost always be present.

The judgment underlines the difficulty of establishing a direct fiduciary duty to shareholders in the context of a large, listed company with large numbers of shareholders. As the decision recognises, it is no accident that the cases in which such a duty has been held to exist mostly concern small, closely held companies where there is often a family or other personal relationship between the parties. As the court commented, the present case is a long way removed from that paradigm case.

That does not however mean that the directors of large, listed companies do not owe any duties to shareholders in providing information about a transaction. As the defendants accepted in the present case, directors do owe a duty to provide shareholders with sufficient information to enable them to make an informed decision as to how to vote at a shareholder meeting, as well as a duty to take reasonable care in making certain statements or recommendations.

Background

The decision arises from shareholder litigation brought in connection with Lloyds’ acquisition of Halifax Bank of Scotland (HBOS) and the connected recapitalisation of the enlarged group at the height of the financial crisis. The acquisition and recapitalisation required the approval of Lloyds’ shareholders.

The claimants, a group of individual and institutional shareholders in Lloyds, are bringing proceedings against five former directors of Lloyds and Lloyds itself. They allege that the directors breached fiduciary and other duties owed directly to shareholders when advising them that the acquisition and recapitalisation were in their best interests, and in procuring shareholders’ approval of the transactions on the basis of misleading information and the concealment of the true financial position of HBOS.

Specifically they allege that:

  1. the circular which Lloyds sent to its shareholders ahead of the general meeting to approve the acquisition contained material misstatements and omissions which led to it being misleading; and
  2. the directors’ recommendation to shareholders that they vote in favour of the resolutions was in breach of duty given what they knew about HBOS’s financial position at the time.

The claimant shareholders say that, as a result of (i) and (ii), the directors were in breach of various tortious and fiduciary duties which they owed to the claimants.

In this application, the defendants applied for summary judgment/strike out in respect of the claimants’ allegation that the directors owed shareholders a series of broad fiduciary duties.

The defendants pointed to the well-established principle that the directors of a company owe fiduciary duties to the company and, in general, do not owe such duties to individual shareholders. While accepting that there are exceptions to this general principle (for example if directors acquire shares from shareholders with knowledge, gained as a director, as to the true value of the acquired shares), the defendants argued that the claimants had not identified any special circumstances which gave rise to fiduciary duties being owed by the directors of Lloyds directly to the shareholders in the period leading up to the shareholder meeting.

The defendants did accept that they owed the shareholders a duty in equity to provide them with sufficient information to enable them to make an informed decision as to how to vote at the EGM as well as a duty to take reasonable care in the provision of the recommendation to vote in favour of the resolutions.

Decision

Mr Justice Nugee said it was established law that directors do not owe fiduciary duties to a company’s shareholders simply because they are directors, but only where, on the facts of the particular case, a special relationship exists between the director and the shareholders.  This may be some personal relationship or a particular dealing or transaction between them.

In this case, the claimants had failed to plead any special relationship between the directors and the shareholders of Lloyds of the sort required by the authorities. All the pleaded facts really amounted to was that the directors, who knew more about the company than the shareholders, were giving the shareholders advice and information to enable them to decide how to vote at the forthcoming EGM. That was the only relationship pleaded and it did not give rise to the broad fiduciary duties alleged. The judge said:

The relationship is one of giving advice and information for a particular purpose: there is nothing here which as far as I can see comes close to a relationship where the directors have in any more extended sense undertaken to act for or on behalf of the shareholders in such a way as to give rise to a duty of loyalty, or have undertaken an obligation to put the interests of shareholders first, or are themselves entering into transactions with the shareholders, or where there are any of the other hallmarks of a fiduciary relationship.”

Accordingly, the fiduciary duty claims were struck out.

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Broker breached fiduciary duty by not disclosing sum of commission received

The Court of Appeal has held that a credit broker was in a fiduciary relationship with borrowers, with the consequence that the broker breached its fiduciary duty when it failed to inform the borrowers of the size of commission it received from the loan and PPI providers involved. As a result, the credit provider had to account to the borrowers for those commissions.

The court found that the duty had been breached despite the existence of both: 1) clear statements in the contractual documentation to the effect that the broker was providing information only and not advice; and 2) disclosure of the fact that the credit broker was likely to receive commission for the sale.

It should be noted that the Court of Appeal commented that this case was a “very unsuitable vehicle” by which to resolve the issues of principle involved due to the fact that the defendant (which was in liquidation) was unrepresented.

McWilliam v Norton Finance (UK) Ltd (t/a Norton Finance (In Liquidation)) [2015] EWCA Civ 186 

Summary

Norton Finance UK Limited (“Norton”) offered credit broker services. The McWilliams, who had a history of debt problems, used Norton’s service to obtain a consumer loan in the sum of £25,500 to consolidate their credit card debt and to fund the building of a conservatory. The McWilliams also took out payment protection insurance (“PPI”), which together with the ‘broker fee’ of £750 and ‘completion fee’ of £500, which was payable to Norton by the McWilliams, brought the total amount borrowed to £30,495. Of this total, £5,610.25 represented fees and commission, while 62.6% of the £3475 PPI premium constituted commissions.

The leading judgment, with which the rest of the Court agreed, was given by Tomlinson LJ. The Court found that, despite no express contractual term to that effect, on the facts a contract of agency existed between the parties (following the recent Plevin v Paragon Personal Finance Limited (Appellant) [2014] UKSC 61 (“Plevin“) decision). In so doing, the Court overturned the first instance judge’s finding on this point.

However, this was not conclusive as to the question of whether there was a fiduciary relationship. Tomlinson LJ considered that the relevant question was “whether Norton was acting in a capacity which involved the repose of trust and confidence” and that a critical factor in this determination was the financial sophistication or otherwise of the borrowers. In this respect, the Court found that although the McWilliams were not classed as “non-status borrowers” – which is a term applied to borrowers with impaired or low credit ratings who would find it difficult to obtain credit from traditional sources – the McWilliams were nonetheless “not financial sophisticates“. Rather, “they were people of relatively modest means with a history of credit problems. They were vulnerable, in that they had debt which was for them substantial in respect of which they needed assistance in finding a loan to ease the burden of servicing that debt and to put them in a position where they could carry out an improvement to their home“.

Quoting from the Arklow Investments Limited v Maclean [2000] 1 WLR 594 and Bristol and West Building Society v Mothew [1998] Ch 1 decisions, the Court found that the present case constituted a paradigm instance of a fiduciary relationship. As a result, Norton’s duty to its client and its own interest could not be allowed to conflict and nor could it profit from its position without its clients’ informed consent.

When Mrs McWilliams spoke with an employee of Norton, she was informed that Norton did not provide advice, only information. Additionally, Norton’s Keyfacts document stated that it was an information only sale. However, Norton’s Group Compliance Manager gave evidence to the effect that Norton delivered its brokerage service by obtaining certain relevant information from the borrowers, inputting it into a computer program which generated matching loan options and then informing the applicant about the loan with the most competitive rate. On this basis, Tomlinson LJ concluded that Norton had, at the very least implicitly, told the McWilliams that the terms offered by the relevant lending company “were the most competitive to which they had access“. While Tomlinson LJ acknowledged that this did not amount to a recommendation of suitability in the regulatory sense of the concept employed by the FCA, he considered that it was an indication that “what was being offered was the best possible deal“. As a result, the Court considered that the Hurstanger Limited v Wilson[2007] 1 WLR 2351 (“Hurstanger”) decision provided relevant authority. In this respect, the Court overturned the first instance judge’s finding that Hurstanger ought to be distinguished “on the basis that Norton offered no advice or recommendation“. Instead, the Court considered that there was no indication that the broker in Hurstanger had “offered any advice or recommendation that went beyond that which was effectively given here by Norton“. The Court also considered that whether or not the broker provided advice was not a critical feature in determining whether a fiduciary duty had been assumed.

The Court then turned to the question of whether the borrowers’ informed consent to the broker receiving commission had been obtained. The application form which Mrs McWilliams had completed included an acknowledgment that Norton would receive and could retain commission. Additionally, Norton had sent the McWilliams a copy of the standard form FISA Borrower Information Guide, which stated that brokers were likely to receive commission from lending companies. However, Norton did not inform the McWilliams of the actual quantum of any of the commission payments it received. Applying Hurstanger, the Court held that the provision of information as to the size of the commission payments was necessary in order to “bring home” the potential conflict to the borrowers. It followed that the borrowers’ informed consent had not been given and the Court ordered that the commission sums received by Norton (together with interest) were to be paid to the McWilliams.

Observations

While it is difficult to say that the outcome in this case was not just, it appears likely that the decision will be restricted to its own facts, not least because of the Court’s comments regarding its unsuitability as a vehicle for considering the relevant points of principle.

If the decision does have any wider applicability beyond its own facts, it would appear to only be in circumstances where:

  • there is a contract of agency (express or implied);
  • the borrowers are vulnerable and financially unsophisticated retail customers;
  • they are relying on the agent to the extent that they are vulnerable to any disloyalty by that agent to them; and
  • the agent has not obtained their informed consent to the specific amount of commission which is received.

The requirement that, for informed consent to be obtained, the quantum of any commission payments must be disclosed to the prospective borrowers resembles the finding in the Plevin decision. In that case, the Supreme Court found that, although the FCA’s Insurance Conduct of Business Rules (“ICOB”) had not required disclosure of the size of commission payments, failure to do so where these were particularly high had fallen foul of the ‘fairness’ requirement under the Consumer Credit Act 1974 (“CCA”). It is interesting to note that in reaching the decision in Plevin, the Supreme Court overruled a decision of Tomlinson LJ in Harrison v Black Horse Ltd [2012] Lloyd’s Rep IR 521, to the effect that the fact ICOB did not require disclosure of the size of any commission paid was decisive and so no conflict of interest had arisen.

The fiduciary duties identified in this case create a greater level of protection for consumers under equitable principles than is currently provided for by the FCA with respect to consumer credit regulation. Whilst the FCA implemented new rules on 2 January 2015 controlling the upfront fees that credit brokers can charge retail customers, and the FCA’s Consumer Credit Rules (CONC) provide that the existence of commission must be disclosed by credit brokers (CONC 4.5.3), they do not require the amount of commission to be disclosed unless the customer asks for that information. Furthermore, Tomlinson LJ acknowledged that the implicit representation by Norton that what was being offered was the best deal fell short of being advice in the regulatory sense. That this could amount to regulated advice is not envisaged by CONC.

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Structured credit products – key Australian decisions

In late 2012, the Federal Court of Australia handed down first instance judgments in two interesting cases involving claims brought by the purchasers of structured credit products prior to the widespread dislocation in the global market for such products. Each involved questions relating to the liability of those that structure and sell structured credit products and of the rating agencies that issue credit ratings to such products.

The striking findings include findings of liability against a credit rating agency and will be of interest and relevance to participants in the markets for structured products in the United Kingdom and beyond.

Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in Liquidation)1

Wingecarribee involved a class action brought by three Australian local councils (Wingecarribee, Swan and Parkes) against an Australian subsidiary of Lehman Brothers (“LBA”) in relation to the purchase by the councils from LBA of a number of synthetic CDOs in the years between 2003 and 2008. For the first few years of the relationship, the CDO investments which the councils made were successful, in that they caused no material losses and generated satisfactory returns (and an improvement on the council’s previous investments in term deposits and floating rate notes).

However, when the market dislocation took hold in 2007 (by which time two of the councils had entered into individual managed portfolios (“IMPs”) with LBA), a number of the investments the councils had made had suffered significant losses. In particular, three of the synthetic CDOs which they had purchased had lost their entire value, and others had suffered material losses of capital. In addition, the councils’ investments in the Dante series of notes were effectively in limbo pending the resolution of an impasse between the London and New York courts concerning the effectiveness of the notes’ so called ‘flip’ provisions (which affect the priority of payments between the noteholders and the swap counterparty and therefore the value of the notes).

Between them, the councils claimed that LBA had breached its contract with them on the basis that the synthetic CDOs did not have the characteristics which had been promised in that LBA had said that they were suitable for a conservative investment strategy, that they were liquid, and that the high credit ratings they had been given placed them in the same investment ‘universe’ as Australian government and large bank debt. The two councils who had entered into IMPs with LBA further alleged that the synthetic CDOs breached the IMP agreements because they were not appropriate investments, and (in breach of the investment guidelines) they were investments: (i) for which there was no active secondary market; and (ii) which were derivatives.

In addition, the councils claimed that LBA had breached its fiduciary duties as an investment adviser in recommending products the sale of which LBA would benefit from without disclosing that fact to the councils. Finally, they each claimed for breach of an Australian-specific consumer protection provision of statute which creates strict corporate liability for misleading or deceptive conduct.

The Federal Court found that LBA was liable to the councils in respect of each of these claims and therefore for damages on the following bases:

  • the councils’ full loss incurred for those notes that had been wiped out;
  • the difference between par and what the councils received for those notes that had matured (or that the councils had sold) at less than par;
  • the difference between the current value and par of those notes the councils still held; and
  • immediate payment of the net present value of the Dante notes (which, artificially, was calculated by averaging the differing outcomes dependent on whether the conclusions of the New York or UK courts prevailed).

Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)2

The second case was also a class action, this time brought by a group of 13 Australian local councils and Statecover, a local government workers’ compensation insurer. These claims were for negligent misrepresentation (and breach of the Australian statutory prohibition on misleading or deceptive conduct).  However, the claims were brought against each of the councils’ financial advisor (LGFS), the arranging bank (ABN Amro) and the rating agency (S&P) in relation to the Rembrandt 2006-2 and 2006-3 series of notes, which were Australian dollar denominated issues of constant proportion debt obligations (CPDOs) created by ABN Amro.

The CPDOs were ten year notes which had, as their reference assets, a pool of Credit Default Swaps (CDSs) based on the constitution of the CDX and iTraxx indices (which together were known as the Globoxx index). The CDX and iTraxx indices were created in 2003 and sought to consist of CDS contracts with the 125 most liquid investment grade obligors consistent with a diversified industry make-up.

In simple terms, the performance of the notes depended on the interaction between the mark-to-market prices of the underlying CDS contracts on the one hand, and the income from CDS premiums which the structure generated on the other, as the bid-offer spreads on those CDS contracts rose or fell. It was explained by one of the experts at trial that the theory behind the structure was the tendency of credit spread curves to exhibit ‘mean reversion’, by which it is meant that, whether they go up or down in the short term, spreads tend to revert to a long term mean.

Unlike corporate obligors or country debt, for which the rating agency has a substantial amount of observable data on which to base its rating, S&P’s methodology for rating structured products such as CPDOs placed heavy reliance on the use of quantitative modelling. This typically involved running a very large number of stochastic simulations, known as a Monte Carlo process, to predict what the default probability of the particular product would be (from which, subject to a further qualitative exercise, a credit rating would be derived). Inherent in this is that, in order to run the simulations, the rating agency will have to make a number of assumptions (or model inputs). Rating the CPDOs involved S&P applying a number of different inputs into the model:

  • The starting, or initial, CDS spread;
  • The long term average spread (LTAS) (i.e. the assumption made as to the mean to which spreads will tend to revert in the long run);
  • The Mean Reversion Speed (i.e. the speed at which spreads will tend to revert to the LTAS); and
  • The volatility of spreads (i.e. how far they will move up or down before reverting to the LTAS).

Prior to the rating of the Rembrandt 2006-3 series of notes, S&P had rated earlier iterations of ABN’s CPDO product on assumptions which were criticised by the judge as not having been what a reasonable and competent rating agency would have adopted to rate the notes. In summary, some of the inputs used by S&P were found to have been overly optimistic assumptions, whilst others were found to have been “arbitrary, irrational and unreasonable“. Overall, the rating process failed to ensure that the performance of the CPDOs was modelled on the basis of market conditions which were reasonably anticipated (non-stressed) as well as exceptional but plausible (stressed).

The net result of these failings was that the earlier CPDOs had received an AAA rating from S&P which, on standards of reasonable competence, no rating agency would have given them. On behalf of one of its clients, Statecover, LGFS purchased AUS$10m of one such note (the AAA-rated Rembrandt 2006-2 CPDO notes) from ABN Amro.

Towards the end of 2006, LGFS was looking for financial products it could market to its clients to compete with its competitors’ successful marketing of CDO products to local councils, which had caused LGFS’s profits to plummet in recent years. In that context, the Rembrandt 2006-3 note was created by ABN Amro specifically for LGFS for the purposes of on-selling to its clients. As such, it needed to be issued with an AAA rating from S&P.

The judge found that, notwithstanding material changes to the market conditions, S&P nevertheless assigned the notes an AAA rating (and had allowed the rating to be disseminated to potential investors) on the basis that ABN Amro had described the notes as a carbon-copy of the series 2 notes. Significantly, S&P did not carry out any modelling of the series 3 notes for the purpose of the rating. The judgment cites contemporaneous evidence of a concern about the ratings process within S&P, referring to an internal S&P email in which one senior ratings analyst described the rating as “analytical bs at its worst. I know how these ratings came about and they had nothing to do with the model!

The 13 councils between them purchased AUS$16m of the Rembrandt 2006-3 notes, with LGFS retaining a further AUS$24m on its balance sheet. However, the sustained widening of spreads (i.e. in the absence of mean reversion) from mid-2007 caused the notes to fail, initially being downgraded to a BBB+ rating and then finally collapsing, returning less than 10% of the initial capital investment, in October 2008.

The Court found that S&P was liable to the councils and LGFS both for breach of the statutory prohibition on misleading or deceptive conduct and, more interestingly from the perspective of market participants outside Australia, negligent misrepresentation. This was on the basis that the AAA rating was a representation that, in S&P’s opinion, the issuer had an “extremely strong capacity” to meet its obligations and that this opinion was held on reasonable grounds after taking reasonable care.

ABN Amro was also liable to the councils and LGFS on the basis that it had deployed the AAA rating and, in doing so, had made its own representations as to the meaning and reliability of that rating, which amounted both to misleading or deceptive conduct and negligent misrepresentation.

LGFS was also liable to the claimants for, inter alia, negligently advising them that the notes were a suitable investment and for breach of its fiduciary duties to the councils.

Accordingly, LGFS, S&P and ABN Amro were proportionately liable to the claimants for the loss suffered from their investment in the Rembrandt 2006-2 and 2006-3 notes, and S&P and ABN Amro were liable to LGFS for its loss on the retained balance of the 2006-3 notes.

Points of interest

  • The willingness of the Federal Court of Australia to find that a duty of care was owed to investors (and that this duty was breached) by the rating agency, S&P, is especially striking given the absence of any contractual nexus between the parties. This is particularly so given that the development of Australian case law on liability for pure economic loss has tended to follow similar lines (and take into account similar factors) to that in England.
  • S&P’s disclaimers were found to be ineffective on the basis of both their manner of communication to the councils (which was insufficiently prominent given their purported effect) and because the Court found that S&P was attempting to exclude liability to investors who had relied on the rating for their investment decisions in circumstances where S&P had been paid precisely for the provision of an opinion about that investment. It was found that to give effect to the disclaimer would have been to render the rating “meaningless“.
  • The finding of negligent misrepresentation against the selling and structuring banks regarding their deployment of the AAA or AA credit ratings which the relevant products received presents an interesting contrast to the analogous case of CRSM v Barclays3 in the English Courts, in which implied representations about the meaning attributable to a AAA rating were found to be limited to the fact that the products (notes linked to a series of CDO²s) had received such a rating. (Click here for our briefing on the CRSM case).
  • The treatment of LGFS as both an investment adviser to some of the councils, and having owed them fiduciary duties, was on the basis of a prolonged course of conduct, including suggestions that they would act as a ‘trusted adviser’ and was in spite of the absence, for most of the councils, of any formal retainers.
[2012] FCA 1028.
2 [2012] FCA 1200.
Cassa di Risparmio della Repubblica di San Marino S.p.A. v Barclays Bank Ltd [2011] EWHC 484 (Comm)

Damien Byrne-Hill
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